dissenting: I respectfully dissent from the majority opinion. Although the profusion of concurring views about and distractions from the “majority” opinion somewhat obscure its thrust, the ostensible plurality favors either invalidating section 1.267(a) — 3(c)(2), Income Tax Regs., and/ or holding that the retroactive application of the regulation, if assumed valid, violates the Due Process Clause of the Fifth Amendment to the Constitution.
A. Invalidation of Section 1.267(a)-3(c)(2), Income Tax Regs. — I disagree with the majority’s invalidating the regulation for the following reasons: (1) The regulation is a reasonable interpretation of the existing law, and its invalidation would cause anomalous results; (2) the U.S.-U.K. Income Tax Treaty1 does not characterize or recharacterize the (interest) income; instead, it renders it exempt from tax if and when it is otherwise recognizable; and (3) the legislative history supports the substance of the regulation as promulgated.
(1) Section 1.267(a)-3(c)(2), Income Tax Regs., Is a Reasonable Interpretation of the Law and Is Thus Valid — Section 267 requires a matching of deduction and income items to prevent artificial deductions from occurring when related parties have different accounting methods. Majority op. p. 659. That purpose is accomplished through section 267(a)(2), which prohibits a deduction until such time as the income is recognizable by the payee.
The majority, although supplying appropriate case precedent by which to consider a regulation, has not sufficiently explained why section 1.267(a)-3(c)(2), Income Tax Regs., does not constitute a reasonable interpretation of congressional intent underlying section 267. This is especially so because the example contained in the legislative history was followed in the questioned regulation.
But for the U.S.-U.K. treaty, the majority agrees with respondent’s position that, if sections 881(a)(1) and 1442(a) constitute a method of accounting, section 267(a)(2) requires actual payment before a domestic payor would be entitled to deduct interest payable to a foreign payee. Accordingly, if interest income was not excludable from tax under the treaty, the majority agrees with respondent’s position that no deduction would be permissible until the interest was paid.2 In that regard, the parties in this case are and were subject to section 267(a)(2), irrespective of the promulgation of section 1.267(a)-3(c)(2), Income Tax Regs.
Two years after enacting section 267(a)(2), Congress, however, acknowledging that there may be differences when foreign payees are involved, provided in section 267(a)(3) that the Secretary promulgate regulations to accomplish the same objective (i.e., matching principles) as in section 267(a)(2) where foreign payees are involved. Drawing upon the explanation and example contained in the legislative history for section 267(a)(3), the Secretary promulgated section 1.267(a)-3(c)(2), Income Tax Regs., requiring the cash method approach to deductibility by the payor even though the foreign payee were exempt from U.S. taxation. That regulation section is limited to interest income and not to income items in general.3
Section 267(b), to some extent, defines the breadth of section 267 by extending it to various related parties. Further, the reference to foreign payees in section 267(a)(3) reflects congressional intent that they be subjected to the matching principles of section 267(a)(2). The majority’s holding that a payor is not subject to section 267 because the income would be exempt from tax when paid circumvents that congressional intent. More specifically, Congress did not relieve taxpayers from the requirements of section 267 where one of the related members is tax-exempt under section 501. See sec. 267(b)(9). It, therefore, does not follow that, if an entity is exempt from tax and the related entities are subject to section 267, an otherwise taxable entity that is exempt from some portion of its income, especially under a treaty, would result in the related entities’ not being subject to section 267. Although the majority attempts to technically distinguish between an exempt organization and being exempt from tax, it has not provided a congressional purpose for making such a distinction here. Majority op. p. 665 note 10. In that same vein, how would the majority’s holding affect domestic taxpayers if the amount received is exempt from tax? For example, the “payee” may receive compensation for injuries or sickness which is exempt from income under section 104.4
(2) The U.S.-U.K. Income Tax Treaty — The majority concludes that, because the U.S.-U.K. treaty excludes the interest from the foreign payee’s gross income, such income will never be subject to the accounting method contained in sections 881(a)(1) and 1442(a). I agree that the U.K. company will have no U.S. tax liability with respect to the interest; however, I must disagree with the majority’s conclusion that, because the income is tax exempt, it is or becomes nonexistent for purposes of the accounting method requirements of sections 881(a)(1), 1442(a), and 267. The character of income is not changed simply because a treaty provides relief from part or all of the tax of one of the treaty countries. Rather, the U.S.-U.K. treaty simply has the effect of eliminating the U.S. tax.
The majority has failed to state or interpret the language or intent of the treaty in question.
Any effort to ascertain the intent of the parties to any agreement must begin with the language in the agreement itself. The plain meaning of treaty language controls unless “application of the words of the treaty according to their obvious meaning effects a result inconsistent with the intent or expectations of its signatories.” Sumitomo Shoji America, Inc. v. Avagliano, 457 U.S. 176, 180 (1982), quoting Maximov v. United States, 373 U.S. 49, 54 (1963). [Rust v. Commissioner, 85 T.C. 284, 288 (1985).]
Additionally, it should be noted that—
In construing a treaty, courts should give great weight to the meaning ascribed by the Government departments charged with negotiation and enforcement of the treaty. Kolovrat v. Oregon, 366 U.S. 187, 194 (1961); Factor v. Laubenheimer, 290 U.S. 276, 295 (1933); State of Minnesota v. Block, 660 F.2d 1240, 1258 (8th Cir. 1981). * * * [Id.]
In this regard, petitioner did not advocate the legal analysis used by the majority to reach its conclusion that section 267 was inapplicable or that the regulation in question is invalid. Conversely and more significantly, respondent, on brief, did not even address the legal theory of the majority.5
As a matter of current law, “the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.” Sec. 7852(d)(1); see also sec. 894(a). Under that standard, courts should attempt to harmonize statutes and treaties under the same rules as are applied to seemingly conflicting statutes. See Whitney v. Robertson, 124 U.S. 190 (1888).6 It is unlikely that a statute or treaty was intended to be abrogated or modified by a subsequent statute or treaty without some acknowledgment by Congress. See, e.g., Cook v. United States, 288 U.S. 102, 120 (1933). Here, the majority has, in a rote manner, used the income exemption feature of the treaty to relieve domestic taxpayers from the congressionally intended requirements of section 267 without any showing of how such a result serves congressional intent.
The majority’s holding is wholly dependent upon its interpretation of the section 267 “includible in gross income” language and reasoning that the treaty, with the assistance of section 894, causes the income not to be gross income, and, therefore, section 267 does not apply. The majority’s unprecedented and out-of-context use of a few words from the statute and treaty results in a non sequitur. To the extent that the majority holds that the treaty or section 894 redefines the term “interest income” as no longer constituting income or gross income, the majority’s reasoning is faulty and without support. The majority’s reasoning is based upon its own novel axiom that exempting income from taxation causes it to no longer be income or gross income.7
Suppose, instead, that the treaty provided for a rate reduction from 30 to 5 percent.8 There is no doubt that, despite its lower tax rate, the interest remains income. In the same vein, if one-half of the income was exempt from tax, all of the interest would remain income, but only one-half would be subject to tax. In this case, because interest income was made exempt from the U.S. tax, the majority finds no matching or need to match because there is no income by virtue of its total exclusion. The majority, by use of language from the treaty and section 894, inexplicably removes the taxpayers in this case from the requirements of section 267.9
The agreement between the United States and the United Kingdom to exempt the foreign payee from U.S. tax does not relieve the parties from the requirements of section 267 or vary cash method accounting principles mandated by Congress and implemented in the regulations by the Secretary. The treaty does not change the accounting method; rather, it determines just which treaty country will ultimately tax the income. The United Kingdom will properly tax the foreign payee’s interest because it is income. The treaty’s role is not to characterize or recharacterize income as “not being income”; instead, it simply frees it, ultimately, from U.S. tax.
Finally, the effect of a tax treaty should not be considered until after a determination is made under the tax law of the respective nations.10 In other words, one must first determine if the item is income, and then it may or may not be exempt, depending on the treaty. In this case, it appears that the treaty section exempting the foreign affiliate from U.S. taxation on the interest was intended to avoid double taxation to the foreign affiliate because the interest income was already subject to foreign taxation. Treaties normally deal with that concern, and there is no justification for the majority’s use of treaty language to color or characterize the nature of income of one of the treaty nations. Here, use of the U.S.-U.K. treaty income exemption to preempt a method of accounting requirement under the tax law of one of the treaty nations is an illogical sequence of cause and effect and could not have represented the intent of the treaty or statute in question. Additionally, such use of a treaty’s language to justify different treatment for U.S. taxpayers with similar circumstances is even more inappropriate. The accounting standard is deductibility upon payment, irrespective of whether the payee has been specifically exempted from tax upon receipt. The regulation has not gone beyond the matching principle of section 267 as suggested by the majority, but instead has adapted it for foreign payee situations as recommended by Congress.
(3) Legislative History — The majority notes that both the House and Senate committee reports concerning section 267(a)(3) contemplate the deductibility of “items payable to a related foreign payee even though the items are not subject to U.S. tax or generally includable in the recipient’s gross income.” Majority op. p. 669. In that regard, the committee reports contain an example for purposes of implementing section 267(a)(3) that is inclusive of the requirements of the regulations promulgated by the Secretary under section 267(a)(3). The only differences between section 1.267(a)-3, Income Tax Regs., and the congressional example are that the example did not concern interest income, and the foreign payee in the example was not subject to U.S. tax because it received foreign-source income, rather than being exempted from the U.S. tax by treaty. In line with the example, the committee reports proceed with the statement that the “regulations could require the U.S. subsidiary to use the cash method of accounting with respect to the deduction of amounts owed to its foreign parent”. S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3) 1, 959; H. Rept. 99-426 (1985), 1986-3 C.B. (Vol. 2) 1, 939.
While the majority finds this legislative history “troublesome”, it reflects congressional intent and, therefore, in my view, provides substantial support and authority for the questioned regulation. The majority emphasizes that the final regulations did not include income other than interest income. The exclusion of income other than interest income is not the subject of this case. This case concerns a petitioner with interest income, and we do not have to decide whether other portions of the example or regulations should be sustained. In considering the issue before us, we must recognize that the principle of the example goes beyond and is inclusive of the requirements contained in the regulation under consideration.
(4) Conclusion — While the majority correctly notes that “our primary inquiry is whether the regulation is not manifestly contrary to the statute and is not arbitrary or capricious”, majority op. p. 666, I cannot conclude, as it does, that limiting the payor to a cash method deduction is manifestly contrary to the statutory mandate under section 267(a)(3). To the contrary, I find that the regulations “apply the matching principle of paragraph [(a)](2)”. Sec. 267(a)(3). The substance of section 267(a)(2) is that a related party expense or interest item must be deducted by the payor when the “amount is includible in the gross income of the [payee]”. Thus, the “matching principle of paragraph (2)”, in substance, requires the payor to report deductions on the cash method. The regulations promulgated under section 267(a)(3), in my view, are entirely consistent with the statutory mandate. The majority’s attempt to find contradiction in “the matching principle of [section 267(a)(2)]” and the cash method requirement found in the regulations under section 267(a)(3) is, at best, one of semantics.
B. Retroactive Application Under the Circumstances Here Is Not a Violation of Due Process — Generally, I disagree that the retroactive application of the statute and regulation here was violative of petitioner’s due process because: (1) It merely clarified the application of the principles in section 267(a)(2) for foreign payees; (2) section 267(a)(2), enacted in 1984, already encompassed the foreign payee situation; (3) Congress, in enacting section 267(a)(3), provided examples that included the circumstances involved in this case and thereby placed petitioner on notice; (4) the regulation does not preclude a deduction; it merely concerns timing and places similarly situated taxpayers on a par and, therefore, does not cause the harsh result suggested by the majority; and (5) delay in issuance is not, per se, a denial of due process where there is no change in the law.
The majority agrees that section 267(a)(2) applies to both domestic and foreign parties. More importantly, the majority acknowledges that Congress enacted section 267(a)(3) to cause the matching principle of section 267(a)(2) to apply to foreign parties. Finally, the majority agrees that, but for the treaty, the timing provisions of sections 881(a)(1) and 1442(a) constitute the method of accounting for the interest in question under section 267. In its alternative holding, the majority’s premise is that the regulation is a valid interpretation of the statute. If the majority were true to its premise or assumption, then section 267(a)(2) would have been the law when petitioner’s income tax returns were filed and when the questioned regulation was issued. The majority clings to its view concerning the effect of the treaty in order to reach the conclusion that there was a due process violation.
Considering these premises, the majority is wrong to ignore the fact that section 267(a)(2) already compelled the result that respondent clarified in section 1.267(a)-3(c)(2), Income Tax Regs. Implying that taxpayers were without guidance until 1992 when the regulation was issued overstates the situation. Albeit legislative, the regulation at issue does not contain the promulgation of a new substantive rule as the majority suggests. In the setting of this case, we must focus on the fact that the regulation treats interest consistently with the matching principles of section 267(a)(2), as Congress mandated. The majority implies that respondent’s choice to include interest in the regulation and to relieve taxpayers with deductions not involving interest from the section 267 requirements resulted in a substantive rule of law. This focus is incorrect because interest is the subject of this case, and it would have been subject to section 267(a)(2).
The time lapse between the filing of the income tax returns and the issuance of the regulation is not as significant in considering whether due process has been afforded in this case. Where, as here, the regulation does not change the law or establish a new substantive rule of law, the result could have been expected and is not violative of a taxpayer’s right of due process. In United States v. Carlton, 512 U.S._, 114 S. Ct. 2018 (1994), the Supreme Court, in discussing the question of reliance, quoted Justice Stone’s explanation that
“Taxation is neither a penalty imposed on the taxpayer nor a liability which he assumes by contract. It is but a way of apportioning the cost of government among those who in some measure are privileged to enjoy its benefits and must bear its burdens. Since no citizen enjoys immunity from that burden, its retroactive imposition does not necessarily infringe due process. . . .” [United States v. Carlton, 512 U.S. at_, 114 S. Ct. at 2023 (quoting Welch v. Henry, 305 U.S. 134, 146-147 (1938)).]
In this case, the interval between the enactment of section 267(a)(2) and (3) was about 2 years. The Commissioner also issued public notice of her position between 4 and 5 years after enactment of section 267(a)(3). Section 1.267(a)-3(c)(2), Income Tax Regs., was promulgated about 9 years and 7 years after section 267(a)(2) and (3), respectively. The tax returns in question were filed approximately 5 to 7 years before the regulation was issued. In any event, the statement of the law in the various enactments, notices, and regulations that followed section 267(a)(2) was the same law and matching principle already contained in section 267(a)(2). In these circumstances, it is curious that petitioner would have been surprised by the requirement of the regulation or that due process would be made an issue. Indeed, petitioner did not raise or argue constitutional due process. The due process discussion is a creation of the majority and without the counsel of the parties.
By way of comparison, this Court has issued opinions deciding what the substance of a regulation would have been, but which the Secretary had failed to issue until some 8 to 18 years after Congress had so mandated.11 In those instances (involving sections 58(h) and 2032A) Congress had failed to legislate because of complexity or some other reason and mandated that the Secretary issue legislative regulations establishing the substantive rules of law. Conversely, our issuing those substantive rules of law 8 to 18 years after congressional mandate far exceeds the period we consider here, under circumstances where the regulation merely clarifies the statute.
Finally, the majority lapses into the question of the regulation’s validity in deciding whether due process has been afforded, even though it assumes the regulation to be valid. The majority, relying on United States v. Carlton, supra, decides that there was a lack of due process because the “retroactive application is so harsh and oppressive as to transgress the constitutional limitation.” Majority op. p. 674 (quoting United States v. Carlton, 512 U.S. at_, 114 S. Ct. at 2022). In this regard, the majority assumes the regulation to be neither illegitimate nor arbitrary. Although the majority’s ostensible focus is intended to consider the time within which respondent acted, its reasoning lapses into and relies upon its finding that the regulation is invalid. See majority op. p. 678 note 21. Its holding that the effect of the regulation is unduly “harsh and oppressive” does not follow if the majority was true to its assumption that section 267(a)(2) would cause the same result as the regulation merely clarifies. The majority finds the regulation to be harsh and oppressive solely due to the lapse of time.
Accordingly, I must respectfully dissent from the majority’s holding that section 1.267(a)-3(c)(2), Income Tax Regs., is invalid or, if valid, results in a due process violation.
Hamblen, Parker, Swift, and Parr, JJ., agree with this dissent.Use of the term “U.S.-U.K. Income Tax Treaty” in this dissent denotes reference to the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, Dec. 31, 1975, U.S.-U.K., 31 U.S.T. 5668.
The majority also agrees with respondent’s position that the matching principle of sec. 267(a)(2) is focused upon the avoidance of U.S. tax, and it is irrelevant that the payee was on the accrual method for all purposes in the United Kingdom.
If the terms of the treaty are not employed to exempt petitioner from the requirements of sec. 267(a)(2), it would have been unnecessary for the Government to issue regulations for circumstances involving foreign payees, because they were already subject to the sec. 267(a)(2) provisions. It is likely that the Government issued the regulations in question in order to relate the decision that the matching principles of sec. 267(a)(2) would not apply to income other than interest. Excepting interest, the failure to include other income is not (as suggested by the majority) a reason to find that the Secretary’s position on interest is incorrect.
The general rule of sec. 104 states that “gross Income does not include” certain specified items enumerated in the statute.
On brief, respondent quoted the nondiscrimination portion of the treaty and explained that it was not violated by the regulations in question.
See also Bittker & Lokken, Federal Taxation of Income, Estates and Gifts, par. 66.2.11, at 66-26 (2d ed. 1991).
One might ask that, if, as the majority holds, the treaty causes the payments to the foreign payee not to be income or gross income, would the domestic payor be entitled to a deduction at all? Clearly, that could not occur under the language and intent of sec. 267. It is only by circumventing sec. 267 or finding a way to avoid its requirements that the majority has found the means to permit a deduction without a payment. The exemption of the foreign payee is certainly not a valid or appropriate reason for preempting the requirements of sec. 267.
Absent a treaty, sec. 881(a) imposes a flat 30-percent tax on, inter alia, U.S.-source interest received by a foreign corporation.
The majority reads sec. 267 and the U.S.-U.K. treaty in a vacuum, overlooking the need for symmetry in the Internal Revenue Code or between the Code and the treaty. For example, in defining subpt. F income, sec. 952(b) contains, in part, the following:
In the case of a controlled foreign corporation, subpart F income does not include any item of income from sources within the United States which is effectively connected with the conduct by such corporation of a trade or business within the United States unless such item is exempt from taxation (or is subject to a reduced rate of tax) pursuant to a treaty obligation of the United States. * * * [Emphasis supplied.]
This example illustrates how an item of income may be exempt under one provision and includable under another provision of the Internal Revenue Code. Further, it shows how an exemption from tax under a treaty does not cause recharacterization or reclassification of the income item. Rather, it resolves which country will receive tax revenue or under which portion of the Internal Revenue Code the income item will be subject to tax.
The majority inadvertently makes the same point, majority op. p. 665 note 10, where it explains that the fact that an organization is tax exempt does not, per se, change the character or nature of income, unless received for an exempt purpose; i.e., the items received by an exempt organization may constitute unrelated business income that is subject to tax. Although the majority makes this distinction, it fails to take account of it in its reasoning and ultimate conclusion that the treaty’s exemption from gross income causes recharacterization of the item for purposes of sec. 267 and the regulations thereunder.
In Bittker, Federal Taxation of Income, Estates and Gifts, par. 66.8.2, at 66-21 (1981), it is stated that
In determining the effect of a particular treaty, the practitioner must bear in mind that the Internal Revenue Code is the starting point; treaty provisions reduce or eliminate U.S. tax liabilities, but they do not create them. * * * Once it is determined that an item is made taxable by the Internal Revenue Code, however, it is necessary to consult the appropriate treaty, if there is one, to ascertain whether the item qualifies for an exemption, reduced rate of tax, or other allowance.
Estate of Hoover v. Commissioner, 102 T.C. 777, 784 (1994); Estate of Maddox v. Commissioner, 93 T.C. 228, 233-234 (1989); First Chicago Corp. v. Commissioner, 88 T.C. 663, 676-677 (1987), affd. 842 F.2d 180 (7th Cir. 1988); Occidental Petroleum Corp. v. Commissioner, 82 T.C. 819 (1984).