Dover Corp. v. Comm'r

*324 OPINION

HALPERN, Judge: Dover Corporation (petitioner) is the common parent of an affiliated group of corporations making a consolidated return of income (the group or affiliated group). By notice of deficiency dated September 14, 2000 (the notice), respondent determined deficiencies in Federal income tax for *325 the group for its 1996 and 1997 taxable (calendar) years in the amounts of $ 9,329,596 and $ 24,422,581, respectively. All but one of the adjustments that gave rise to those determinations have been settled, and this report addresses the sole remaining issue, which involves an interaction between the so-called check-the-box regulations*21 and the definition of foreign personal holding company income (FPHCI); viz, whether the deemed sale of assets immediately following their deemed receipt (pursuant to the check-the-box regulations) from a disregarded foreign entity gives rise to FPHCI.

Unless otherwise stated, all section references are to the Internal Revenue Code in effect for 1997, the year at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

             Background

Introduction

This case was submitted for decision without trial pursuant to Rule 122. Facts stipulated by the parties are so found. The stipulation of facts filed by the parties, with attached exhibits, is included herein by this reference. Respondent objects, on the grounds of relevance, to 26 exhibits referenced in certain of the stipulations. See the discussion infra section IV.

Petitioner is a Delaware corporation, whose shares are publicly traded and which maintains its principal place of business in New York, New York.

Business Activities of the Affiliated Group

Together, the affiliated group is a diversified industrial manufacturer, producing through its members and foreign*22 subsidiaries a broad range of products and sophisticated manufacturing equipment for other industries and businesses. During and prior to 1997, the group's business activities were divided into five business groups, one of which was known as Dover Elevator.

Dover Elevator

Dover Elevator, like each of the other business groups, was managed by a headquarters corporation, Dover Elevator*326 International, Inc. (DEI), a domestic corporation. However, not all of the corporations that constituted Dover Elevator were direct or indirect subsidiaries of DEI. During 1997, DEI's United Kingdom (UK) elevator business was conducted by Hammond & Champness Limited (H&C), a UK corporation engaged in the business of installing and servicing elevators. H&C was wholly owned by a UK holding company, Dover U.K. Holdings Limited (Dover UK), which was wholly owned by a Delaware corporation, Delaware Capital Formation (DCF), which, finally, was wholly owned by petitioner.

Sale of H&C

On June 30, 1997, Dover UK and petitioner entered into an agreement with Thyssen Industrie Holdings U.K. PLC (Thyssen), a German corporation registered in England and Wales, and its German parent, Thyssen Industrie AG, for the*23 sale by Dover UK to Thyssen of the entire issued share capital of H&C (the agreement or stock sale agreement). The agreement provided that it and other specified documents and agreements relating to the sale were to be held in escrow until the "Escrow Release Date" (July 11, 1997), by which time it was anticipated that the purchaser would have "completed its due diligence inquiries, and * * * determined that it does wish to proceed with * * * [the sale]" (the "escrow condition"). Dover UK, as "Vendor", also agreed to accomplish certain document deliveries and undertakings by July 11, at which time Thyssen, as "Purchaser", was required to "satisfy the consideration for the Shares". Dover UK also agreed to carry on the H&C business "in the normal course without any interruption" between June 30 and July 11, 1997. On July 11, 1997, Thyssen notified Dover UK that the escrow condition had been satisfied, and (we assume, since there is no stipulation) the purchase price was received by Dover. ¹

*24 Petitioner obtained an opinion of UK counsel dated July 3, 2001, that, as a matter of English law, beneficial title to the*327 H&C shares passed from Dover UK to Thyssen on July 11, 1997, when the escrow condition was satisfied.

Retroactive Election To Treat H&C as a Disregarded Entity

By letter dated December 3, 1998, petitioner, on behalf of its (then) former indirect subsidiary, H&C, requested that respondent grant an extension of time, pursuant to sections 301.9100-1(c) and 301.9100-3, Proced. & Admin. Regs., for H&C to file a retroactive election to be a disregarded entity for Federal tax purposes (the request for 9100 relief). Specifically, petitioner requested: "H&C be granted an extension of time to make an election: (a) * * * to be disregarded as an entity separate from its owner for U.S. tax purposes and (b) effective immediately prior to the sale of stock in H&C by Dover UK to Thyssen UK." ² In the request for 9100 relief, petitioner stated that the date of the sale was June 30, 1997, and, on the Form 8832, Entity Classification Election (Form 8832), attached to the request for 9100 relief, it set forth June 30, 1997, as the proposed effective date of the election.

*25 Initially, respondent was reluctant to grant the request for 9100 relief, in large part, because, in respondent's view, petitioner should not be entitled to benefits it might claim resulted from the disregarded entity election; i.e., the avoidance of FPHCI on the deemed sale of the H&C assets. However, after representatives of petitioner and respondent conferred, and petitioner made a supplemental submission, respondent, on March 31, 2000, granted the requested relief. Specifically, respondent granted to H&C "an extension of time for making the election to be disregarded as an entity separate from its owner for federal tax purposes, effective immediately prior to the sale on * * * [June 30, 1997], until 60 days following ³ the date of this letter." Respondent, however, added the following caveat:

   no inference should be drawn from this letter that any gain from

   the sale of * * * [H&C's] *26 assets immediately following its

   election to be disregarded as an entity separate from its owner

   gives rise to gain that is not foreign*328 personal holding company

   income as defined in section 954(c)(1)(B) of the Internal

   Revenue Code.

On or about October 10, 1999, H&C made an election on Form 8832 to be disregarded as a separate entity. The Form 8832 specifies that the election is to be effective beginning June 30, 1997.

             Discussion

This case presents an issue of first impression and, insofar as we are aware, the first occasion that any court has had to opine on the impact of the so-called check-the-box regulations on the application of a specific provision of the Internal Revenue Code of 1986 (the Code), in this case, section 954(c)(1)(B)(iii) (defining, in part, FPHCI). ⁴

The provision of the Code principally at issue is section 954. Section 954 is found in subpart F of part III, subchapter N, chapter 1, subtitle A of the Code (Subpart F), which encompasses sections 951-964. Subpart F is concerned with controlled foreign corporations (CFCs). Neither party disputes that, in 1997, both Dover UK and H&C (up until it became a disregarded entity) were CFCs, as that term is defined in section 957(a). Section 951 provides that each United States shareholder of a CFC shall include in gross income certain amounts, including "his pro rata share * * * of the * * * [CFC's] subpart F income" for the taxable year. Sec. 951(a)(1)(A)(i). ⁵ Subpart F income includes "foreign base company income (as determined under section 954)". Sec. 952(a)(2). Pursuant to section 954(a)(1), foreign base company income includes FPHCI, which is defined, in pertinent part, in section 954(c) as follows:

*28 *329 SEC. 954(c) Foreign Personal Holding Company Income. --

        (1) In general. -- For purposes of subsection (a)(1),

     the term "foreign personal holding company income"

     means the portion of the gross income which consists of:

           *   *   *   *   *   *   *

          (B) Certain property transactions. -- The excess

        of gains over losses from the sale or exchange of

        property --

           *   *   *   *   *   *   *

             (iii) which does not give rise to any

          income.

1. Regulations Under Section 954(c)(1)(B)(iii)

In pertinent part, section 1.954-2(e)(3), Income Tax Regs., which defines "property that does not give rise to income", provides:

     (3) Property that does not give rise to income.

   Except as otherwise provided in this paragraph (e)(3), for

   purposes of this section, the term property that does not give

   rise to income includes all rights and interests*29 in property

   (whether or not a capital asset) including, for example,

   forwards, futures and options. Property that does not give rise

   to income shall not include --

           *   *   *   *   *   *   *

        (ii) Tangible property (other than real property) used

     or held for use in the controlled foreign corporation's

     trade or business that is of a character that would be

     subject to the allowance for depreciation under section 167 or 168 and the regulations under those sections (including

     tangible property described in section 1.167(a)-2);

        (iii) Real property that does not give rise to rental

     or similar income, to the extent used or held for use in

     the controlled foreign corporation's trade or business;

        (iv) Intangible property (as defined in section

     936(h)(3)(B)), goodwill or going concern value, to the

     extent used or held for use in the controlled foreign

     corporation's trade or business[.]

In*30 pertinent part, section 1.954-2(a)(3), Income Tax Regs., provides: "The use * * * for which property is held is that use * * * for which it was held for more than one-half of the period during which the controlled foreign corporation held the property prior to the disposition."

*330 2. The Check-the-Box Regulations

a. Development and Issuance of the Regulations

The Commissioner announced, in Notice 95-14, 1995-1 C.B. 297, that the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) were considering simplifying the entity classification regulations to allow taxpayers to treat both domestic (unincorporated) and foreign business organizations as partnerships or associations (generally taxable as corporations) on an elective basis. In Notice 95-14, the Commissioner justified the proposed radical departure from the existing classification regulations by observing that, as a "consequence of the narrowing of the differences under local law between corporations and partnerships * * * taxpayers can achieve partnership tax classification for a non- publicly traded organization that, in all meaningful respects, is virtually indistinguishable*31 from a corporation." Id. The Commissioner further observed that the proliferation of revenue rulings, revenue procedures, and letter rulings determining or relating to the classification for Federal tax purposes of limited liability companies and partnerships formed under State law had made the existing classification regulations unnecessarily cumbersome to administer, and the resulting complexities risked leaving small unincorporated organizations with insufficient resources and expertise to apply the current classification regulation to achieve the organization's desired classification. Id. The Commissioner also stated that, because the same types of concerns "are mirrored in the foreign context," the IRS and Treasury "are considering simplifying the classification rules for foreign organizations". Id. at 298. Notice 95-14 invited comments and scheduled a public hearing. Id. at 299.

In 1996, the written comments and public hearing were followed by the issuance of, first, proposed and, then, final classification regulations. See PS-43-95, Proposed Income Tax Regs., 61 Fed. Reg. 21989 (May 13, 1996) (the proposed regulations); T.D. 8697 (December 18, 1996), 1997-1 C.B. 215*32 (the final regulations). The classification regulations are commonly referred to as the "check-the-box" regulations because of their elective feature. See, e.g., Schler, "Initial Thoughts*331 on the Proposed 'Check-the-Box' Regulations", 71 Tax Notes 1679 (June 17, 1996).

Not only did both sets of regulations permit most domestic (unincorporated) and foreign business organizations to elect between association and partnership classification for Federal tax purposes, as first proposed in Notice 95-14, ⁶ but, of particular relevance to this case, they both extended the elective regime to single-owner organizations. Under the final regulations, single-owner organizations are permitted to elect "to be recognized or disregarded as entities separate from their owners." Sec. 301.7701-1(a)(4), Proced. & Admin. Regs.

*33 The final regulations became effective as of January 1, 1997, with a special transition rule for existing entities. T.D. 8697, 1997-1 C.B. at 219. ⁷

*34 The preamble to the final regulations contains the following warning to taxpayers:

   in light of the increased flexibility under an elective regime

   for the creation of organizations classified as partnerships,

   Treasury and the IRS will continue to monitor carefully the uses

   of partnerships in the international context and will take

   appropriate action when partnerships are used to achieve results

   that are inconsistent with the policies and rules of particular

   Code provisions or of U.S. tax treaties. [

  T.D. 8697, 1997-1 C.B. at 216.]

The preamble to the proposed regulations contains a substantially identical warning, except that the promise is to "issue appropriate substantive guidance" rather than "take appropriate action" with regard to the use of partnerships for what Treasury and IRS consider improper purposes in the international context. See 61 Fed. Reg. at 21990 (May 13, 1996). We surmise that the change in language signaled an intent*332 not only to address perceived abuses in the use of partnerships in amended regulations, revenue rulings, or other public pronouncements that, generally, would have*35 prospective effect but also to challenge those perceived abuses on audit. For no apparent reason, the warning did not extend to allegedly inappropriate uses of disregarded entities, the type of organization involved in this case.

b. Amendments to the Regulations

Since they were issued, the (final) check-the-box regulations have been amended several times. The only relevant amendments were additions to the regulations that, together, constitute the existing paragraph (g) of section 301.7701-3, Proced. & Admin. Regs. See T.D. 8844, 1999-2 C.B. 661, 666-667;T.D. 8970, 2002-1 C.B. 281, 282. Although those amendments are generally effective as of the dates of issuance (November 29, 1999, and December 17, 2001, respectively), both amendments provide for retroactive application for elections filed before those dates if all affected persons take consistent filing positions. See sec. 301.7701-3(g)(2)(ii), (4), Proced. & Admin. Regs. The parties have stipulated that the election by H&C, on Form 8832, to be a disregarded entity was filed on or about October 10, 1999, which precedes the general effective dates. On brief, both parties have cited and relied upon portions*36 of section 301.7701-3(g), Proced. & Admin. Regs. Therefore, we find that the parties agree to the retroactive application of paragraph (g) of section 301.7701-3, Proced. & Admin. Regs., to H&C's disregarded entity election.

c. Applicable Provisions of the Regulations

Section 301.7701-3(a), Proced. & Admin. Regs., sets forth the general rule that "[a] business entity that is not classified as a corporation * * * can elect its classification for federal tax purposes as provided in this section".

In pertinent part, section 301.7701-3(g)(1)(iii), Proced. & Admin. Regs., provides:

     (iii) Association to disregarded entity. If an eligible

   entity classified as an association elects * * * to be

   disregarded as an entity separate from its owner, the following

   is deemed to occur: The association distributes all of its

*333    assets and liabilities to its single owner in liquidation of the

   association.

Section 301.7701-2(a), Proced. & Admin. Regs., states that, "if * * * [an] entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner".

Under section 301.7701-3(c)(1)(i), *37 Proced. & Admin. Regs., a classification election, including an election to change classification, is made by filing a Form 8832 with the IRS service center designated on that form. Under subdivision (iii), the election is effective "on the date specified by the entity on Form 8832" if, as in this case, one is specified.

Under section 301.7701-3(g)(3)(i), Proced. & Admin. Regs., an election to change classification "is treated as occurring at the start of the day for which the election is effective", and "[a]ny transactions that are deemed to occur * * * as a result of a change in classification [e.g., in the case of a change in classification from association to disregarded entity, the deemed liquidation] are treated as occurring immediately before the close of the day before the election is effective". For example, if H&C's disregarded entity election is effective as of the start of business on June 30, 1997, the deemed liquidation of H&C is treated as occurring immediately before the close of business on June 29, 1997.

The making of a disregarded entity election "is considered to be the adoption of a plan of liquidation immediately before the deemed liquidation", thereby qualifying*38 the parties to the deemed liquidation for tax-free treatment under sections 332 and 337. Sec. 301.7701-3(g)(2)(ii), Proced. & Admin. Regs.

Lastly, section 301.7701-3(g)(2)(i), Proced. & Admin. Regs., provides:

     (2) Effect of elective changes. -- (i) In general.

   The tax treatment of a change in the classification of an entity

   for federal tax purposes by election under paragraph (c)(1)(i)

   of this section is determined under all relevant provisions of

   the Internal Revenue Code and general principles of tax law,

   including the step transaction doctrine.

The preamble to the 1997 proposed regulations, which contains the identical provision, explains the purpose of the above quoted provision:

  *334 This provision * * * is intended to ensure that the tax

   consequences of an elective change will be identical to the

   consequences that would have occurred if the taxpayer had

   actually taken the steps described in the * * * regulations.

   [REG-105162-97, 62 Fed. Reg. 55768 (Oct. 28, 1997).]

Petitioner argues that, by permitting*39 a corporate taxpayer to "disregard" the separate entity status of a subsidiary and, instead, treat the subsidiary's business as a hypothetical branch or division of the parent, the check-the-box regulations override the principle, based upon Moline Props., Inc. v. Commissioner, 319 U.S. 436, 438-439, 87 L. Ed. 1499, 63 S. Ct. 1132 (1943), that the separate entity status of a corporation may not be ignored for Federal tax purposes. As a result (as petitioner sees it), Dover UK is deemed not only to sell H&C's assets (rather than its shares in H&C) but is deemed to be engaged in H&C's business at the time of that sale. Therefore, petitioner argues that the H&C assets are excluded, by section 1.954-2(e)(3)(ii) through (iv), Income Tax Regs., from the definition of property "which does not give rise to any income", with the result that the deemed sale of those assets did not give rise to FPHCI pursuant to section 954(c)(1)(B)(iii). ⁸

*40 Alternatively, petitioner argues that, giving effect to the "plain and ordinary meaning" of section 954(c)(1)(B)(iii), Dover UK's deemed sale of the operating assets of H&C "could not possibly have been a sale of property 'which does not give rise to any income' because those assets were components of an active, ongoing commercial enterprise, which did give rise to income." Therefore, petitioner argues that, because the requirement in section 1.954-2(e)(3)(ii) through (iv), Income Tax Regs., that such assets be used in the seller's trade or business goes beyond the narrow statutory mandate that such assets simply not be property "which does not give rise to any income", that regulation is invalid.

*335 B. Respondent's Arguments

Respondent argues that the deemed sale of the H&C operating assets was not a sale of property used or held for use in Dover UK's business. Therefore, respondent continues, that property was not excluded from the definition of property "which does not give rise to any income" pursuant to section 1.954-2(e)(3)(ii) through (iv), Income Tax Regs., and its deemed sale by Dover UK gave rise to FPHCI taxable to petitioner. Secs. 951(a)(1)(A)(i), 952(a)(2), 954(a)(1), *41 (c)(1)(B)(iii).

Based primarily on the statutory language and legislative history of section 954(c)(1)(B), respondent also rejects petitioner's argument that section 1.954-2(e)(3)(ii) through (iv), Income Tax Regs., is invalid.

1. Introduction

On July 14, 2003, after the parties' submission of briefs, pursuant to Rule 52, petitioner moved to strike respondent's argument that, as a matter of law, the doctrine of duty of consistency mandates a finding that Dover UK's sale of H&C stock to Thyssen was completed as of June 30, 1997, not July 11, as urged by petitioner.

2. Duty of Consistency Argument

In its motion, petitioner denies that it is attempting to "change or recharacterize the facts [regarding the date of the sale of the H&C stock] in this fully stipulated case" or that it has "acted in a deceitful or misleading way" as implied by respondent. Rather, petitioner states that (1) the issue as to whether the stock sale agreement provided for a June 30 or July 11 sale of the H&C stock presents an issue of law and (2) its prior representation that the date of sale was June 30, 1997, constituted "a clear cut*42 mistake of law * * * not a misrepresentation of fact". Petitioner also argues that respondent was not surprised by petitioner's argument because, on December 12, 2001, more than a year before it filed its opening brief, on March 5, 2003, petitioner apprised respondent of its new position regarding the date of sale. That notification*336 consisted of a letter to respondent's counsel enclosing a copy of an opinion of U.K. counsel that, under English law, July 11, 1997, was the actual date on which the sale of the H&C stock was completed.

Respondent objects to petitioner's motion on the ground that (1) respondent's position is nothing more than a legitimate legal argument and (2) petitioner has not shown that respondent's arguments are "redundant, immaterial, impertinent, frivolous, or scandalous matter" within the meaning of Rule 52.

In essence, petitioner's motion raises the issue of whether we should strike respondent's attack on petitioner's argument that the sale of the H&C stock occurred on July 11, 1997, the date referred to in the stock sale agreement as the "escrow release date", rather than on June 30, 1997, the date of that agreement and the date represented by petitioner to*43 be the date of sale in the request for 9100 relief. In framing that issue, the parties have assumed that, were we to find that the stock sale occurred on July 11, 1997, rather than on June 30, 1997, there necessarily would be an 11-day period between the deemed liquidation of H&C into Dover UK and Dover UK's deemed sale of the H&C operating assets, during which period Dover UK must be deemed to have operated the H&C business as its own. Under those circumstances, petitioner's assertion that Dover UK's deemed sale of the H&C operating assets constituted a sale of property used in its (Dover UK's) business is arguably more persuasive than it would be if the assets are deemed to have been sold immediately after the deemed liquidation of H&C.

The underlying assumption by both parties is that, whether the sale of the H&C stock (and, therefore, the deemed sale of H&C's assets) occurred on June 30 or July 11, 1997, the deemed liquidation of H&C is considered to have occurred immediately before the close of business on June 29, 1997, the day before the effective date of H&C's disregarded entity election, as specified in the Form 8832 filed by H&C. See sec. 301.7701-3(c)(1)(iii), (g)(3)(i), *44 Proced. & Admin. Regs. We question that underlying assumption. In its initial request for 9100 relief, petitioner specifically requested that "H&C be granted an extension of time to make * * * [a disregarded entity election] effective immediately prior to the sale of stock in H&C by Dover UK to Thyssen UK". (Emphasis *337 added.) Consistent with petitioner's request, respondent granted to H&C, "an [60-day] extension of time for making [a disregarded entity] election * * * effective immediately prior to the sale [of H&C stock] on [June 30, 1997]". (Emphasis added.) Both petitioner, in filing the Form 8832 listing June 30, 1997, as the effective date of the disregarded entity election, and respondent, in accepting that filing, believed that June 30, 1997, was the date of the H&C stock sale and that the deemed liquidation occurred "immediately prior to" that sale. Therefore, although it is not addressed by the parties, we believe that the parties' mutual understanding that the deemed liquidation of H&C was to be "effective immediately prior to" the sale of the H&C stock raises an issue as to whether that deemed liquidation should be treated as occurring (1) "immediately prior to" *45 the sale, whether that sale occurred on June 30 or July 11, 1997, or (2) regardless of the actual date of sale, immediately before the close of business on June 29, 1997, the day before the effective date of the disregarded entity election, as specified in the Form 8832 filed by H&C. We find it unnecessary to resolve that issue, however, because, as discussed infra section V.C., our decision does not depend upon the length of time between the deemed liquidation of H&C and the actual sale of its stock (i.e., deemed sale of its assets).

Because resolution of the date-of-sale issue is unnecessary to our decision in this case, the issue as to whether respondent's duty of consistency argument should be stricken is essentially moot.

3. Conclusion

Petitioner's motion to strike will be denied.