This week the Tax Court in Good Fortune Shipping v Commissioner,148 TC No. 10 upheld regulations relating to the exemption of income from the international operation of ships. Taxpayers are frequently teeing up issues relating to the validity of regulations, and this opinion is an important victory for the government. I will briefly describe the case and the way the Tax Court resolved the dispute.read more...
The statutory scheme under Section 883 (wildly simplified) is that gross income attributable to international shipping activities is exempt from US tax if the foreign country in which the corporation is organized grants an equivalent exemption to corporations organized in the United States. In Good Fortune the owners of the shipping company were in fact residents of a country that did grant a similar exemption, but the shareholders held the stock in bearer form rather than in registered form. The statutory scheme tied the exemption to shares “owned by individuals” of a reciprocating foreign country; the regulations additionally restricted the benefit to shares that were owned in a certain way, and in particular excluded from the possible statutory exclusion scheme shares that were owned in bearer rather than registered form.
Bearer ownership and transferability is generally evidenced by physical delivery; registered form ownership ties ownership to a name that is registered with the corporation or its agent. US tax law has generally frowned on conveying benefits that are dependent on residence of ownership when shares or securities are held in bearer form for the obvious reason that it is easy to circumvent rules that are meant to tie exclusions or reduced withholdings on beneficial ownership in a particular jurisdiction when ownership can be conveyed just by possessing the security. Bearer form ownership promotes privacy, which is a value that tax agencies weigh quite differently than taxpayers.
In Good Fortune, in upholding regulations that essentially stated that bearer shares of a foreign corporation may not be taken into account in establishing the ownership of the stock of the foreign corporation, the Tax Court, applying the two-step Chevron analysis, leaned heavily on Mayo in finding that Congress had not spoken directly on the issue (step 1) and ultimately concluded that the regulations in place for the year in question were a permissible construction of the statute (step 2).
In finding that the precision needed was lacking in Step 1 the opinion emphasized that there was a legislative gap in how to prove ownership:
The words “owned by individuals” in section 883(c)(1) do not, as petitioner appears to acknowledge, explain or otherwise address how to establish ownership by individuals for purposes of section 883(c)(1), let alone how to establish ownership where the shares of the foreign corporation are owned in bearer form. The dictionary definitions of the word “own” on which petitioner relies which petitioner claims are unambiguous definitions, do not address the problem under section 883(c) of determining how to establish ownership by individuals for purposes of section 883(c)(1) that the Internal Revenue Service (IRS) confronts when it examines a return of a foreign corporation seeking the benefits of section 883(a)(1) for a prior taxable year
Upon reaching Step 2, the opinion looked to legislative history to 1986 statutory changes that tied the reciprocal exemption to corporate ownership rather than just the location of where the ship was registered:
A foreign corporation’s entitlement under section 883(a)(1) to exclude certain income from gross income and exempt that income from U.S. tax no longer was based solely upon the country in which the foreign corporation’s vessel was registered or documented. Instead, Congress added in its amendment of section 883 in the 1986 Act a second hurdle to that favorable treatment by enacting section 883(c) in order to curb abuse by residents of certain foreign countries who owned stock in a foreign corporation that was seeking the benefits of section 883(a)(1) where those foreign countries did not provide an equivalent exemption to U.S. corporations.
With that context the opinion discussed how bearer shares, which tie ownership to physical delivery, “make it virtually impossible to know who the actual shareholders or owners of a corporation are because the only proof of ownership is physical possession at a particular point in time of the paper bearer share certificate.” The absence of a registry contributes to ownership anonymity. As such, it was a short step for the court to conclude that the regs passed muster under Step 2:
We conclude that the bearer share regulations do not contravene section 883(c)(1) but are a reasonable construction of that section which provides the IRS with the appropriate tools needed to enforce section 883. The bearer share regulations provide certainty and resolve the difficult problems of proof associated with establishing ownership of bearer shares, especially for prior taxable years. In not allowing bearer shares to be taken into account in establishing the ownership of the stock of a foreign corporation for purposes of determining whether the foreign corporation is described in section 883(c)(1) and thus whether it is entitled to the benefits of section 883(a)(1), the bearer share regulations set forth a sensible approach to effecting the intent of Congress in enacting section 883(c)(1) to ensure that abuse will not occur which will result in certain types of shipping transportation income described in section 883(a)(1) not being taxed.
Good Fortune shows how in the absence of statutory detail on implementation, agencies have considerable discretion in promulgating rules, especially true when the rules relate to exemptions, which as the Tax Court noted here, are to be interpreted narrowly.