The US Tax Court released its opinion on the deductibility of expenses in Adams Challenge (UK) Ltd v. Commissioner on January 21 2021. The IRS victory in this case has important consequences for foreign corporations with US operations that may be unsure whether they have a US trade or business and effectively connected income. Such taxpayers should file protective Forms 1120-F to ensure that they are entitled to claim deductions in the event the IRS asserts they have a US trade or business and effectively connected income.
Adams Challenge involved a UK company that chartered a vessel to an operator decommissioning oil and gas wells on the US outer continental shelf. Because the company did not realise these activities constituted a US trade or business with effectively connected income, it did not file US tax returns for two of the years at issue, 2009–10, until 2017, after the IRS had already prepared substitutes for returns (SFRs) for the company.
The ensuing litigation was broken up into two phases, relating to (i) whether the taxpayer had a US trade or business and effectively connected income; and (ii) whether it was entitled to deduct its expenses associated with that income. The Tax Court held for the IRS on the first issue in January 2020, and released its decision on deductibility roughly a year later.
At issue in the case was the application of section 882(c)(2) of the Internal Revenue Code and the regulations thereunder, as well as their interaction with the US–UK tax treaty.
Section 882(c)(2) provides that a foreign corporation must file a US tax return in order to receive the benefit of deductions and credits against its effectively connected income. While the statute is silent as to timing, Treas. Reg. § 1.882-4(a)(3) is not. It provides that to be effective for section 882(c)(2) purposes, the return must be filed within 18 months after its due date. The regulation also permits foreign corporations to satisfy the filing requirement by filing protective returns indicating they do not believe they have a US trade or business and/or effectively connected income.
The Tax Court previously held in Swallows Holding v. Commissioner that the regulatory imposition of a timing requirement onto section 882(c)(2) was invalid, but the Third Circuit, applying a different standard of review, reversed. Based on the parties’ briefing, it appeared that Adams Challenge would provide an occasion for the Tax Court to revisit its decision in Swallows Holding.
Yet the Tax Court’s opinion did not touch on the issue. Instead, looking to a line of earlier case law, the Tax Court held that section 882(c)(2) itself implicitly incorporates a timing requirement: to obtain the benefit of deductions and credits, a foreign corporation must file its return before the IRS prepares an SFR, which acts as a ‘terminal date’. Here, the company filed its returns for 2009 and 2010 only after the IRS had prepared SFRs, and thus was not entitled to deductions under the statute, as interpreted by the Tax Court.
The Tax Court further held that the US-UK tax treaty did not override the statute in this respect, looking to both the business profits article and the non-discrimination article of the treaty.
The business profits article states that “there shall be allowed as deductions expenses that are incurred” by the US permanent establishment of a UK taxpayer. In the Tax Court’s view, this does not mean that such deductions must be allowed in every case, but rather that such deductions will be allowed where certain conditions are met. The Tax Court pointed to evidence that the treaty was not intended to disturb existing administrative practices. Similarly, the Tax Court held that the section 882(c)(2) requirement was not discriminatory, noting that foreign corporations have an additional 18-month grace period to file returns for this purpose, and that the requirement can easily be discharged by filing a protective return.
The Tax Court’s interpretation of the business profits article as consistent with section 882(c)(2) may appear strained. This is understandable, given the Tax Court’s obligation (where possible) to harmonise the treaty with the statute. A different result could potentially obtain if a taxpayer instead sought competent authority relief under the mutual agreement procedure article of the applicable treaty. The US competent authority may view the denial of deductions as a penalty, which is not eligible for negotiation under many US treaties, although the US-UK treaty does permit negotiation of penalties. Foreign competent authorities may take a very different view of the deductibility issue than the IRS does.
Ultimately, any foreign corporation that believes it could potentially have a US trade or business and effectively connected income should file protective returns to safeguard its right to deductions. Adams Challenge represents an unfortunate instance where the taxpayer was taken by surprise by the broad application of the US trade or business and effectively connected income rules, and suffered gross basis taxation as a result. With protective returns, other taxpayers have it in their power to avoid the second of those dangers.
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