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SIH Partners LLLP v. Commissioner of Internal Revenue

United States Court of Appeals, Third Circuit

May 7, 2019

SIH PARTNERS LLLP, EXPLORER PARTNER CORPORATION, Tax Matters Partner, Appellant
v.
COMMISSIONER OF INTERNAL REVENUE

          Argued March 8, 2019

          On Appeal from the United States Tax Court, Internal Revenue Service (Tax Court No. IRS-1: 15-03427) Tax Court Judge: Mary Ann Cohen

          Sean M. Akins Robert A. Long, Jr. Ivano M. Ventresca Covington & Burling, Thomas H. Dupree (argued) Jacob Spencer Gibson Dunn & Crutcher, Kristen M. Garry Mark D. Lanpher Robert A. Rudnick Shearman & Sterling Attorneys for Appellant

          Gary R. Allen Judith A. Hagley (argued) Gilbert S. Rothenberg Francesca Ugolini United States Department of Justice Tax Division, Julie A. Porter Gasper Richard A. Rappazzo Internal Revenue Service, Jeffrey H. Fenberg Suite 300 Attorneys for Appellee

          BEFORE: AMBRO, RESTREPO, and GREENBERG, Circuit Judges

          OPINION

          GREENBERG, CIRCUIT JUDGE

         I. INTRODUCTION

         This matter comes on before this Court on the appeal of SIH Partners LLLP Explorer Partner Corp., Tax Matters Partner, challenging a United States Tax Court decision on summary judgment holding it liable for back income taxes. For the reasons stated below, exercising plenary review, see Duquesne Light Holdings, Inc. & Subsidiaries v. Comm'r of Internal Revenue, 861 F.3d 396, 403 (3d Cir. 2017), we will affirm the decision and order of the Tax Court.

         I. BACKGROUND

         In its comprehensive opinion, the Tax Court made detailed factual findings which we accept. See SIH Partners LLLP v. Comm'r of Internal Revenue, No. 3427-15, 2018 WL 487089, at *1-4 (T.C. Jan. 18, 2018). We point out, however, that the Court found many facts that are immaterial to our analysis.[1] Though the financial history of this case is very complex the issues before us boil down to whether a United States entity incurs taxes on income made by its Controlled Foreign Corporations ("CFC")[2] in circumstances defined by applicable statutes and their implementing regulations, and, if so, the tax rate on the income.

         Normally, a CFC's income is not taxable to its domestic shareholder or shareholders unless and until the income is distributed to them, a process commonly known as repatriation. Thus, a domestic shareholder in a CFC does not incur a taxable event by reason of its CFC earning income until the shareholder actually receives a monetary return from its foreign investment and holdings. In the face of this straight-forward principle, easily stated though not always easily applied, taxpayers attempting to avoid domestic taxes though nevertheless seeking to benefit from foreign earnings of their CFC hit upon the idea of taking loans either from the CFC or from third-party financial institutions using the CFC's assets as collateral or having the CFC guarantee the loans. Even though those maneuvers allowed domestic shareholders to benefit from a CFC's earnings, it appears that prior to 1962 the IRS did not consider the taking of a collateralized or guaranteed loan from or with the participation of a CFC as a taxable event, even though the process allowed domestic shareholders effectively to obtain a monetary return on their foreign investment.

         The foregoing tax avoidness method permitted a domestic shareholder to delay indefinitely any taxes on foreign income, while making use of the foreign income by continuously taking out loans using its CFC's assets as collateral or by having the CFC guarantee the loans. Domestic corporations exploited this loophole by forming CFCs in foreign tax havens to which they transferred portable income, thereby avoiding or at least delaying taxes on the income at United States domestic tax rates, even though the taxpayers had the benefit of having received the income.

         Not surprisingly Congress took steps to close the CFC loophole by enacting the Revenue Act of 1962 ("Act") "to prevent the repatriation of income to the United States in a manner which does not subject it to U.S. taxation." Dougherty v. Comm'r of Internal Revenue, 60 T.C. 917, 929 (1973) (citation omitted). The Act essentially requires the inclusion in the domestic shareholder's annual income of any increase in investment in United States properties made by a CFC it controls. The rationale for the Act is clear-any investment by a CFC in United States properties is tantamount to its repatriation. Id. United States property is defined as including, among other things, "an obligation of a United States person[.]" 26 U.S.C. § 956(c)(1)(C); see also id. § 951. The Act goes further as it provides that "a controlled foreign corporation shall, under regulations prescribed by the Secretary [of the Treasury], be considered as holding an obligation of a United States person if such controlled foreign corporation is a pledgor or guarantor of such obligations." Id. § 956(d).

         Taking up the baton from Congress, in 1964 the IRS promulgated the two regulations at issue in this case. First, the agency determined when a CFC's pledge or guarantee would result in the CFC being deemed the holder of the loan:

[A]ny obligation of a United States person with respect to which a controlled foreign corporation . . . is a pledgor or guarantor will be considered to be held by the controlled foreign corporation . . . .

26 C.F.R. § 1.956-2(c)(1). Second, the IRS determined how much of the "obligation" a CFC pledgor or guarantor would be deemed to hold:

[T]he amount of an obligation treated as held . . . as a result of a pledge or guarantee described in § 1.956-2(c) is the unpaid principal amount of the obligation . . . .

Id. ยง 1.956-1(e)(2). As the Tax Court summarized, "a CFC whose assets serve (even though indirectly) as security for the performance of an obligation of a United States person will be considered a pledgor or guarantor of that ...


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