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I'm just not sure how I come out on this or how I should come out on this. But each time I read the opinion of the U.S. Court of Appeals for the Third Circuit in Swallows Holding, Ltd. v. Comr., No. 06-3388 (2/15/08), a major IRS victory, I debate its conclusion although not necessarily on policy grounds.

Swallows involved a Barbados corporation in the real estate business. It received rental income from an unrelated party for the years 1993-1996 but, although it filed its first tax return in September of 1992, tax returns for the 1993-1996 years were not filed by it until 1999. The issue in the case is the interpretation (or plain meaning, as Swallows would have it) of §882(c)(2) and Regs. §1.882-4(a)(3)(i).

Briefly, §882(c)(2) provides that a foreign corporation may only receive the benefits of allowable deductions and credits if it files a true and accurate tax return “in the manner prescribed in Subtitle F ….” Regs. §1.882-4(a)(3)(i) provides that, if a return was filed for the immediate preceding year, the required return for the current taxable year must be filed within 18 months of the due date set forth in §6072.

The taxpayer filed tax returns for the years in issue well beyond the prescribed period set forth in the regulation, and the IRS proceeded to implement the regulation, disallowing the deductions and asserting deficiencies. Swallows argued that, unlike some other tax statutes, §882(c)(2) was silent as to the required “time” for filing (the statute referring only to the “manner” prescribed for filing rather than the common phraseology of “time and manner” of filing) and that the regulation, therefore, was an invalid exercise of the IRS's rulemaking authority.

The Tax Court in Swallows Holding, Ltd. v. Comr., 126 T.C. 96 (2006), held for the taxpayer, stating that the plain reading of the statute did not impose a “timely” filing requirement (although the ability to file late returns and to secure deductions was not without limit as, for example, where the IRS has already filed substitute returns) and that the regulation was invalid because it was unreasonable in light of the plain meaning of the statute and an application of the factors set forth in National Muffler Dealers Ass'n v. U.S., 440 U.S. 472 (1979). National Muffler established a number of factors that are to be reviewed in determining whether the IRS's interpretive regulation is reasonable, and the Tax Court concluded that Regs. §1.882-4(a)(3) did not meet a number of them, e.g., the regulation was not promulgated contemporaneously with the statute; existing case law had consistently held that the statute did not include a “timely” filing requirement, etc.

In rounding out its decision, the Tax Court also found that the standard set forth in National Muffler had not been replaced by Chevron U.S.A., Inc. v. National Resources Defense Counsel, Inc., 467 U.S. 837 (1984), and that, in any event, the result would have been the same under that case. In Chevron, the Supreme Court concluded that if the interest of Congress is clear, an agency “must give effect to the unambiguously expressed interest of Congress,” but if the statute is silent or ambiguous, the agency's interpretation will be upheld if it is based on a permissible construction of the statute.

The Third Circuit concluded that the Tax Court erred in applying National Muffler to the exclusion of Chevron. In the court's view, the IRS has to be given discretion to provide a regulation (as long as it's reasonable) in order to interpret an ambiguous provision.

The court cited a number of cases (going both ways) that dealt with the issue of whether the term “manner” also includes a timing element; it also cited other sections of the Code which, by IRS regulations, have been interpreted to include a timing element. Moreover, the court determined that “manner” is broad enough to include a possible “timing” element and that one could read the words “in the manner prescribed in subtitle F” to include a timing element or, alternatively, to infer that Congress did not have the timing requirement in mind. As a result, the court concluded that the language of §882(c)(2) is obviously not clear and unambiguous and that the regulation at issue was justified and not unreasonable.

Well, I'm not yet a believer. The Third Circuit cited a number of cases that have “struggled” over the issue, suggesting that the language of the statute is ambiguous, although I'm still not that convinced. Two such cases are representative. Anglo-American Tea Trading Co. v. Comr., 38 B.T.A. 711 (1938), held quite clearly that the predecessor statute to §882(c)(2) should not be read so as to include the concept of time and, in fact, relied on a number of cases holding to that effect. Espinosa v. Comr., 107 T.C. 146 (1986), held that, in the case of the nonresident alien statutory analogue, i.e., §874(a), the language should be read to include the concept of time. But the facts in that case were quite different and fairly egregious and, in fact, the court acknowledged that.

I also find it interesting that we have two statutes, §874(a) and §882(c)(2), and a bunch of predecessor statutes, each of which uses the same language and none of which includes the “time” element. Yet we are led to believe that Congress has not yet “spoken to the precise question at issue,” Huh? And the Swallows appellate court goes on to say that “Congress does not uniformly use the phrase 'time and manner’ when it desires a particular Code provision to embody a timing element.” It seems to me that what Congress desired in this particular case begs the very question we're pondering.

I recognize the contrary argument that we would not be having this running debate if things were all that clear and unambiguous. But I'm not convinced that Congress has not, in fact, spoken to the issue or that we know that it desires §882(c)(2) to embody a timing element. The plain language of both the relevant current and predecessor statutes is quite clear and stands in contrast to those statutes using the term “in the time and manner.” If there were such ambiguity, and if Congress “desired” the time element to be included, why hasn't it yet spoken up over all these years? On the other hand, I suppose one could argue that Congress has specifically chosen not to act in the face of the IRS regulations, thereby reflecting its acquiescence in their interpretation.

I'd like to think that Congress knows what it's doing when it legislates language of a statute and that we don't need external guidance to set us straight. On the other hand, this wouldn't be the first time that Congressional intent needed a little interpretive boost from the IRS or even the courts. Transcending this debate, however, is the question of what the answer in this case should be purely as a policy matter, although, sadly, that has not always been regarded as relevant. Maybe it should be.

This commentary also will appear in the May 9, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz and Plambeck, 908 T.M., U.S. Income Taxation of Foreign Corporations, and in Tax Practice Series, see ¶7120, Foreign Persons' U.S. Activities.