Foreign Corporation’s Tardiness Causes It to Forfeit Deductions

Adams Challenge (UK) Ltd. must forfeit all deductions and credits on its U.S. tax returns, because it didn’t file the returns until several years after the returns were due and the IRS had prepared a return for the corporation.

Adams Challenge was incorporated under the laws of the U.K. Adams Challenge’s only income-producing asset was a support vessel. A U.S. firm chartered Adams Challenge’s vessel to perform work in the Gulf of Mexico. From this charter, Adams Challenge earned gross income of about $45 million. In a prior opinion, the U.S. Tax Court held that that this income was “effectively connected” with the conduct of a U.S. trade or business and was subject to tax under the tax code.

In a subsequent decision, the court ruled that the company was not entitled to deductions and credits and is taxed, therefore, on its gross income effectively connected with its conduct of a U.S. trade or business (Adams Challenge (U.K.) Ltd. v. Commissioner, 156 T.C. No. 2 (2021)).

Adams Challenge did not file federal income tax returns for 2009 and 2010 until February 2017. This was more than two years after the IRS had prepared returns for it under tax code Section 6020(b) and issued the notice of deficiency. Invoking Section 882(c)(2), the I.R.S. contended that Adams Challenge was not entitled to any deductions or credits against its gross income for 2009 and 2010.

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.” See Section 882(c)(1)(A). Since 1928, Congress has conditioned the grant of deductions to a foreign corporation upon its filing of a U.S. income tax return. Section 882(c)(2) provides: “A foreign corporation shall receive the benefit of the deductions and credits allowed to it…only by filing…with the Secretary a true and accurate return, in the manner prescribed in subtitle F.” Section 882(c)(2) does not explicitly require that the return be filed timely, or that a delinquent return be filed by any particular deadline. The question before the court was whether Section 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. This question has been the subject of judicial discussion for almost a century.

In Taylor Securities, Inc. v. Commissioner, the court 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. Treasury Regulation Section 1.882-4(b)(3) (1958) stated: “If a…foreign corporation has various sources of income within the United States and a return of income has not been filed by it…the district director shall (i) cause a return of income to be made, (ii) include therein the U.S. source income…concerning which he has information, and (iii) assess the tax and collect it from one or more of those sources…without allowance for any deductions.”

The statute does not require a foreign corporation to file a timely return in order to preserve its entitlement to deductions and credits. However, the statute does establish a “terminal date” by which such a return must be filed. That terminal date is the date on which the IRS exercises its authority to prepare and subscribe a return for the taxpayer under Section 6020(b). This terminal period for filing a return was not fixed but varied depending on when the IRS got around to exercising its authority.

Regulations promulgated in 1990 made changes to the 1957 regulations:

1. Treasury prescribed a definite deadline for the filing of a return by a foreign corporation where, as here, the current year was the first year for which it was required to file a U.S. return. The filing deadline was “18 months of the due date as set forth in Section 6072” for the filing of a return.
2. If a foreign corporation believed it had no U.S. income tax liability, it was permitted to file a return reporting no gross income or deductions, attaching a statement that the return was being filed for protective reasons. By so doing, it would “protect the right to receive the benefit of…deductions and credits” if it was later determined to have U.S. taxable income.
3. The existence of a bilateral income tax treaty did not immunize a foreign corporation from meeting the filing deadlines.
4. The filing deadline will be waived if the foreign corporation establishes that it acted reasonably and in good faith in failing to file a U.S. income tax return (including a protective return).

The IRS prepared and subscribed returns for Adams Challenge for its 2009 and 2010 taxable years on April 9, 2014. On Nov. 25, 2014, the IRS sent Adams Challenge a notice of deficiency that allowed no deductions. Adams Challenge petitioned the Tax Court on Feb. 20, 2015. Adams Challenge did not submit a “return” for either year until Feb. 15, 2017. Because Adams Challenge failed to file a return for either year within the terminal period established by Section 882(c)(2), it was entitled to no deductions or credits for either year.

Adams Challenge did not seriously dispute that, under the regulations, it was entitled to no deductions for 2009 and 2010. The deadline for filing Adams Challenge’s 2009 return was Dec. 15, 2011, and the deadline for filing its 2010 return was Dec. 15, 2012. Adams Challenge did not file protective returns for those years until Feb. 15, 2017. The regulations provide that the filing deadline may be waived if the foreign corporation establishes to the satisfaction of the IRS that the corporation acted reasonably and in good faith in failing to file a U.S. income tax return (including a protective return). Adams Challenge has not shown that it requested a waiver.

Adams Challenge’s primary contention is that the filing deadline in the regulations is invalid under the U.S. Tax Court’s opinion in Swallows Holding, Ltd. v. Commissioner. In Swallows Holding, the IRS had not exercised its authority to prepare a return for the taxpayer. The taxpayer voluntarily filed returns for all relevant years, but it had neglected to file them within 18 months of the filing date specified in Section 6072, as the regulations required. The court held that the filing deadline set forth in the regulation was invalid.

The U.S. Court of Appeals for the Third Circuit disagreed. The court held that Section 882(c)(2) was ambiguous; and that the filing deadline established by Treas. Reg. Section 1.882-4(a)(3)(i) was “a permissible exercise of Treasury’s authority.” Adams Challenge failed to file its 2009 and 2010 returns by the terminal date established by Section 882(c)(2), namely, the date on which the IRS exercised its authority. Adams Challengewas “thus entitled to no deductions or credits for 2009 and 2010 under the statute without reference to the regulations. We have no need to address the validity of the regulatory filing deadline,” the Tax Court said.

Treaty Is No Help

The Tax Court next considered whether the U.S.-U.K. Tax Treaty compelled a different outcome. It did not. The business profits article of the Treaty provides: “In determining the business profits of a permanent establishment, there shall be allowed as a deduction, expenses that are incurred for the purposes of the permanent establishment.”

Adams Challenge, the court noted, “misapprehends the meaning of the phrase, ’shall be allowed.’” This phrase typically means “shall be allowed so long as certain conditions are met.” Section 882(c)(2) sets forth administrative and procedural conditions limiting the deductibility of business expenses. There is no “clear repugnancy” between Section 882(c)(2) and the treaty. These administrative requirements are not “absolutely incompatible” with the business profits article of the treaty. The statute and the treaty, the court concluded, “can be read harmoniously to give effect to each.” Section 882(c)(2) exists harmoniously with the treaty because U.K. corporations can deduct business expenses while also complying with the statute (i.e., by filing that return before the IRS prepares a return for it).

Under Article 25(1), Adams Challenge had to show that Section 882(c)(2) subjects foreign corporations to more burdensome taxation or to more burdensome requirements “connected therewith.” Adams Challenge urged that Section 882(c)(2) subjected it to more burdensome requirements. Adams Challenge and its domestic counterparts were, the court said, “on a level playing field” with respect to how their U.S. income tax liabilities would be determined. “We give considerable weight here to the interpretations clearly expressed by Treasury and the IRS,“ the court said. Treasury has repeatedly stated that Section 882(c)(2) does not violate the non-discrimination article of the Treaty. The IRS has similarly opined that Section 882(c)(2) and the regulations interpreting it did not violate the non-discrimination article of the Treaty.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.