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Tate & Lyle Inc. v. Commisioner of International Revenue Service

June 26, 1996

TATE & LYLE INC. AND SUBSIDIARIES

v.

COMMISSIONER OF INTERNAL REVENUE SERVICE, APPELLANT



Appeal from the United States Tax Court

(No. 92-00740)

Before: MANSMANN, ALITO and LEWIS, Circuit Judges.

MANSMANN, Circuit Judge.

Argued April 25, 1996

Filed June 24, 1996)

OPINION OF THE COURT

In this appeal, the Commissioner has asked us to review a ruling which allowed a United States taxpayer to deduct interest owed to a related foreign payee when it was accrued rather than paid. Specifically, we must determine whether the United States Tax Court erred in holding that Treas. Reg. Section(s) 1.267(a)-3 is invalid to the extent that it requires accrual basis taxpayers to defer deductions for interest owed to a related foreign payee until the year the interest is paid. Also at issue is whether, assuming Treas. Reg. Section(s) 1.267(a)-3 is valid, retroactive application of the regulation violates the Due Process Clause of the Fifth Amendment.

Because we find that Treas. Reg. Section(s) 1.267(a)-3 is a valid exercise of the powers delegated to the Secretary under I.R.C. 267(a)(3), and that retroactive application of the regulation to the taxpayer does not violate due process, we will reverse the decision of the Tax Court.

I.

The following facts were stipulated by the parties *fn1 before the United States Tax Court. *fn2 The taxpayer is an affiliated group of corporations of which Tate and Lyle, Inc. (TLI) is the common parent, and Refined Sugars, Inc. (RSI), is a wholly owned subsidiary. Both TLI and RSI are United States corporations and were included on the taxpayer's consolidated federal income tax returns for the tax years at issue. Tate and Lyle plc (PLC) is a United Kingdom corporation which indirectly owns 100% of TLI and RSI. The taxpayer and PLC are members of the same controlled group of corporations as defined in I.R.C. 267(f).

PLC made interest-bearing loans to TLI and RSI, the tax consequence of which was interest expense to the taxpayer and interest income to PLC. The taxpayer and PLC report income and deductions using the accrual method of accounting. On its U.S income tax returns, the taxpayer deducted interest expense owed to PLC by TLI and RSI in the year it accrued. The taxpayer did not pay the interest to PLC until the year following the year of accrual. *fn3

The interest income received by PLC was U.S. source income not effectively connected with a trade or business in the United States. *fn4 Under I.R.C. Section(s) 881(a)(1), such income is subject to U.S. tax at a rate of 30%. *fn5 Pursuant to Article 11(1) of the United States-United Kingdom Income Tax Convention *fn6 (treaty), 31 U.S.T. 5668, which was in effect at all times here, the interest income received by PLC was exempt from United States tax.

The Commissioner disallowed the taxpayer's deduction for interest expense in the years accrued and subsequently mailed to the taxpayer notices of deficiency for the tax years ended September 29, 1985, September 28, 1986, and September 26, 1987. *fn7 In response to the notices of deficiency, the taxpayer filed a petition in the United States Tax Court challenging the Commissioner's determination.

The following facts, not part of the stipulation, are evident from the record. The Commissioner asserted before the Tax Court that I.R.C. Section(s) 267(a)(2) and (a)(3) and Treas. Reg. Section(s) 1.267(a)-3 allow payor a deduction for interest only in the tax year when the related payee would normally report the interest as income for United States tax purposes. Normally, interest income received by a foreign corporation from sources within the United States and which is not effectively connected with a trade or business in this country, is reported on the cash basis method of accounting under I.R.C. Section(s) 881 and 1442. The Commissioner determined that the taxpayer was entitled to deduct interest only in the year it paid the interest to PLC.

The Tax Court held that because the accrued interest was not includable in PLC's income because of an exemption under the tax treaty rather than as a result of PLC's method of accounting, Treas. Reg. 1.267(a)-3 was invalid because it did not apply the matching principle of I.R.C. Section(s) 267(a)(2). A four-judge plurality determined that even if the provisions of Treas. Reg. Section(s) 1.267(a)-3 were found to be within the broad regulatory authority granted by I.R.C. Section(s) 267(a)(3), the retroactive application of the regulation violated the Due Process Clause of the Fifth Amendment. *fn8 Accordingly, the Tax Court found that the taxpayer was not required to defer its interest deduction until it actually paid the interest.

The Commissioner appeals to us from the final decision of the Tax Court entered on February 13, 1995. *fn9 We have jurisdiction under I.R.C. Section(s) 7482(a). See Lerman v. Commissioner, 939 F.2d 44, 45 (3d Cir.), cert. denied, 502 U.S. 984 (1991).

II.

We turn first to the issue of whether Treas. Reg. Section(s) 1.267(a)-3 is a valid interpretation of I.R.C. Section(s) 267(a)(3). The validity of a treasury regulation is a question of law over which we exercise plenary review. Mazzocchi ...


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