David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: legal maelstrom.

There's a tax case that's been working its way through the appeals process that delves into the relationship between tax law and regulations in the U.S. In Whirlpool v. Commissioner, the appliance maker is fighting an assessment on some of its foreign income in a case that's drawn interest from a number of third parties who see the outcome affecting their arrangements as well.

Later in the episode, we'll hear from Gary Wilcox, who'll be discussing his article examining administrative law questions raised by the foreign tax credit regulations.

But first here to talk more about Whirlpool v. Commissioner and its possible consequences is Tax Notes senior legal reporter Andrew Velarde. Andrew, welcome back to the podcast.

Andrew Velarde: Hi, Dave. Good to be here.

David D. Stewart: All right. Why don't you first start us off with what is this case all about?

Andrew Velarde: Sure. Let's talk big picture here. It's a subpart F branch income dispute related to Whirlpool's manufacturing operations in Mexico, which could end up costing the company around $100 million in tax expense over the last decade.

At the center of the dispute is the foreign branch company sales income rule, FBCSI, a Whirlpool restructuring, and government allegations that the new structure represented "the paradigm of abuses" that Congress had targeted when creating the rule.

The final ruling in favor of the government could have significant ramifications beyond the company itself as you alluded to, Dave. Given that Whirlpool is not alone in using the tax structure at issue here and the appellate court's ruling could be read very broadly, if one were so inclined.

David D. Stewart: All right, well, let's get into that. What is this transaction at issue?

Andrew Velarde: So, in detail here, in 2007, Whirlpool restructured its operations, creating two foreign entities at issue here. You have Whirlpool Overseas Manufacturing, WOM, a controlled foreign corporation (CFC) organized in Luxembourg with a single part-time employee. And Whirlpool Internacional, WIM, a disregarded entity, not separate from WOM, organized in Mexico. WIM did the manufacturing and assembly of washers and refrigerators, while WOM held title to the materials and the inventory.

See, Whirlpool had looked to take advantage of the Mexican maquiladora incentive scheme, which allows tax and duty free importation of materials if the finished goods are exported out of the country. Whirlpool received a tax ruling from Luxembourg confirming WOM's sales income was attributable to a Mexican permanent establishment and therefore not taxable in Luxembourg. And the income was not taxable in Mexico either because WOM was not considered to have a Mexican permanent establishment by that tax authority and the Luxembourg-Mexico tax treaty. Because of U.S. tax deferral, the income was also not immediately taxed in the U.S.

So what did we have here? Well, according to the IRS, you had stateless income from a restructuring done solely for tax reasons.

David D. Stewart: All right. So clearly the IRS chose to challenge this arrangement. So, what is the rule at the heart of the dispute?

Andrew Velarde: Sure, Dave. There's a manufacturing exception to income treated as FBCSI for related party sales. But the IRS argued WOM couldn't use that because of the branch rules. So, let's talk about that a little bit.

Under section 954(d)(2), foreign branch sales are taxable FBCSI when a CFC uses a branch outside its country of organization, and that use has substantially the same effect as use of a wholly owned subsidiary would. I want you to remember that term there, "substantially the same effect." It's going to come back.

The branch rule of section 954(d)(2) was enacted as a backstop to the general rule for subpart F income under section 954(d)(1), which was itself designed to catch income made through a low tax subsidiary separated from the related party manufacturer.

Now, under regs, when determining if there was a substantially same effect, the branch rules institute a tax rate disparity test. This is a complex mechanical test, but if you fail the test, then a manufacturing branch and the remainder are treated as separate corporations when determining FBCSI.

Whirlpool argued that the test can't be applied unless the CFC's remainder has income allocable to the purchasing and selling activities, which it said it didn't have. And as a final fallback argument, Whirlpool also challenged the validity of the section 954(d)(2) regs arguing they exceeded scope of the statute.

David D. Stewart: OK. So, this case was first taken up at the Tax Court. So, how did the Tax Court find?

Andrew Velarde: Correct. Yeah. So, litigation started at the Tax Court several years back. Briefing was in 2019, and close to a year after that, we finally got a decision from the Tax Court, which handed a victory to the IRS.

The Mexican branch was treated as a subsidiary of the Luxembourg CFC and the sales income earned by the CFC constituted FBCSI. It was clear that WOM carried on activities through WIM, according to the Tax Court. Examining the "substantially same effect" prong, as if the branch were a CFC.

Here's a quote from Judge Lauber, "By carrying on its act activities 'through a branch or similar establishment' in Mexico, Whirlpool Luxembourg avoided any current taxation of its sales income. It thus achieved 'substantially the same effect' — deferral of tax on its sales income — that it would have achieved under U.S. tax rules if its Mexican branch were a wholly owned subsidiary deriving such income. That is precisely the situation that the statute covers.

In short, even without the refinements supplied by the regulations implementing section 954(d)(2), the bare text of the statute, literally read, indicates that Whirlpool Luxembourg's sales income is FBCSI that must be included in the petitioners' income under subpart F."

But the court wasn't done there. It also did examine the regs in determining the substantially the same effect through allocation of income between the branch and the remainder CFC. And then through a comparison of actual and hypothetical tax rates. That's how the rules work.

I won't get more into the details of how those mechanical rules operate because court summed it up best when they said, "The text is again quite dense, and the relevant sentence is not one that Ernest Hemingway would have written." I just love that line.

But applying the test, the court held that WOM was taxed at an appreciably lower rate than the rate Mexico would have taxed it at, assuming a 28 percent hypothetical Mexican rate. And thus it held it was substantially the same.

The structure, "Epitomizes the abuse at which Congress aimed: The selling corporation derived income from the sale of property, without any appreciable value being added to the product by the selling corporation."

And then as a final note, the court easily dispensed with the argument that the rates were invalid. They found that nothing in the statute prevented Treasury from writing rules to address manufacturing branches.

David D. Stewart: All right, well that seems to have closed the door pretty hard on Whirlpool's transaction. But they took this on to the appeals court. So, where did the case go from there?

Andrew Velarde: Sure. This might be for Whirlpool a little bit "be careful what you wish for" when they did their appeal here.

So, Whirlpool did appeal to the Sixth Circuit and they lost there in December as well. Though the focus at that level was far more on the statute itself rather than an examination of the regs, which could be to the detriment of companies beyond Whirlpool. Again, though the focus was on what it means to have substantially the same effect.

The court looked to the legislative history behind the statute, and while Whirlpool pleaded with the court to look at the regs, the court said the statute was clear and the regs could not change that. I have a quote here from the [Sixth] Circuit Court now, "The agency's regulations can only implement the statutes commands, not vary from them. And the relevant command here — that Lux's sales income 'shall constitute foreign-based company sales income of' Lux — could hardly be clearer," the court held.

It's worth noting that the appellate court was split however, and the dissent argued that WOM didn't have any FBCSI because it manufactured the property it bought and sold. And it's cited to the regs.

Under those regs, WOM bought property that it substantially transformed before it sold it, and the dissent criticized the IRS for reading requirements into the regs that weren't there. When expressing concern over how much WOM monitored and controlled the manufacturing done by WIM.

David D. Stewart: All right, so 0 for 2. Where does this case stand now and what's next?

Andrew Velarde: Sure. We've had a few recent developments. Whirlpool wasn't done when it lost at the appellate court. They requested a rehearing with the circuit, warning about the breadth of decision, arguing it could affect hundreds of laws that they argue are only effectuated through regs. The statute in [section] 954 included language under a regulation prescribed by the secretary when describing how to determine FBCSI for branches. According to Whirlpool, this language meant that the statute could only be implemented through regs, and the circuit was wrong not to examine those regs.

That language importantly applies to many other statutes beyond 954 as well. But speaking of just 954, Whirlpool argued that the companies had relied on those regs for more than 50 years. And that by ignoring them, a large amount of investment decisions would be put in jeopardy as it could apply to many maquiladora structures.

Now, how many maquiladora structures out there is not easily discovered — I know because I've tried — but some estimates put it at around 3,000. So, perhaps it should come as no surprise that some prominent industry groups voiced support for a rehearing and warned about the potential fall.

Now, this rehearing request was ultimately denied by the court. Included among these groups was the National Association of Manufacturers and the United States Council for International Business, just to name two of them.

They express fear similar to Whirlpool's against the [Sixth] Circuit Court decision that by rejecting an analysis of the regs, it could be read even broader than the Tax Court's decision.

The government, for its part, asserted that the statute was self-executing and the circuit engaged in a case-specific analysis of the facts and the decision wouldn't catch taxpayers that didn't engage in a similar tax avoidance scheme like Whirlpool. Those taxpayers could still rely on the regs.

There had been some speculation that the court would rehear the case — after all, they asked for a full briefing on the matter and there were multiple amicus briefs filed in this case. In the end though however, with only the dissent from the decision in favor of granting the rehearing, the original circuit decision stood, and the rehearing request was denied.

We'll have to wait to see what the true ramifications are. There's already been at least one disclosure from a multinational auto parts manufacturer in an SEC filing that is attempting to distinguish its Mexican-Luxembourg maquiladora relationship from Whirlpool in the face of the IRS asserting of $325 million more in income tax expense in that case.

How many more companies will be affected is not yet clear. Though it's a safe bet that many are closely analyzing this case.

David D. Stewart: Yeah, we'll definitely have to keep an eye on this issue and follow up when we find out exactly how big it is. Well, Andrew, this has been great. Thank you for being here.

Andrew Velarde: Thank you, Dave. Thanks for having me.

David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?

Paige Jones: Thanks, Dave. In Tax Notes Federal, Matthew Stevens and David Martin examined tax issues arising from investing in single stock swaps and analyzed basket swaps. Lee Sheppard examines the judicial record of Supreme Court nominee Judge Ketanji Brown Jackson. In Tax Notes State, Brian Hauser and Kevin Herzberg consider how state laws are handling taxing cloud transactions. Nikki Dobay and Jeremy Gove explore the tax compliance questions that remain in the wake of Wayfair. In Tax Notes International, Robert van Brederode examines the collapse of the Dutch wealth income tax. Six KPMG practitioners examine the new R&D capitalization rules and how they affect common transfer pricing arrangements. In Featured Analysis, Marie Sapirie examines what the IRS can do for identity verification to better respect taxpayers' privacy interests than it did with its implementation of a facial recognition system last year.

And now, for a closer look at what's new and noteworthy in our magazines, here's Tax Notes Federal Editor in Chief Ariel Greenblum.

Ariel Greenblum: Thanks, Paige. I'm here with Gary Wilcox, a partner with Mayer Brown. Welcome to the podcast, Gary.

Gary Wilcox: Thank you. Glad to be here.

Ariel Greenblum: We're here to discuss your Tax Notes Federal article titled, "Will Jurisdictional Nexus Survive Chevron Step 1?" which you co-authored with Lucas Giardelli. Could you give us a brief overview of the article?

Gary Wilcox: Yes. Obviously it relates to the recent foreign tax credit regulations and the addition of a so-called "jurisdictional nexus requirement," or it's referred to in the final regs as an attribution requirement.

It represents a significant change in the rules for claiming foreign tax credits and literally overnight has cost multinational companies significant amounts of new tax. They are under immense pressure to sort out how these regs will play out in a number of countries. And they have their first quarter earnings coming up, so it's a bit of uncertainty for companies in a rushed amount of time to deal with. And I guess all of that kind of gets your attention.

I started looking into it and noticed that there were some excellent articles out there on the earlier proposed regulations, highlighting the history of the section 901 credit for foreign income tax. And discussing how that provision has more or less remained the same for over 100 years. Obviously the code section has changed in number, but the words of the statute have not changed in more than 100 years.

And I thought, "Well, what could I contribute that's different?" And I think a lot about how a court would address the validity of regulations. And I decided to really focus the argument on, "Well, now that we have final regulations and what's done is done, going forward, how would a validity challenge play out in the courts?"

And I have to admit, when I first started thinking about this, I go, "Oh gosh, this is going to be really difficult for taxpayers." I mean, don't get me wrong, I don't think the regs were a good idea. I don't think they should have been issued, particularly with there being a lack of any indication from Congress that Treasury had the authority to impose these new requirements. But to say a reg is invalid is a whole different and far more challenging question.

And we're dealing with a statute, as I said, hasn't changed much since it was originally enacted in 1918. There's very little legislative history other than the fact we know Congress was trying to prevent tax payers from being subject to double taxation.

The operative term in the statute is income tax. And admittedly, when you have a term like that, that's not defined in the statute, both taxpayers and the government have successfully in certain cases established that there's an ambiguity due to the lack of a definition. And based on that ambiguity, you can argue that there's an implied delegation of authority to Treasury to write regulations to clarify that ambiguity.

And once it's determined there's an ambiguity, you get into the so-called "step 2" of the Chevron deference standard where the odds of a taxpayer challenging a regulation go up exponentially against the taxpayer at that stage. And the reason is you have to basically show that the government has acted unreasonably.

And to say that it was unreasonable to issue regs, interpreting a statute that's been around for 100 years with what is now an established meaning, well, that's unreasonable. Or the fact that it wasn't contemporaneous, that's unreasonable. Well, those aren't really problems in step 2.

And as started thinking about it more and researching, I became more convinced that this issue would really play out in step 1 of Chevron where the question is: "Is the statute ambiguous or is there some sort of silence where you can say that Congress delegated authority to Treasury to write regulations?" I focused this article on step 1 to kind of play out what steps a court would take in the Chevron step 1 analysis, what evidence it would consider. And at what point would it defer to Treasury?

Ariel Greenblum: Thanks, Gary, for that. What prompted you to write about this topic?

Gary Wilcox: I had clients asking me, "Can Treasury really do this?" I think also whenever you see such a drastic change in the — I will call the law — these regulations are intended to have the force of law, without there being an underlying change in statute, my antenna just goes up. And to me, it was worth exploring, combined with requests by clients, to look into it. It made it a really interesting topic to explore further.

Ariel Greenblum: Great. Before we let you go, where can listeners find you online?

Gary Wilcox: I'm with Mayer Brown, I'm on the Mayer Brown website. My email is there [gwilcox@mayerbrown.com]. You can look me up. Or LinkedIn, I'm on LinkedIn as well.

Ariel Greenblum: Thank you for joining us on the podcast, Gary.

Gary Wilcox: Thank you, Ariel. Glad to do it.

Ariel Greenblum: You could find Gary and Lucas' article online at taxnotes.com. And be sure to subscribe to our new YouTube channel, Tax Notes, for more in-depth discussions on what's new and noteworthy. Again, that's Tax Notes with an S. Back to you, Dave.

David D. Stewart: That's it for this week. You can follow me online @taxstew, That's S-T-E-W, and be sure to follow @taxnotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalyst.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.

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