On July 27 the District of Columbia Circuit Court of Appeals issued its opinion in Good Fortune Shipping SA v. Commissioner, No. 17-1160, reversing the Tax Court and invalidating the “bearer share” regulations under § 883 of the Internal Revenue Code.
Section 883(c)(1) exempts the United States source income from the international operation of ships from U.S. net and gross taxes provided the foreign country in which the corporation operating the ships grants a similar exemption to U.S. organized vessel operators. This exemption is available only if 50% or more of the value of the foreign corporation’s stock is owned, directly or indirectly, by individuals that are residents of a foreign country that also grants an equivalent exemption to U.S. corporations.
The applicable regulations provide that bearer shares are disregarded when determining if a corporation passes the ownership test – under all circumstances.
The taxpayer in Good Fortune Shipping challenged the validity of the bearer share provision of the ownership regulations, asserting that they did not satisfy the tests required for deference under Chevron USA, Inc. v. Natural Resources Defense Council, Inc. 467 U.S. 837 (1984). Essentially, the taxpayer argued that the statue is unambiguous and further interpretation by the IRS in regulations is not necessary. Specifically, the word “own” as used in the statute has an unambiguous meaning and that renders the ownership regulations “arbitrary, capricious, or manifestly contrary to the statue”
The Tax Court concluded “that ‘Congress has [not] directly spoken to the precise question at issue,’” and “that section 883(c)(1) as well as its legislative history is silent; in other words, there is a “gap” in that section as well as its legislative history” and determined that the Treasury was authorized under Chevron to fill the gap with regulations. Good Fortune Shipping SA v. Com’r, 148 T.C. No. 10, slip op. at 33 (Mar. 28, 2017).
The D.C. Circuit set the standard for the IRS to prevail under Chevron as requiring” that section 883 is silent or ambiguous as to the treatment of bearer shares under § 883(c)(1) and that its interpretation, as embodied in the 2003 Regulation, is reasonable.” No. 17-1160, slip op. at 7-8 (emphasis in original). The D.C. Circuit assumed that § 883 did not unambiguously preclude the IRS’s interpretation – thus rejecting the taxpayer’s initial position.
The court did, however, inquire if the IRS “reasonably explained how the permissible interpretation it chose is ‘rationally related to the goals of’ the statute”. No-17-1160 slip. Op at 9-10 citing Village of Barrington v. Surface Transp. Bd., 636 F. 3d 650, 665 (D.C. Cir. 2011) (quoting AT&T Corp. v. Iowa Utils. Bd., 525 U.S. 366, 388 (1999)). In performing this analysis, the court noted that the statute may give the IRS the ability to establish how ownership can be proven but it is not authorized to” categorically deny consideration of a recognized form of ownership.” No. 17-1160 slip op. at 10.
The court buttressed its holding of invalidity with two other significant facts. First, the IRS’s treatment of bearer shares under section 883 has changed over time without a reasoned analysis of its change which is required for the deference afforded under Chevron. Second, the IRS acknowledges bearer shares as a form of valid ownership under section 884 and has dealt with similar potentially abusive situations in other areas of section 883 and other code provisions.
Both of these factors point to the unreasonableness of the IRS’s decision to exclude bearer shares entirely.
Although this case will have significance in assessing the validity of regulations, the universe of taxpayers impacted by it will be relatively small.