Foreign Corporation Argues Bearer Share Regs Are Invalid

 

GOOD FORTUNE SHIPPING SA,
Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.

[ORAL ARGUMENT NOT YET SCHEDULED]

IN THE
UNITED STATES COURT OF APPEALS
FOR THE DISTRICT OF COLUMBIA CIRCUIT

On Appeal from a Final Decision
of the United States Tax Court

BRIEF FOR APPELLANT

STEPHEN P. FLOTT
JOSEPH G. SIEGMANN
BRITTANY N. ORAVEC
FLOTT & CO. PC
2200 Wilson Blvd, Suite 320
Arlington, VA 22201
(703) 525-5110

CERTIFICATE AS TO PARTIES, RULINGS, AND RELATED CASES

Pursuant to D.C. Circuit Rule 12(c) and Circuit Rule 28(a)(1), Appellant Good Fortune Shipping SA in Case No. 17-1160 respectfully submits the following certificate as to parties, rulings, and related cases.

(A) Parties

The following is a list of all individuals and groups who are known to be parties to this case at this time. There are no known amici curiae.

Appellant: Good Fortune Shipping SA

Appellee: Commissioner of the Internal Revenue Service

(B) Rulings Under Review

Appellant seeks review of the final Order and Decision of the United States Tax Court entered on March 29, 2017.

(C) Related Cases

There are no related cases.

CORPORATE DISCLOSURE STATEMENT FOR GOOD FORTUNE SHIPPING SA

Pursuant to D.C. Circuit Rule 28(a)(1) and D.C. Circuit Rule 26.1, Appellant in Case No. 17-1160, Good Fortune Shipping SA, hereby makes the following disclosures:

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TABLE OF CONTENTS

TABLE OF AUTHORITIES

GLOSSARY

STATEMENT OF JURISDICTION

STATEMENT OF ISSUES

STATUTES AND REGULATIONS

STATEMENT OF THE CASE

SUMMARY OF ARGUMENT

ARGUMENT

CONCLUSION

CERTIFICATE OF COMPLIANCE

CERTIFICATE OF SERVICE

TABLE OF AUTHORITIES

CASES

ASA Investerings P'ship v. Comm'r 340 U.S. App. D.C. 55, 201 F.3d 505, 511 (D.C. Cir.), cert. denied, 531 U.S. 871 (2000)

Chevron, U.S.A., Inc. v. Natural Resource Defense Council 467 U.S. 837 (1984)

Dunne v. Commissioner 95 T.C.M. (CCH) 1236, 1242 (2008)

Flynn v. Comm'r, 269 F.3d 1064, 1068 (2001)

Goldsmith v. Commissioner T.C. Memo 1986-227

Goldsmith v. Commissioner 86 T.C. 1134 (1986)

Household Credit Services Inc. v. Pfennig 541 US 232 (2004)

Mayo Found. For Med. Educ. And Research 562 U.S. 44 (2011)

Mfrs. Assn. v. South Coast Air Quality Management Dist. 541 U.S. 246 (2004)

Nat'l Cable & Telecomms. Ass'n v. Brand X Internet Servs. 545 U.S. 967 (2005)

Pacific Coast Music Jobbers, Inc. v. Commissioner 55 T.C. 866 (1971), affd. Without published opinion 457 F.2d 1165 (5^th Cir.1972)

Park 'N Fly, Inc. v. Dollar Park & Fly, Inc. 469 U.S. 189 (1985)

Pioneer Inv. Servs. Co. v. Brunswick Assoc. ltd P'ship 507 US 380 (1993)

Ragghianti v. Commissioner 71 T.C. 346 (1978), affd. 652 F.2d 65 (9^th Cir.1981)

Rowan Cos., Inc. v. US 452 US 247 (1981)

US v Mead Corp. 533 US 218 (2001)

White v. U.S. 305 U.S. 281 (1938)

Will v. Michigan Dep't of State Police 491 U.S. 58 (1989)

STATUTES

IRC § 213(b) (1921)

IRC § 231(b) (1928)

IRC § 231(e) (1936)

IRC § 231(d) (1938)

IRC § 318

IRC § 544

IRC § 863(e)(2)

IRC § 883 (1954)

IRC § 883(a)(1)

IRC § 883(c)(1)

IRC § 884(c)(4)(B)

IRC § 887(a)

IRC § 1471

IRC § 6867(d)

IRC § 7482(a)(1)

IRC § 7491

42 USC § 409

OTHER AUTHORITIES

Regulations

Treas. Reg. § 1.1295-1(d)

Treas. Reg. § 1.1471-5(f)(1)(i)(C)(2)

Treas. Reg. § 1.883-1(b)(3)

Treas. Reg. § 1.883-1(c)(3)(i)

Treas. Reg. § 1.883-1(c)(3)(ii)

Treas. Reg. § 1.883-2

Treas. Reg. § 1.883-3

Treas. Reg. § 1.883-4(b)(1)(ii)

Treas. Reg. § 1.883-4(b)(2)

Treas. Reg. § 1.883-4(c)(1)

Treas. Reg. § 1.883-4(c)(4)

Treas. Reg. § 1.883-4(d)(1)

Treas. Reg. § 1.883-4(d)(2)

Treas. Reg. § 1.883-4(d)(2)(i)

Treas. Reg. § 1.883-4(d)(2)(i)(B)

Treas. Reg. § 1.883-4(d)(2)(ii)

Treas. Reg. § 1.883-4(d)(4)(i)

Treas. Reg. § 1.883-4(d)(4)(ii)

Treas. Reg. § 1.883-4(d)(4)(iii)

Treas. Reg. § 1.883-4(d)(4)(iv)

Treas. Reg. § 1.883-4(d)(4)(v)

Treas. Reg. § 301.6867-1(f)(2)-(4)

Legislative History

Branch Profits Tax, 57 FR 41644-01, 1992 WL 12000508, 41648 (1992)

S. Rep. No. 275, 67^th Cong. 1^st Sess. P. 14 (1921)

S. Rep. No. 99-313 at 336-46 (1986

65 Fed. Reg. 6066-67 (February 8, 2000)

Secondary Sources

American Heritage Dictionary (2d. ed. 1982)

Black's Law Dictionary (Pocket ed. 1996)

Black's Law Dictionary (10^th ed. 2014)

Investopedia, available at http://www.investopedia.com

I.R.M. 4.10.3-5 (Feb. 25, 2016)

I.R.M. 4.61.7.4

I.R.M. 5.19.13-2 (Jun. 23, 2017)

OECD, Committee on Fiscal Affairs, Harmful Tax Competition: An Emerging Global Issue 33 (April 1998)

OECD, Maritime Transport Committee, Ownership and Control of Ships 8 (March 2003), available at http://ntl.bts.gov/lib/24000/24400/24410/17846120.pdf

OECD, Steering Group on Corporate Governance, Behind the Corporate Veil:

Using Corporate Entities for Illicit Purposes 29-30 (November 2001), available at http://www.oecd.org/daf/ca/43703185.pdf

Oxford English Dictionary, vol. XI (2d ed. 1989)

Random House Dictionary (2d ed. 1987)

Webster's New International Dictionary (3d ed. 1986)

Sue Goodridge, VLCC Prices Rose First Time in 2017, Market Realist, available at http://marketrealist.com/2017/06/vlcc-prices-rose-first-time-in-2017/

GLOSSARY OF ABBREVIATIONS AND ACRONYMS
(D.C. Cir. Rule 28(a)(3))

Challenged Regulations	Treas. Reg. §§ 1.883-4(b)(1)(ii); 1.883-4(c)(1); 1.883-4(d)(1); 1.883-4(d)(4)(i)(c)
FICA	Federal Insurance Contributions Act
IRC	Internal Revenue Code
IRS	Internal Revenue Service
USSGTI	United States Source Gross Transportation Income
VLCC	Very Large Crude Carrier

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STATEMENT OF JURIDICTION

This is an appeal of a case originally pending before the United States Tax Court (“Tax Court”) filed by Good Fortune Shipping SA (“Good Fortune”), contesting the validity of Treasury Regulations upon which the Commissioner of Internal Revenue (“IRS”) based its adjustments to the return of Good Fortune, Tax Court Docket No. 25327-12.

1. Jurisdiction of the Tax Court.

On July 18, 2012, the IRS issued a statutory Notice of Deficiency pursuant to IRC section 6212, proposing adjustments to Good Fortune's tax return for the tax year ending December 31, 2007 (“Notice of Deficiency”).¹

The IRS determined that, because Good Fortune had issued its shares solely in bearer form, it did not satisfy the “qualified shareholder stock ownership test” as set forth in Treas. Reg. § 1.883-4 and, as a result, could not claim an exclusion from U.S. tax under IRC section 883(a)(1).

On October 12, 2012, Good Fortune filed a timely petition in the Tax Court contesting the Notice of Deficiency on the basis that the Challenged Regulations upon which it had been issued were invalid and unenforceable.² The Tax Court had jurisdiction over Good Fortune's petition challenging the Notice of Deficiency.

2. Appealable Order

On March 28, 2017, the Tax Court entered an opinion after trial, denying Good Fortune's motion for partial summary judgment and granting the IRS' motion for summary judgment, finding that the Treasury Regulations challenged by Good Fortune were valid and enforceable; and, on March 29, 2017, entered a final order and decision.³ Good Fortune filed timely notice of appeal to this Court on June 16, 2017, pursuant to IRC sections 7482 and 7483.⁴

3. Venue of Appeal

Good Fortune appealed to the U.S. Court of Appeals for the D.C. Circuit, which has jurisdiction under IRC section 7482(a)(1), and is the proper venue under IRC section 7482(b)(1), because Good Fortune's appeal concerns the validity of Treasury Regulations. In addition, Good Fortune did not have a place of business in any judicial circuit when it filed its Tax Court petition. As a result, none of the specific venue provisions of IRC section 7482(b)(1) apply.

4. Appeal Timely

The notice of appeal, which was filed on June 16, 2017, was timely pursuant to Rule 13(a)(1) of the Federal Rules of Appellate Procedure and IRC section 7843.

STATEMENT OF THE ISSUES

The issues presented are:

STATUTES AND REGULATIONS

Pursuant to D.C. Circuit Rule 28(a)(5), Appellant sets forth the pertinent portions of the statutes and regulations that are applicable to the determination of this appeal in the addendum to this brief.

STATEMENT OF THE CASE

I. Procedural History

Appellant filed a petition in the Tax Court on October 12, 2012, challenging the Notice of Deficiency based its assertion that the following Treasury Regulations: § 1.883-4(b)(1)(ii), § 1.883-4(c)(1), § 1.883-4(d)(1), and § 1.883-4(d)(4)(i)(c) (the “Challenged Regulations”) were invalid and unenforceable.⁵ Appellee filed an answer on December 19, 2012,⁶ asserting that the Notice of Deficiency was correct because the Challenged Regulations are valid and enforceable.

On December 31, 2013, Appellant filed a motion for partial summary judgment asserting that the Challenged Regulations are invalid and unenforceable. On the same date, Appellee filed a motion for summary judgment. On January 21, 2014, Appellant filed a response to Appellee's motion for summary judgment. On the same date, Appellee filed a response to Appellant's motion for partial summary judgment.

On March 7, 2014, Judge Chiechi of the Tax Court heard oral argument and ordered submission of final briefs.⁷ On April 21, 2014, Appellant filed a reply to Appellee's response to its own motion for partial summary judgment. On the same day, Appellee filed a reply to Appellant's response to its motion for summary judgment. On April 28, 2014, Appellant filed a surreply with leave of the court.

On March 28, 2017, Judge Chiechi issued her opinion and entered an order and decision the next day.⁸ Judge Chiechi denied Appellant's motion for partial summary judgment, and granted Appellee's motion for summary judgment.

On June 16, 2017, Appellant filed a notice of appeal from Judge Chiechi's decision and order to this court.⁹

II. Statement of the Facts

Appellant is a foreign corporation organized under the laws of the Republic of the Marshall Islands with a legal residence in the Marshall Islands.¹⁰ When it was organized, Appellant issued all of its stock in bearer form.¹¹

On December 15, 2008, Appellant filed a Form 1120-F for the tax year ending December 31, 2007, asserting an exclusion under IRC section 883. It excluded certain transportation income from its gross income subject to U.S. tax, and included a Form 8275-R notifying the Appellee of its position that it was entitled to the exclusion even though its shares were issued to bearer and explaining the basis of its position that the Challenged Regulations are invalid and unenforceable under the tests set forth in Chevron.¹²

On April 14, 2010, Appellee commenced an examination of Appellant's Form 1120-F for 2007. On November 1, 2010, Appellee provided Appellant with an examination report with proposed changes to its 2007 return, to wit, increasing its taxable income by $3,587,375 and its tax liability by $143,495.¹³

On November 30^th, 2010, Appellant appealed the examination findings to the Appellee's Appeals Office.¹⁴ On July 18, 2012, the Appellee issued a Notice of Deficiency for tax pursuant to IRC section 887(a) in the amount of $143,495.00, the same amount as the adjustment proposed by the examination report, on the basis that Appellant was not entitled to the exclusion provided by IRC section 883 because its shares were issued in bearer form and, based on the Challenged Regulations, it did not qualify for the exclusion provided by section 883(c)(1).¹⁵

Appellant maintains that the Challenged Regulations are invalid.

III. Summary of Section 883 and the Applicable Treasury Regulations

Section 883(a)(1) grants a complete exclusion from the 4% gross tax imposed on nonresident alien individuals and foreign corporations earning United States Source Gross Transportation Income (“USSGTI”) pursuant to section 887(a). Pursuant to section 863(e)(2), 50% of all transportation income earned by vessels owned by foreign corporations and nonresident alien individuals whose voyages either begin or end in the United States is USSGTI. Section 883(a)(1) provides that the exclusion is only available for “[g]ross income derived by a corporation organized in a foreign country from the international operation of a ship or ships if such foreign country grants an equivalent exemption to corporations organized in the United States.” Section 883(c)(1) further limits that the exclusion:

[S]hall not apply to any foreign corporation if 50 percent or more of the value of the stock of such corporation is owned by individuals who are not residents of such foreign country or another foreign country meeting the requirements of such paragraph.

The Treasury Regulations implementing section 883 among other things provide guidance regarding attribution and substantiation of ownership. For example, Treas. Reg. § 1.883-1(b)(3) prescribes what must be included in the foreign company's Form 1120-F. Treas. Reg. § 1.883-2 provides guidance for publicly-traded corporations seeking qualification for exclusion under section 883 and Treas. Reg. § 1.883-3 provides guidance for controlled foreign corporations qualifying for exclusion under section 883.

Treas. Reg. § 1.883-4 provides the stock ownership test for shareholders seeking to meet the requirement of section 883(c)(1). Treas. Reg. 1.883-4(b)(2) defines residency for individual shareholders and other sections provide definitions for other entities that may be shareholders such as non-for-profit organizations and pension funds. The regulations set out rules for constructive ownership and for attribution of ownership. The term “qualified shareholder” is used for a person that meets the requirements set out in the regulations. Without qualified shareholders who own “more than 50% of its shares,” a taxpayer cannot claim the exclusion.

Treas. Reg. 1.883-4(b)(1)(ii) and the other Challenged Regulations prohibit attribution of bearer shares to anyone. This prevents the shares from being attributed to anyone, even if they would otherwise satisfy the requirements set out in the regulations to be a qualified shareholder. As a result, a taxpayer like Appellant cannot qualify for the section 883 exclusion. The denial of attribution of bearer shares for purposes of meeting the ownership test set forth in section 883 and the Treasury Regulations is the matter at issue.

SUMMARY OF ARGUMENT

Appellant challenges the validity and enforceability of the Challenged Regulations based on the two step test set forth out by the Supreme Court in Chevron.

I. THE CHALLENGED REGULATIONS FAIL CHEVRON STEP ONE

Chevron step one begins with an analysis of the express or plain language of the statute that the relevant regulations are intended to interpret. The role of the court under Chevron is not to substitute its view of how a statute should be implemented for that of the relevant agency, but to ensure that that agency's regulations are reasonably consistent with what Congress legislated.

When the plain language of a statute provides a clear indication of Congress' intent, there is little, if any, room for regulatory interpretation or legislation. Chevron mandates that regulatory agencies, including the Appellee, follow the clearly expressed intent of Congress. On the other hand, when statutory language either provides a clear indication that Congress wants a regulatory agency to “fill in the gaps” or if the language used is not clear, the relevant agency is expected to promulgate reasonable regulations to implement the statute in accordance with the intent of Congress.

IRC section 883(c)(1) provides that, for a foreign corporation's USSGTI to be exempt from US tax, more than 50% of “. . . the stock of such corporation [be] owned by individuals who are not residents of such foreign country or another foreign country meeting the requirements of such paragraph.”

The meaning of the word “own” in section 883 had at the time it was enacted, and still has, the commonly accepted meaning of “to possess.” Proving ownership of an asset differs depending on the item in question, but the meaning of ownership does not change.

The word “own” is straightforward. It leaves no gap for the Appellee to fill. The Challenged Regulations effectively prohibit ownership of bearer shares for purpose of the section 883 exclusion. Yet, nowhere in the plain language of the statute, its legislative history, or the other sections of the IRC does Congress indicate an intent to exclude bearer shares as a form of ownership for purposes of applying the section. The Challenged Regulations in effect legislate a limitation beyond what Congress intended when it used “own” in the statute. Accordingly, the Challenged Regulations fail Chevron step one.

II. THE CHALLENGED REGULATIONS FAIL CHEVRON STEP TWO BECAUSE THEY LACK A RATIONAL BASIS AND, AS A RESULT, ARE ARBITRARY AND CAPRICIOUS

If the Challenged Regulations do not fail Chevron step one, the court must examine them under Chevron step two. This inquiry focuses on the reasonableness of the regulations in light of the language of the statute and the intent of Congress in enacting it.

In this instance, the Chevron analysis shifts to how a shareholder proves ownership of the company seeking to take advantage of the section 883 exclusion. Congress offered no guidance as the statute is silent on this point. As ownership is at the heart of the statute's key objective, the Treasury Department is clearly authorized to issue regulations that spell out what taxpayers that wish to use the exclusion must do to document and prove their ultimate beneficial ownership.

The language in the statute itself does not disallow any form of ownership. It simply uses “own” without qualification. Yet, the Challenged Regulations ignore the inclusive implication of “own” and decree that ownership by means of bearer shares disqualifies their owners from being treated as qualified shareholders, thereby preventing the Appellant from benefiting from the exclusion.

The Appellee has not provided a rational basis for singling out bearer shares for this treatment when other forms of ownership are as, or even more, likely to create abuse of the exclusion. In the absence of a reasonable basis for this disparate treatment, the Challenged Regulations fail Chevron step two because they constitute an arbitrary and capricious interpretation of the statute.

ARGUMENT

Chevron, U.S.A., Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984) sets out the now well-established two step test to evaluate the degree to which an agency's regulations interpreting statutory language are entitled to judicial deference. It is now beyond doubt that Treasury Regulations are subject to Chevron scrutiny.¹⁶

The first part of the Chevron test starts with the statutory language to assess if it is “silent or ambiguous” with respect to the issues or terms being implemented by the agency regulations under review.¹⁷ If the statutory language is clear on its face, the agency's regulations must be consistent with that language.

If the statutory language is silent or ambiguous, the agency has authority to issue regulations implementing the statute, consistent with congressional intent, leading to the second Chevron step which examines whether regulations constitute a “reasonable interpretation” of the statute.¹⁸ The standard for reasonableness is whether there is a rational basis for the agency's interpretation. If regulations are arbitrary and capricious within the context of the statute, they are not reasonable and are not entitled to Chevron deference.

For the reasons set forth below, we submit that the Challenged Regulations fail both Chevron steps and should be invalidated.

I. The Standard of Review of the Tax Court's Decision is De Novo.

This court reviews decisions of the Tax Court in the same “manner and . . . extent as decisions of the district court in civil actions tried without a jury.”¹⁹ The court reviews Tax Court determinations of law on a de novo basis.²⁰ The facts in this case are agreed. The dispute centers on the validity and enforceability of the Challenged Regulations, which is a question of law. Thus, the Tax Court's ruling on the issues in this case is subject to de novo review by this court.²¹

II. The Challenged Regulations fail Chevron Step One Because the Language of IRC Section 883(c)(1) is Clear and Unambiguous with Respect to Ownership.

Under Chevron step one the question is “whether Congress has 'directly addressed the precise question at issue.'”²² The court must determine whether the issue presented was addressed by Congress in the statutory language under consideration.Statutory interpretation starts with a review of “'the language employed by Congress and an assumption that the ordinary meaning of that language accurately expresses the legislative purpose'.”²³ If the statute fully explains the contested term or phrase, regulations that are inconsistent with that language fail Chevron step one. Once Congress speaks to the precise matter at issue, the agency has no authority to interpret the statue differently.

Absent an indication to the contrary, Congress intends words to have “their ordinary, contemporary, common meaning.”²⁴ Absent an indication that Congress intended the words in section 883(c) to have other than their ordinary meaning, they should be understood as they were at the time the statute was enacted.

In Mayo, the Supreme Court examined a regulation implementing part of the FICA law dealing with the application of FICA taxes to students. The regulation at issue in that case created a bright line rule that applied to students who worked forty or more hours per week. The regulation determined that such students were not working “incident to and for the purpose of pursuing a course of study.”²⁵ In effect, the regulation classified such students as employees. As a result, schools that employed them were liable to deduct FICA taxes from the students' pay and to pay the employer's share of FICA taxes.²⁶

In applying Chevron step one to its evaluation of the regulations in question, the Supreme Court determined that the FICA statute did not define “student” in such a way as to foreclose further interpretation.²⁷ The statute defined a “student” as an individual “enrolled and regularly attending classes at school.”²⁸ The Supreme Court said that definition could apply to persons who spend more time working than attending classes.²⁹ As a result, an individual could simultaneously be a “student” within the statutory definition of student and a worker. It used the example of an individual enrolled and regularly attending classes, e.g. going to night school three nights a week, while working as a full time employee.³⁰ Since the purpose of the FICA statute is to ensure that workers and their employers pay FICA taxes, the Court saw the need to distinguish between students who work some of the time and workers who study some of the time in order to determine when FICA taxes should be paid by the employer and its employees. In Mayo, the employer was a teaching hospital that was not deducting FICA from its residents or paying the employer's share of FICA for them. The regulations at issue in Mayo established a bright-line rule based on the number of hours students worked per week. Those who worked 40 or more hours a week were classified as workers, which the Court found to be consistent with the statute. The ambiguity in the definition of student in this context provided the “gap” that the regulations filled appropriately.³¹

In its decision, the Tax Court asserts that the words at issue in the statute, “owned by individuals” do not “explain or otherwise address how to establish ownership by individuals for purposes of section 883(c)(1), let alone how to establish ownership where the shares of the foreign corporation are owned in bearer form.”³² The Tax Court emphasized that the legislative history of the statute is silent “as to how ownership by individuals may be established . . . including such a foreign corporation the shares of which were issued in bearer form.”³³ It then concluded that these are “essentially the same as the reasons for which the Supreme Court rejected the taxpayers' position and their arguments in support of their position in [Mayo].³⁴

The Tax Court wrongly conflated proof of ownership with the meaning of ownership.

The relevant part of section 883(c)(1) reads as follows:

Paragraph (1) or (2) of subsection (a) (as the case may be) shall not apply to any foreign corporation if 50 percent or more of the value of the stock of such corporation is owned by individuals who are not residents of such foreign country or another foreign country meeting the requirements of such paragraph.

The word at issue in this section is “owned”. The key issue under Chevron step one is whether Congress created an ambiguity — such as that in Mayo between a definition of student that could include students who work and workers who study — in the meaning of “own” such that Treasury Department regulations were needed to interpret it in the context of the exclusion.

The word “own” in section 883(c)(1) had a commonly understood meaning when the section was enacted. For example, the 1982 edition of American Heritage Dictionary defines “own” as, “to have or possess . . . to obtain possession of what belongs to one.”³⁵ Similarly, the 1986 edition of Webster's New International Dictionary defines “own” as, “to have or hold as property or appurtenance; have a rightful title to, whether legal or natural; possess . . .”³⁶

Of course, the evidence or character of ownership depends on the item owned. Bearer shares are negotiable instruments that are owned by the person that physically possesses them.³⁷ In that respect, bearer shares are like currency. The fact that possession equals ownership of currency or bearer shares does not change the reality that bearer shares and currency are owned by the persons who possess them.³⁸ Contrast this with possession of a check drawn the favor of another person, which, in the absence of a valid endorsement in the holder's favor, does not equal ownership of the funds represented by the check.

Unlike Mayo, in which the definition of student was open to interpretation in the context of the FICA statute, the word at issue in this case has a plain meaning within the context of the statute. No additional interpretation required. Nothing in the text of the statute itself suggests that “own” needs regulatory interpretation.

The Tax Court conflates ownership of bearer shares, which is not ambiguous, with establishing or proving ownership of such shares. While related, these are not identical issues. The Challenged Regulations in effect exclude bearer shares from ownership for purposes of the section 883 exclusion by prohibiting owners of such shares from being “qualified shareholders”. Without having qualified shareholders, a taxpayer cannot claim the exclusion under section 883(c). In other words, ownership of bearer shares is not considered ownership for purposes of the exclusion.

Appellant does not contest the Treasury Department's authority to issue regulations addressing attribution and proof of ownership.³⁹ However, the Challenged Regulations use that authority not to set rules to demonstrate ownership of bearer shares, but to deny it. Appellant asserts that under Chevron step one the Treasury Department does not have authority to redefine ownership in such a way as to exclude bearer shares as a valid form of ownership.

III. The Challenged Regulations fail Chevron Step Two Because they are Arbitrary and Capricious in that there is no Rational Basis for them

Assuming for the sake of argument that the court accepts that the Challenged Regulations fill a gap or ambiguity in the statute,⁴⁰ they fail Chevron step two because they are not “a reasonable interpretation of the enacted text.”⁴¹ Courts have authority to review regulations but they “may not disturb an agency rule unless it is 'arbitrary or capricious in substance, or manifestly contrary to the statute.'”⁴²

In its opinion, the Tax Court adopted the Appellee's argument that the difficulty of proving ownership of bearer shares is a reasonable basis to justify the Challenged Regulations.⁴³ According to sources provided by the Appellee in its briefs and cited by the Tax Court,⁴⁴ anonymity is a significant problem “in the international community, and specifically in the shipping industry.”⁴⁵ This aspect of bearer shares allegedly makes it difficult to establish the identity of the true owner of the shares, and justifies Treasury Department's enactment of the Challenged Regulations.⁴⁶

Even accepting the potential for abuse with the use of bearer shares to disguise the true owners of a taxpayer, there is potential for abuse with other kinds of shares, which are expressly allowed, including shares registered in the name of their reputed owners. As will be shown below, the fact that a name appears on a share certificate is not conclusory proof that that person is the true owner of the shares. The person whose name appears on a stock certificate could be a disclosed or undisclosed nominee, a disclosed or undisclosed trustee, or a straw-man with no genuine economic interest in the shares. As such, there is no rational basis for the Challenged Regulations. All types of share ownership have potential for abuse. Accordingly, all assertions of ownership should be subject to thorough review by the Appellee when it examines a claim for exclusion under section 883. There is simply no way to know if the representation that appears on a Schedule S is true or not without investigation. Unlike in Mayo, where establishing a bright-line rule made regulatory sense, singling out bearer shares for disparate treatment under section 883 does not.

Chevron's purpose was to establish limits of executive agencies rulemaking authority to prevent agencies from issuing regulations that effectively reinterpret statutes passed by Congress, from acting as unelected legislative bodies.⁴⁷

a. The Challenged Regulations are not Supported by the Statutory Language or the Canons of Statutory Construction

Agencies are rightly accorded wide latitude in interpreting statutory language, but must be guided by Congressional intent expressed in the language and legislative history of the statute they are interpreting.⁴⁸ The Treasury Department failed to take this approach when crafting the Challenged Regulations, as there is no rational basis for eliminating bearer shares as a permissible form of ownership within IRC section 883(c).

The text of the statute is the starting point when considering Congressional intent.⁴⁹ There is nothing in the text of section 883 regarding proof of ownership. There is also nothing in the statute that dictates any particular form of ownership or even provides an inference that certain types of ownership are not to be permitted. The statute states only “. . . the stock of such corporation is owned by individuals.”⁵⁰

The cannons of statutory construction begin with the ordinary usage of terms unless Congress gave the terms a specific or technical meaning.⁵¹ Congress did not define “own,” and the dictionaries at the time of enactment, 1986, provided the same definition for “own” as they do now. The Supreme Court held that in cases with multiple ordinary usages, the agency's use of just one of these meanings is reasonable.⁵² However, in this case there is only one meaning of “own” and it does not exclude ownership of bearer shares. Unlike “student” in the context of the FICA statute where it was clear that “workers who study” were encompassed within the word “student' as defined in the statute requiring clarification, there is no similar ambiguity about “own” within the language of section 883 to require clarification.

If the statutory language leaves doubt as to the meaning of a particular word, the cannons of statutory construction direct us to look to the legislative history of the statute as a source of Congressional intent.⁵³ The precursor of section 883, section 213(b)(8) was enacted by Congress in 1921 in order “to encourage international adoption of uniform tax laws affecting shipping companies so U.S. shipping companies would not be subject to double taxation in foreign countries.”⁵⁴

Section 213(b)(8) eventually evolved into section 883.⁵⁵ By 1986, Congress did not believe that the section “. . . w[as] not meeting the goal of reserving the right to tax transportation income to the country of residence of the taxpayer (and therefore to eliminate double taxation) . . .”⁵⁶

Accordingly, Congress amended section 883 to tighten the exclusion. The revision changed the basis of reciprocity from the country of the vessel's flag to the country of incorporation of the company which owns the vessel or otherwise receives hire.⁵⁷ The first hurdle created by the amendment was that the foreign corporation that owns a vessel had to be organized in a country that extended a reciprocal exemption to companies organized in the United States. The revision also added an important additional requirement, namely, that the foreign corporation claiming the exclusion be more than 50% owned by individuals who either reside in the corporation's country of incorporation or in another country which has an equivalent exemption for United States corporations. Congress did not express a concern with the nature of the foreign corporation's stock structure or otherwise, explicitly or implicitly, suggest a limitation on the kind of stock issued by the foreign corporation. Instead, Congress focused on ensuring that the section 883 exclusion is tied to the country where the foreign corporation is organized and the countries where more than 50% of its ultimate beneficial owners reside.

The third element used in the cannons of statutory construction is to look to other sections of the code to see how the same term is used. Continuity in the use of statutory text leads to a presumption that Congress meant the same term to be applied consistently in different statutes.⁵⁸ This canon has been used by courts to find that definitions in one section of the IRC ought to be held consistent throughout the Code, particularly if the legislative history indicates Congress that intended the definitions to remain consistent throughout the statutes.⁵⁹

In fact, neither the IRC nor other Treasury Regulations exclude bearer shares as a form of ownership in any other instance in which ownership is an issue.⁶⁰ For example, IRC section 884(c)(4)(B), which allows publicly traded corporations to qualify as residents of foreign countries for purposes of the branch profits tax, the legislative history of that section specifically states “corporations with bearer shares can meet the burden of proof . . . as long as they have no knowledge and no reason to know their stock is closely held.”⁶¹ Treasury Regulation 1.1471-5(f)(1)(i)(C)(2) implementing section 1471 in keeping with that section's legislative history provides that “an FFI will not be prohibited from qualifying as a qualified collective investment vehicle solely because it has issued interests in bearer form, provided that the FFI ceased issuing interests in such form after December 31, 2012 . . .”⁶² While this section sunsets the use of bearer shares, it does not prohibit those issued before the sunset date (December 31, 2012).

b. The Challenged Regulations are Arbitrary and Capricious.

“Arbitrary” describes a determination made without consideration of or regard for facts, circumstances, fixed rules, or procedures.⁶³ “Capricious” is defined as contrary to the evidence or established rules of law.⁶⁴

The Challenged Regulations are arbitrary and capricious when one considers the Treasury Department's openness to other types of ownership in the section 883 regulations. Indeed, as Judge Chiechi pointed out during oral argument, proving the ownership of bearer shares is no harder or more difficult that proving the true owners of shares held by nominees or trustees.⁶⁵

Indeed, proving beneficial ownership and attribution of shares registered in a person's name requires more than presentation of share certificates. The provisions of Treas. Reg. § 1.883-4(c)(4) are instructive in this regard.

A shareholder of a corporation that issues stock shall be treated as owning stock of a foreign corporation that is owned by such corporation on any day in a proportion that equals the value of the stock owned by such shareholder to the value of all stock of such corporation. If, however, there is an agreement, express or implied, that a shareholder of a corporation will not receive distributions from the earnings of a stock owned by the corporation, the shareholder will not be treated as owning that stock owned by the corporation. Emphasis added.

This sensible “follow the money” rule recognizes that ownership involves more than simply having a name listed on a share certificate.

In Mayo, the Supreme Court found it reasonable for the Treasury Department to draw a bright line between “workers who study and students who work”⁶⁶ to “improve administrability” and to avoid “the wasteful litigation and continuing uncertainty that would inevitably accompany any purely case-by-case approach.”⁶⁷ In using the very well-accepted number of hours in a full time work week, i.e., 40, as the standard to differentiate between those who are students and those who are workers, the Treasury Department had a rational reason for drawing the bright-line at that point.

Appellee argued that the Challenged Regulations draw a bright-line similar to the line drawn in Mayo, with the goal of improving tax administration and reducing the burden of engaging in time consuming case-by-case analyses.⁶⁸ In Mayo, the bright-line rule eliminated the need for case-by-case treatment. This justification fails in the case of the section 883 exclusion. There is simply no way to remove the case-by-case approach to examinations of tax returns that claim the section 883 exclusion because the key issues to be examined by the Appellee are the identity and residence of the actual ultimate beneficial owners of the taxpayer. The Challenged Regulations do not alter that one iota.

Exemptions and deductions are by legislative grace.⁶⁹ Thus, the taxpayer has the burden of proving to the satisfaction of the IRS that its ultimate beneficial owners are “qualified shareholders” as defined in the section 883 regulations. Whether the shares of the corporations in the chain of ownership are issued in the names of the true owners, nominees, trustees or bearers, the Appellee has the exact same task in each instance, namely, to determine the accuracy of the position taken on the return. To do so, in addition to requesting the ownership statements⁷⁰ that were prepared and signed before the return was filed, it will also demand further documentation, such as banking, financial, and legal records, to substantiate that true ownership is in fact what the taxpayer claimed it is on the filed return.⁷¹ If the Appellee is not satisfied that the taxpayer has met its burden of proof, it may disallow any section 883 exclusion. It simply makes no difference what form the shares relied on take.

To place this exercise in context, what follows is a brief explanation of how a section 883 exclusion would be claimed and then examined by the Appellee: (1) the taxpayer claims the exclusion on its Form 1120-F for a tax year by filing Schedule S on which it lists the percentages (equaling at least “more than 50%”) of the shares controlled by its ultimate beneficial owners (the qualified shareholders) and the countries of residence of those shareholders by percentage; (2) the Appellee selects the return for examination and issues its initial document request, listing the information the examiner wants to review in order to substantiate the ownership shown on the Schedule S filed with the taxpayer's Form 1120-F, including the ownership statements made under penalties of perjury by the qualified shareholders which statements outline the ownership structure from qualified shareholder(s) to the taxpayer; (3) the taxpayer provides the documents requested; (4) after review and discussion with the taxpayer or its representative regarding the documentation provided by the taxpayer, the Appellee determines whether the taxpayer has demonstrated to Appellee's satisfaction that the ownership and residence of the taxpayer's qualified shareholders satisfy the section 883 regulations; and (5) issues a notice of deficiency, as it did in this case, or closes the examination without adjustment.

If the taxpayer wishes to prevail in the examination, it has no option but to provide all of the documents that the Appellee requests. The Appellee does not take the documentation at face value, but evaluates its validity and credibility as to the issue of ownership.⁷² As Judge Chiechi succinctly summarized during oral argument in the Tax Court, “when you do an audit, what do you do? You say even if it's on the books, even if it's not bearer, you say 'Show me,' right?”⁷³

Taxpayers always have the burden of proving to the satisfaction of the Appellee that they meet the requirements of any claimed exclusion.⁷⁴ Indeed, if the Appellant had not filed a Form 8275-R disclosing its disagreement with the Challenged Regulations, the Appellee would not have known that its shares had been issued to bearer. The Appellee can deny any exclusion claim under section 883 if it is not satisfied with proof of ownership. Thus, there is little risk of abuse from bearer shares in the instant case or under section 883 generally. Indeed, in the context of section 883, the Appellee has provided no rational basis for disallowing bearer shares while explicitly accepting other opaque forms of ownership, such as nominees and trustees.

The fact that a person is listed as the owner of shares in a corporation's books and records does not by itself prove that that person is the true owner of the shares.⁷⁵ The true owner is the person who derives financial benefit of the investment, which may or may not be the person whose name appears on a share certificate.⁷⁶ Two other forms of ownership explicitly condoned in the section 883 regulations obfuscate the identity of the true owners, namely, nominees and straw-men. Nominees are persons who hold legal title to shares for the benefit of others or who receive funds but distribute them to others.⁷⁷ The nominee is listed on the stock certificate and in the corporate registry but is not the beneficial owner of the shares. Straw-men are third parties used as temporary transferees to disguise or hide the true owner and beneficiary of the investment.⁷⁸

Despite the obvious identification issues presented by nominees and straw-men, the section 883 regulations neither prohibit them nor hold them to a higher standard of documentation:

[i]n the case of a person owning stock in the foreign corporation indirectly through one or more intermediaries (including mere legal owners or recordholders acting as nominees), each intermediary in the chain of ownership between that person and the foreign corporation seeking qualified foreign corporation status completes an intermediary ownership statement described in paragraph (d)(4)(v) of this section or has a valid intermediary ownership statement in effect under paragraph (d)(2)(ii) of this section.⁷⁹

The section 883 regulations require ownership statements for all taxpayers seeking to use the exclusion. Why permit registered shares in the names of nominees or straw-men to be attributed to their ultimate beneficial owners, when issues of true ownership are difficult and time consuming to investigate, but exclude attribution of bearer shares?

The simple alternative to the per se exclusion mandated by the Challenged Regulations would be setting out a stringent methodology and a strict standard of proof for those ultimate beneficial owners who use bearer shares. The Appellee took this kind of approach in Section 8.02(3) of Rev. Proc. 91-12 (1991-1 C.B. 473).

(3) SECTION 883. To claim exemption under section 883, the foreign corporation must attach statement to the Form 1120F for the taxable year setting forth the following information: the name of the corporation; employer identification number (if any); the country of incorporation; a statement that the foreign country of incorporation provides an equivalent exemption through domestic law and citing the applicable authority or diplomatic note between the country of residence and the United States confirming the exemption; a statement that more than 50% of the value of the outstanding shares is owned by shareholders which are residents of countries which provide an equivalent exemption for the type of transportation income applicable; and the statement required in section 8.03 of this revenue procedure. Upon examination, the foreign corporation must have documentation available to support the statements required herein. In the absence of such documentation, bearer shares will be deemed to be owned by individual residents of a foreign country which does not provide an equivalent exemption, for purposes of section 883(c). Emphasis added.

This approach both honors the meaning of own in section 883 and serves notice to taxpayers that establishing ownership of bearer shares will require full and complete documentation, even though this is redundant since all taxpayers should be on notice that they have to prove any exclusion they claim on their tax return. Indeed, this approach is consistent with how the Appellee would approach any claim of exclusion by demanding documentation to substantiate ownership. There is a rational basis for the Appellee to look with heightened skepticism into opaque forms of ownership. However, there is no rational basis for the Appellee to single out one form of opaque ownership when all forms of ownership should be carefully scrutinized.

Appellee claims that the difficulty of proving ownership of bearer shares justifies the Challenged Regulations.⁸⁰ However, Appellee's position in other instances, and Tax Court decisions, allow ownership of bearer shares to be proved through application of “general principles of corporate law” and the consideration of surrounding circumstances.⁸¹

The Appellee cannot square its willingness to determine ownership of bearer shares when tax revenue is at stake⁸² with its denial of such ownership in applying the section 883 exclusion. Commercial realities in the shipping industry ensure that there is ample documentation to support claims of ownership, regardless of the type of shares issued. Oceangoing vessels to which section 883 applies are expensive. For example, a very large crude carrier (“VLCC”) can cost in excess of $80 million dollars.⁸³ Banks and other financial entities that lend money to owners to buy or build these vessels conduct thorough due diligence to ascertain the identity of the person(s) behind a company that is buying a vessel and seeking a loan to do so. Not only do these financing institutions have to satisfy the pervasive “know-your-customer” rules, but also to satisfy their directors and shareholders that they investigated, and are satisfied with, the credit worthiness of the borrowers.

As an example of the commercial realities that apply, during discovery the Appellant provided the Appellee with the following documentation to establish the beneficial ownership of its bearer shares:

As this list of documents makes clear, Appellee's assertion in the Tax Court that there is no way to know who owns the vessel in question is simply untrue. Shipping is capital intensive. Oceangoing vessels are expensive. Thus, as in this case and virtually all others, owners borrow money to purchase them. The amount of money, the rate of interest, repayment period, default provisions and loan to value ratios are a product of extensive negotiation between the lenders and the owners. The resulting loan, as the foregoing list illustrates, requires substantial documentation consisting of bank account records, personal guarantees, management agreements, retention accounts for charter hire, charter party agreements, correspondence between parties, to mention a few examples of contemporaneous evidence that establishes beneficial ownership.

Opacity of beneficial ownership in international shipping varies little from that of privately owned companies in land based industries. Private companies maintain books and records not only to satisfy their lenders, but also to track the performance of their business or investment. The fact that they do not make their books and records public does not mean they do not have them and cannot prove who owns them.

The Appellee is unlikely to take ownership of a company under examination at face value, even if the shares are registered, eliminating any justification for the Challenged Regulations on the basis that it is more difficult to prove ownership of bearer than registered shares.

The last nail in the coffin of the Challenged Regulations is the requirement that all taxpayers seeking to use the section 883 exclusion collect and maintain on file ownership statements from each qualified shareholder relied on to meet the “more than 50%” test needed to qualify for exclusion.⁸⁴ Ownership statements are written statements, signed under penalties of perjury, that describe the ownership of the taxpayer from the qualified shareholder(s) down to the corporation claiming the exclusion, including each intermediary entity or person. Each intermediary entity or person must prepare and sign separate ownership statements, also signed under penalties of perjury, describing their role in the ownership structure.⁸⁵ Ownership statements are valid for three years unless there is a change in ownership in the interim and must be renewed every three years.⁸⁶

If the potential penalties of perjury are enough to prevent nominee and straw-men from attempting to deceive the Appellee about the true ownership of the taxpayer, there is no reason that this same assumption should not apply to the owners who hold bearer shares. Those signing the ownership statements have as much to lose if they perjure themselves regardless of whether the shares are issued to bearer or are registered.

CONCLUSION

Given that proving the true ownership of registered and bearer shares involve the same process, there is no rational basis, as there was in Mayo, for the Challenged Regulations to treat bearer shares differently than registered shares held by nominees, straw-men, or the actual owners. In effect, these regulations not only replace the simplicity of the word “own” in section 883 with an imputed meaning that “own” includes “how to prove ownership”, violating the first step of Chevron, they are an arbitrary and capricious interpretation of the statute that prejudges the ownership issue and denies owners of bearer shares the opportunity to prove to Appellee's satisfaction that the holders of the shares are their true owners. Section 883. requires a case-by-case analysis of the ownership of taxpayers claiming the section 883 exclusion regardless of the nature or form of ownership.

For the foregoing reasons, the Challenged Regulations are not entitled to Chevron deference and should be invalidated.

Dated: October 23, 2017

By: Stephen P. Flott

JOSEPH G. SIEGMANN
BRITTANY N. ORAVEC
Flott & Co. PC
2200 Wilson Boulevard, Suite 320
Arlington, VA 22201
Telephone: (703) 525-5110 Ext 126
email: sflott@flottco.com