Consistency and the Validity of Regulations

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Guest contributor Monte Jackel discusses guaranteed payments and how differing regulations inconsistently approach whether such guaranteed payments are indebtedness. While the post highlights substantive technical issues it also flags a procedural issue: the difficulty in challenging tax regulations outside normal tax enforcement procedures. That procedural issue, present in the current teed up Supreme Court case CIC v Commissioner which is now set for oral argument on December 1, as Monte suggests and as I discussed last year in Is It Time To Reconsider When IRS Guidance Is Subject to Court Review?, may call for a legislative fix. Les

How can a guaranteed payment on capital under section 707(c) of the Internal Revenue Code be both an actual item of “indebtedness” if, but only if, there is a tax avoidance motive for purposes of section 163(j)’s limitation on business interest expense but only be “equivalent to” but not actually be indebtedness for purposes of the foreign tax credit? Well, if you are the IRS with the “pen in hand”, anything is possible.

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Section 163(j)(5) defines “business interest” for purposes of section 163(j) as “any interest paid or accrued on indebtedness properly allocable to a trade or business.” Thus, the key term here is “indebtedness”. More on that later. 

Similarly, income equivalent to interest is referenced in section 954(c)(1)(E) and in regulation §§1.861-9(b)(1) and 1.954-2(h)(2) and specifically refers to guaranteed payments on capital as equivalent to interest expense at regulation §1.861-9(b)(8). On the other hand, the very same guaranteed payment on capital is treated as actual interest expense under regulation §§1.469-2(e)(2)(iii) and 1.263A-9(c)(2)(iii). 

It is very hard to either see or to justify treating guaranteed payments on capital under section 707(c) as both actual interest expense or as equivalent to interest expense for purposes of different provisions of the Internal Revenue Code. Either a guaranteed payment represents interest on indebtedness under all provisions of the Internal Revenue Code or it does not, unless a specific provision of the Code expressly treats guaranteed payments on capital a certain way. Merely because a statute or implementing regulation treats a guaranteed payment on capital as equivalent to interest does not mean that it can be both actual indebtedness for some but not all provisions of the Code and as equivalent to but not actual interest on indebtedness for purposes of other provisions of the Code. 

The recently finalized foreign tax credit regulations, T.D. 9922, had this to say about the issue:

The Treasury Department and the IRS have determined that guaranteed payments for the use of capital share many of the characteristics of interest payments that a partnership would make to a lender and, therefore, should be treated as interest equivalents for purposes of allocating and apportioning deductions under §§1.861-8 through 1.861-14 and as income equivalent to interest under section 954(c)(1)(E). This treatment is consistent with other sections of the Code in which guaranteed payments for the use of capital are treated similarly to interest. See, for example, §§1.469-2(e)(2)(ii) and 1.263A-9(c)(2)(iii). In addition, the fact that a guaranteed payment for the use of capital may be treated as a payment attributable to equity under section 707(c), or that a guaranteed payment for the use of capital is not explicitly included in the definition of interest in §1.163(j)-1(b)(22), does not preclude applying the same allocation and apportionment rules that apply to interest expense attributable to debt, nor does it preclude treating such payments as “equivalent” to interest under section 954(c)(1)(E). Instead, the relevant statutory provisions under sections 861 and 864, and section 954(c)(1)(E), are clear that the rules can apply to amounts that are similar to interest.

OK, so the IRS is saying here that a guaranteed payment on capital is not and does not have to “indebtedness” for the item to be treated the same as interest expense under the enumerated statutory provisions. This is so without regard to there being a tax avoidance reason for the taxpayer to have used a guaranteed payment on capital instead of actual indebtedness. Technically true in the case of the enumerated provisions but does it make good policy sense or is it merely “talking out of both sides of your mouth” and, thus ultra vires? 

Take a look at how guaranteed payments on capital recently fared under the final section 163(j) regulations (T.D. 9905). The final regulation preamble had this to say about the issue:

Proposed §1.163(j)-1(b)(20)(iii)(I) provides that any guaranteed payments for the use of capital under section 707(c) are treated as interest. Some commenters stated that a guaranteed payment for the use of capital should not be treated as interest for purposes of section 163(j) unless the guaranteed payment was structured with a principal purpose of circumventing section 163(j). Other commenters stated that section 163(j) never should apply to guaranteed payments for the use of capital….In response to comments, the final regulations do not explicitly include guaranteed payments for the use of capital under section 707(c) in the definition of interest. However, consistent with the recommendations of some commenters, the anti-avoidance rules in §1.163(j)-1(b)(22)(iv)…include an example of a situation in which a guaranteed payment for the use of capital is treated as interest expense and interest income for purposes of section163(j).

Without getting into the merits of the example the IRS added to the anti-avoidance rule, suffice it to say that acting “with a principal purpose” of tax avoidance in preferring a guaranteed payment on capital to actual interest on indebtedness is a very low barrier for the IRS to meet. After all, “a principal purpose”, based on existing authority is merely an important purpose but need not be the predominant purpose and the test can be met even if there is a bona fide business purpose for using the guaranteed payment in lieu of actual indebtedness and even though the transaction has economic substance. 

But what about how the U.S. Supreme Court and the IRS itself treated a short sale for purposes of interest deductibility and the unrelated business income tax, respectively? In Rev. Rul. 95-8, 1995-1 C.B. 107, the issue was whether a short sale of property created “acquisition indebtedness” for purposes of the unrelated business income tax under section 514. The IRS concluded, in a revenue ruling that is still outstanding, that the answer was no:

Income attributable to a short sale can be income derived from debt-financed property only if the short seller incurs acquisition indebtedness within the meaning of section 514 with respect to the property on which the short seller realizes that income. In Deputy v. du Pont, 308 U.S. 488, 497-98 (1940), 1940-1 C.B. 118, 122, the Supreme Court held that although a short sale created an obligation, it did not create indebtedness for purposes of the predecessor of section 163.

In turn, the U.S. Supreme Court had this to say about what is “indebtedness” under the Internal Revenue Code (Deputy v. du Pont, 308 U.S. 488 (1940)): 

There remains respondent’s contention that these payments are deductible under § 23 (b) as “interest paid or accrued . . . on indebtedness.” Clearly [the taxpayer] owed an obligation….But although an indebtedness is an obligation, an obligation is not necessarily an “indebtedness” within the meaning of § 23 (b)…. It is not enough….that “interest” or “indebtedness” in their original classical context may have permitted this broader meaning.  We are dealing with the context of a revenue act and words which have today a well-known meaning. In the business world “interest on indebtedness” means compensation for the use or forbearance of money. In [the] absence of clear evidence to the contrary, we assume that Congress has used these words in that sense. (footnotes omitted). 

And so, the U.S. Supreme Court says that “interest on indebtedness” means “compensation for the use or forbearance of money”. A guaranteed payment on capital is a return on equity and cannot be transformed into interest on indebtedness based on some general regulatory authority under section 7805(a), no matter how abusive the IRS views a transaction. And effectively treating a guaranteed payment on capital as “equivalent to interest” but not actually indebtedness for purposes of certain enumerated provisions (such as section 901) seems to be overreaching given the mandate of the U.S. Supreme Court on an economic equivalent to interest on indebtedness at that time, a short sale. 

Can the IRS write a regulation that circumvents the dictates of the U.S. Supreme Court using a general grant of regulatory authority under section 7805(a)? I would think that the answer is clearly and obviously no. But what is the price that the IRS will ultimately pay if the results enumerated here are overruled by a court several years down the road? Other than spending taxpayer dollars unnecessarily, it does not appear that there is any downside in doing so. 

Note that this bifurcated treatment of a guaranteed payment on capital “infects” other recent regulations because in one case (T.D. 9866, the GILTI final regulations) there is an explicit cross reference to the definition of interest income and expense under section 163(j) (which presumably includes the application of the interest expense anti-abuse rule in those final regulations), and in another case (T.D. 9896, the section 267A final regulations) the substance of the definition of interest expense and the anti-avoidance rule exception were incorporated into those regulations.

How can this practice be effectively stopped? Will it require court litigation and years of uncertainty or is there a mechanism for, in effect, penalizing the IRS for taking positions that, if the IRS were a tax advisor to a client other than itself, it could not have concluded the way it does without disclosure on the equivalent of form 8275? 

Could section 7805(a) be amended to curtail this IRS practice? For example, could a sentence or two be added there to say that “the IRS cannot issue regulations or other guidance inconsistent with the literal words of a provision of the Internal Revenue Code unless Congress expressly grants that power”? 

Now, some will say that doing such a thing contravenes the ability of the courts to adjudicate tax disputes and so is perhaps unconstitutional but clearly inadvisable. Others will say that the regulatory guidance process would grind to a halt because of the forceful taking by the Congress of administrative discretion and expertise. 

I don’t think the status quo is acceptable. On the other hand, I do recognize the implementation problems. Is there any solution other than to throw up your hands in disgust and move on to something else? 

Comments

  1. Robert Kantowitz says

    In effect, there is already a limitation on the government’s ability to run roughshod over statutes or to invoke policy (the “tell” is the sanctimonious phrase “The Treasury Department and the IRS have determined . . .”) to fix errors that Congress intentionally or inadvertently made. See State Farm, Chevron (first prong), Altera (the correct Tax Court decision, not the incorrect Ninth Circuit majority opinions). This kind of Treasury/IRS over-reach and courts’ milquetoast response will eventually result in the obliteration of Auer and Chevron deference. Had the recession not intervened in 2008, and then BEPS, to eliminate cross-border double dips, I suspect that the passive FTC regulations might have been challenged and overturned. A judge doing his job would have asked the government attorney, “Would the directors of the non-US party have gone to prison had it not paid the tax?”; the answer would have been yes, and the judge would have held that the tax is a mandatory payment, case closed, judgment for the taxpayer. Despite the organized tax bar’s reluctance to say so, there is a real chance that the ENTIRE expansive 163(j) definition of interest gets struck down because Congress wrote a statute that says “interest on indebtedness” and not “time value of money.”

  2. I am coming late to comment, but I do want to discuss briefly Monte’s question. He asks:

    Could section 7805(a) be amended to curtail this IRS practice? For example, could a sentence or two be added there to say that “the IRS cannot issue regulations or other guidance inconsistent with the literal words of a provision of the Internal Revenue Code unless Congress expressly grants that power”?

    The specific proposal to prohibit § 7805(a) regulations inconsistent with the literal words of the statute would be of limited importance because courts generally will not defer to agency interpretations under the Chevron framework if the meaning of the statute is clear (i.e., not ambiguous). Stated otherwise, courts defer only if they find that the statute is ambiguous.

    If a statute is in want of interpretation (the literal words just don’t offer a clear or rational meaning), then the IRS should have some interpretive authority and, as a fall back, the courts will have interpretive authority, guided where appropriate by the Chevron framework. Keep in mind that § 7805(a) only authorizes interpretive rules.

    For example, take the supervisor written approval requirement in § 6751(b) that is unclear as to when the approval must be obtained. If anything, some literal interpretation of the statute would suggest that approval must be prior to the assessment. Courts (principally the Tax Court) have properly through statutory interpretation gone beyond the literal words to develop interpretations based on Congress’ purpose. (I won’t get into the textualist/purposivist discussion, but suggest readers think about it in this context.) The important point is that this has happened through interpretation because courts have no authority to legislate.

    Section 7805(a) gives the Treasury interpretive authority, so the Treasury, through Chevron-entitled regulations, could have interpreted § 6751(b) in a process the same as courts interpret the section and thereby, with a holistic view of the process and procedural needs of the agency, infused coherence to § 6751(b), avoiding the current mish-mash through piecemeal court decisions. Indeed, Treasury could still do that under Brand X’s interpretation of Chevron. Indeed a comprehensive regulation would be quite helpful, otherwise taxpayers must work their way through many court decisions, not all of which are consistent or easily comprehensible.

    My only point is that the type of limitation on § 7805(a) Monte raises by question would be inappropriate and would limit Treasury’s ability to give taxpayers the guidance they need in a complex tax system.

  3. Geoffrey Sadler says

    You are so right — IRS over-reach and the court’s completely milquetoast response. No teeth! And if I may divert for a moment please — above and beyond the nuts and bolts here… beyond curtailing the tax man’s bullying tactics — every state must have more tax relief, loopholes and tax breaks, never mind tax cuts for the wealthiest Americans and corporations — but tax breaks for the middle class.

    California has been the only state in the union with legit property tax breaks for the middle class – for everyone in fact. Just not only rich folks. In California you have protections over your right to avoid property tax reassessment at present day rates… you get to transfer parents property taxes and keep parents property taxes… when you inherit property, in fact when inheriting property taxes for any kind of property from a surviving parent. And this holds for all property tax transfer scenarios from parents in California. And now the C.A.R. and CA Legislature are attempting to unravel key parts of the property tax transfer process… namely the parent to child transfer or parent to child exclusion or exemption from present day property tax rates – with Proposition 15 (killing commercial property tax breaks) and so-called Prop 19, which is designed to destroy the whole ball of wax! And we have been hoping the entire country, with the pandemic as key motivation, will get to enjoy California style property tax relief! So loans to intra-family trusts will be a thing of the past, pre-1978, if it passes in Nov. Avoiding property tax reassessment will be no more, if these special interest folks are successful.

    At any rate, Prop 13 and Prop 58 have been life savers for home owners and beneficiaries inheriting a home from parents… with that parent to child transfer and property tax exclusion always there or home owners and beneficiaries… with the ability to avoid property tax reassessment — even on a secondary property. And now, abruptly, the entire state finds out at the last moment, prior to the November vote, that something when Proposition 19 rears it’s ugly head, so to speak… claiming it’s “all for the schools and our kids…” when in fact, as property tax specialists will tell you, the real purpose behind Proposition 15 is to pay for unfunded pensions for California government workers… along with other generous benefits, salary raises and perks, as well as some very expensive, long term special interest government public works projects!

    Everyone wants to keep Prop 58 and all of Proposition 13, including tax relief for commercial property owners, not only to cap property reassessment at a 2% tax rate every year, but also to be able to buyout siblings who want to sell inherited property – allowing you to save on the transfer of property from sibling to sibling, buying out a sibling’s share of inherited property of any amount when getting a loan to an irrevocable trust for $400K, $500K, $700K, whatever one needs. If you have a strong stomach, go and read up at https://californiaproposition58.org/2020/09/17/vote-no-on-california-proposition-19/ or you can hope these guys are not successful at destroying critical property tax relief features in Nov. and read up at informational-blogs and Websites such as https://propertytaxtransfertrusts.com to get your facts… Or positive fact-based Proposition 13 and Proposition 58 sites like https://cloanc.com/tag/california-prop-58/ where you can also actually apply for a large loan to a trust, if you need cash right now. As we continue to struggle with this Pandemic, the middle class in all states should also have property tax relief and tax break systems to help struggling and unemployed Americans, now and going forward. Why should only wealthy families and mega-wealthy corporations and CEOs benefit from income tax loopholes and property tax relief?

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