When the federal government owes a taxpayer money, she earns interest, and if she owes the government money, she pays interest. Section 6621 of the Internal Revenue Code sets the rate, which is generally the Federal short-term rate plus 3%, meaning the government and the taxpayer pay the same rate. I.R.C. § 6621(a)(1) (overpayment rate), (2) (underpayment rate).
While that sounds simple and fair, it is not how things actually work. First, a taxpayer who has failed to pay the government also pays (in addition to the interest) a penalty of 0.5% per month until the penalty reaches 25% of the amount due. I.R.C. § 6651(a)(2). Second, corporations are subject to a rate differential:
- They receive a lower overpayment rate; the base corporate rate is the Federal short-term rate plus two percentage points (rather than three), and that drops to 0.5% if the overpayment exceeds $10,000. I.R.C. § 6621(a)(1).
- They also pay a higher underpayment rate; the rate goes from 3% to 5% over the Federal short-term rate if there is an underpayment of over $100,000. I.R.C. § 6621(a)(2), (c)(3)(A).
One of the consequences of having different rates is that a corporation could wind up owing interest to the IRS in a situation where it has offsetting overpayments and underpayments, such as the following:
- ABC Corp. owes the IRS $200,000 for income tax for 2016, which will accrue interest at 5% over the Federal short-term rate; and
- ABC Corp. overpaid its 2017 income tax by $200,000, which will accrue interest at 0.5%.
Under this scenario, ABC Corp. would pay a net interest rate of 4.5% over the Federal short-term rate during periods when it actually doesn’t owe any money to the government because of an off-setting overpayment.
Congress recognized that this was unfair, so in 1998, it added section 6621(d) to the Code; it provides as follows:
To the extent that, for any period, interest is payable under subchapter A and allowable under subchapter B on equivalent underpayments and overpayments by the same taxpayer of tax imposed by this title, the net rate of interest under this section on such amounts shall be zero for such period.
I.R.C. § 6621(d). Under section 6621(d), ABC Corp. would only pay interest for the period prior to its overpayment on the factual scenario outlined above.
Last week, the Federal Circuit issued an interesting decision that focused on whether two related corporations were “the same taxpayer” under § 6621(d). Ford Motor Co. v. United States, No. 2017-2360, 2108 U.S. App. LEXIS 31804 (Fed. Cir. Nov. 9, 2018).
The case involved Ford and a subsidiary, Ford Export Services B.V. (“Export”). Export was set up as a foreign sales corporation, which had certain tax advantages under former section 924 of the Internal Revenue Code. Although technically a separate entity, Export was really just an extension of Ford; it had no employees, and its operations were conducted by ABN AMRO, a trust company in the Netherlands that Ford hired. Ford, 2108 U.S. App. LEXIS 31804 at *7-*8. Its board consisted of Ford employees and employees of ABN AMRO. Id. at *8. And Ford actually handled all of the business activities that Export was supposed to carry out. As the Court of Appeals observed, “Export never performed any activity that Ford did not direct.” Id. Instead, Ford funded Export’s bank account when administrative expenses were due, it collected the amounts due on its sales, it filed Export’s tax returns, and it paid Export’s taxes. Id.
Ford filed separate returns for itself and for Export. Ford itself had an overpayment of $336 million in 1992, while Export had underpayments for 1992-1993 and for 1995-1998. Id. at *8-*9. When the IRS failed to net the interest under section 6662(d), Ford requested that it receive a refund of its overpayment and that the interest on the underpayments be abated. Id. at *9.
The IRS concluded that Ford and Export were not the same taxpayer and rejected Ford’s claim for an interest abatement on that basis. Id. Ford then filed suit in the Court of Federal Claims, where it lost.
On appeal, the Federal Circuit initially noted that the determination of whether two entities were “the same taxpayer” was governed by general legal principles, not the Code. Id. (citing Wells Fargo & Co. v. United States, 827 F.3d 1026, 1038 (Fed. Cir. 2016)). Next, the court observed that separate corporations are normally treated as separate taxable entities, citing the Supreme Court’s holding in Moline Properties v. Commissioner, 319 U.S. 436, 438-40 (1943), where the Court held that a taxpayer could not disregard the separate existence of a corporation he controlled.
The Federal Circuit then indicated that this rule extended to parent and subsidiary corporations, despite the obvious control that a parent has over a subsidiary. 2108 U.S. App. LEXIS 31804*11-*12 (citing Nat’l Carbide Corp. v. Comm’r, 336 U.S. 422, 429 (1949)). In light of that principle, the court posited that Ford’s hands on approach to Export’s business activities did not make the two entities “the same taxpayer.” Id. at *12.
Ford attempted to structure an argument that the requirements for a foreign sales corporation under former section 924 allowed for arrangements that lacked any economic substance. The Court of Appeals rejected this argument because the foreign sales corporation regime was designed by Congress to include enough “economic substance” to meet treaty requirements. Id. at *15-*16. The Federal Circuit also made a pragmatic observation, noting that the whole point of the foreign sales corporation regime was to treat the parent and the subsidiary differently for tax purposes, and commenting that “it is difficult to imagine a clearer way for a statute to express that two entities should be treated as different taxpayers than taxing them differently.” Id. at *16.
Ford relied on some provocative language used by the government in other cases to make the point that it and Export were one and the same. Although the government had previously argued that foreign sales corporations lacked any purpose beyond creating tax benefits and that the tax liability of parent and subsidiary were sufficiently linked that they should be adjusted together, the Federal Circuit was persuaded that the structure established by Congress still required a corporation and its foreign sales corporation subsidiary to be treated as different entities for tax purposes. Id. at *16-*18.
Ford and its lawyers ably argued a tough case. While the argument that Export lacked economic substance and should not be treated as a separate entity for tax purposes has some surface appeal, courts have historically saddled taxpayers with the tax consequences of the structures they use to conduct business. The economic substance doctrine, substance over form doctrine and related equitable principles are tools that are available to the government and generally not to taxpayers.
In other words, form controls over substance when the government is satisfied with the result, but substance controls over form when it’s not.