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. e du/thir dc ir c uit_1996/160UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

___________

No. 95-7253

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TATE & LYLE INC. AND SUBSIDIARIES

v.

COMMISSIONER OF INTERNAL REVENUE SERVICE,

Appellant

___________

Appeal from the United States Tax Cour t (No. 92-00740)

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Argued April 25, 1996 Before: MANSMANN, ALITO and LEWIS, Circuit Judges.

(Filed June 24, 1996)

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Henry B. Miller, Esquire Burt, Maner & Miller 1300 Eye Street, N.W.
975 East Tower Washington, DC 20005

COUNSEL FOR APPELLEE

Gary R. Allen, Esquire Kenneth L. Greene, Esquire Thomas J. Clark, Esquire (ARGUED) United States Department of Justice
Tax Division
P.O. Box 502 Washington, DC 20044

COUNSEL FOR APPELLANT

Robert H. Aland, Esquire (ARGUED) Gregg D. Lemein, Esquire Michael A. Pollard, Esquire
Baker & McKenzie
One Prudential Plaza 130 East Randolph Drive Chicago, IL 60601-6384Jeffrey M. O'Donnell, Esquire

Baker & McKenzie 815 Connecticut Avenue, N.W. Washington, DC 20006-4078

COUNSEL FOR AMICI CURIAE

___________

OPINION OF THE COURT

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MANSMANN, Circuit Judge. In this appeal, the Commissioner has asked us to review a ruling which allowed a United States taxpayer to deduct interest owed to a related foreign payee when it wa s accrued rather than paid. Specifically, we must determine whether the United States Tax Court erred in holding that Treas . Reg.  1.267(a)-3 is invalid to the extent that it require s accrual basis taxpayers to defer deductions for interest ow ed to a related foreign payee until the year the interest i s paid. Also at issue is whether, assuming Treas. Reg.  1.267(a)-3 is valid, retroactive application of the regulation violates the Due
Process Clause of the Fifth Amendment. Because we find that Treas. Reg.  1.267(a)-3 is a valid exercise of the powers delegated to the Secre tary under

I.R.C.  267(a)(3), and that retroactive application of the regulation to the taxpayer does not violate due pro cess, we will
reverse the decision of the Tax Court.

I. The following facts were stipulated by the parties before the United States Tax Court. The taxpayer i s an affiliated group of corporations of which Tate and Lyle, Inc. (TLI) is the common parent, and Refined Sugars, Inc . (RSI), is a wholly owned subsidiary. Both TLI and RSI are Unit ed States corporations and were included on the taxpayer's co nsolidated federal income tax returns for the tax years at iss ue. Tate and Lyle plc (PLC) is a United Kingdom corporation whic h indirectly owns 100% of TLI and RSI. The taxpayer and PLC are members of the same controlled group of corporations as define d in I.R.C.  267(f). PLC made interest-bearing loans to TLI and RSI, the tax consequence of which was interest expense to the ta xpayer and interest income to PLC. The taxpayer and PLC repor t income and deductions using the accrual method of accounting. On its U.S income tax returns, the taxpayer deducted interest expense owed to PLC by TLI and RSI in the year it accrued. The taxpayer did not pay the interest to PLC until the year followin g the year of

accrual. The interest income received by PLC was U. S. source income not effectively connected with a trade or bu siness in the
United States. Under I.R.C.  881(a)(1), such income is subject
to U.S. tax at a rate of 30%. Pursuant to Article 11(1) of theUnited States-United Kingdom Income Tax Convention (treaty), 31

U.S.T. 5668, which was in effect at all times here, the interest income received by PLC was exempt from United State s tax. The Commissioner disallowed the taxpayer's deduction for interest expense in the years accrued and subse quently mailed to the taxpayer notices of deficiency for the tax y ears ended September 29, 1985, September 28, 1986, and Septemb er 26, 1987. In response to the notices of deficiency, the taxpa yer filed a petition in the United States Tax Court challenging the
Commissioner's determination. The following facts, not part of the stipu lation, are
evident from the record. The Commissioner asserted before the

Tax Court that I.R.C.  267(a)(2) and (a)(3) and Treas. Reg.

 1.267(a)-3 allow payor a deduction for interest on ly in the tax year when the related payee would normally report t he interest as income for United States tax purposes. Normally, i nterest income received by a foreign corporation from sources with in the United States and which is not effectively connected with a trade or business in this country, is reported on the cash b asis method of accounting under I.R.C.  881 and 1442. The Commissioner determined that the taxpayer was entitled to deduct interest only in the year it paid the interest to PLC.

The Tax Court held that because the accrue d interest
was not includable in PLC's income because of an ex emption under the tax treaty rather than as a result of PLC's met hod of accounting, Treas. Reg.  1.267(a)-3 was invalid because it did not apply the matching principle of I.R.C.  267(a)(2). A fourjudge plurality determined that even if the provisi ons of Treas. Reg.  1.267(a)-3 were found to be within the broad regul atory authority granted by I.R.C.  267(a)(3), the retroactive application of the regulation violated the Due Proc ess Clause of the Fifth Amendment. Accordingly, the Tax Court fo und that the taxpayer was not required to defer its interest ded uction until it actually paid the interest. The Commissioner appeals to us from the fi nal decision of the Tax Court entered on February 13, 1995. We have jurisdiction under I.R.C.  7482(a). See Lerman v. Commissioner, 939 F.2d 44, 45 (3d Cir.), cert. denied, 502 U.S. 9 84 (1991).

II.
We turn first to the issue of whether Trea s. Reg.
 1.267(a)-3 is a valid interpretation of I.R.C.  267(a)(3). The validity of a treasury regulation is a question of law over which we exercise plenary review. Mazzocchi Bus Co ., Inc. v. Commissioner, 14 F.3d 923, 927 (3d Cir. 1994). As amended in 1984, I.R.C.  267(a)(2) provides for a matching of interest deductions and income where, i n the case of related persons, the payor is an accrual basis taxp ayer and the payee is on a cash basis method of accounting. Sec tion 267(a)(2) specifically provides: (2) Matching of deduction and payee inc ome item in the case of expenses and interest.

-- If --(A) by reason of the method of

accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includib le in the gross income of such person, a nd

(B) at the close of the taxable yea r of the taxpayer for which (but for th is paragraph) the amount would be deductible under this chapter, both t he taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),

then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income o f the person to whom the payment is made (or
, if later, as of the day on which it would be so allowable but for this paragraph). . .

.

Section 267(a)(2), as amended in 1984, applied to i nterest allowable as a deduction for taxable years beginnin g after December 31, 1983. Deficit Reduction Act of 1984, Pub. L. No. 98-369,  174(c), 98 Stat. 494, 708. The purpose behind the 1984 amendment was to require related persons "to use the same accounting method with respect to transactions between themselves in order to prev ent the allowance of a deduction without the corresponding inclusion in income." H. Rep. No. 98-432, 98th Cong., 2nd Sess. , reprinted in1984 U.S.C.C.A.N. 697, 1206. The Ways and Means Committ ee further stated that "[t]he failure to use the same accounting method with respect to one transaction involves unw arranted tax benefits, especially where payments are delayed for a long period of time, and in fact may never be paid." Id. Cong ress thus amended section 267(a)(2) to require an accrual bas is taxpayer to deduct interest owed to a related cash basis taxpay er when payment is made. Id. Congress explained that "[i] n other words, the deduction by the payor will be allowed no earli er than when the corresponding income is recognized by the payee ." Id. In 1986, Congress again amended section 26 7, this time to add subsection (a)(3) because it felt that the m atching provision of section 267(a)(2) was "unclear when th e related payee was a foreign person that does not, for many Code purposes, include in gross income foreign source income that is not effectively connected with a U.S. trade or business ." S. Rep. No. 99-313, 99th Cong., 2nd Sess. at 959, reprinted in 1986-3 C.B. (Vol. 3) 1, 959. Section 267(a)(3) reads as f ollows: (3) Payments to foreign persons.--The Secretary shall by regulations apply the matching principle of paragraph (2) in cas esin which the person to whom the payment is to

be made is not a United States person.

Like section 267(a)(2), section 267(a)(3) was made retroactive to taxable years beginning after December 31, 1983. T ax Reform Act of 1986, Pub. L. No. 99-514,  1881, 100 Stat. 2085, 2914.

In accordance with section 267(a)(3), the Secretary issued final regulations on December 31, 1992. T.D . 8465, 1992-2 C.B. 12. Treas. Reg.  1.267(a)-3(b)(1) sets forth the following general rule: section 267(a)(3) requires a taxpayer to u se the cash method of accounting with respect to
the deduction of amounts owed to a related foreign person. An amount that is owed to a related foreign person and that is otherwi se deductible under Chapter 1 thus may not be deducted by the taxpayer until such amount is paid to the related foreign person. . . . An amount is treated as paid for purposes of this section if the amount is considered p aid for purposes of section 1441 or section 14 42 (including an amount taken into account pursuant to section 884(f)).

Treas. Reg.  1.267(a)-3(c) provides certain exceptions and special rules to paragraph (b) of this section. Pa ragraph (c)(1), which applies to income that is effectively connected
with the conduct of a United States trade or busine ss of a related foreign person, does not apply if the relat ed foreign person is exempt from United States income tax on t he amount owed pursuant to a tax treaty. Paragraph (c)(2) address es the treatment of items exempt from tax because of a tax treaty. Specifically, paragraph (c)(2) requires that: Interest that is not effectively connected income of the related foreign person is an amount covered by paragraph (b) of this section, regardless of whether the related foreign person is exempt from United State s taxation on the amount owed pursuant to a treaty obligation of the United States.

Thus, under the regulation, a taxpayer who owes int erest to a related foreign person, where the related foreign p ayee is exempt
from taxation on the interest received from U.S. so urces not effectively connected with a U.S. trade or business of the foreign payee due to a tax treaty, may not deduct t he interest owed to the related foreign person until the taxpay er actually pays the interest to the related foreign person. Treas. Reg.
 1.267(a)-3 is effective with respect to interest d eductions allowable in tax years beginning after December 31, 1983. Treas. Reg.  1.267(a)-3(d). The parties to this appeal agree that Trea s. Reg.
 1.267(a)-3 is a legislative regulation which was i ssuedpursuant to a clear congressional delegation of rul e making

authority. In reviewing an agency's construction o f a statute which it administers, we take our lead from the Sup reme Court's opinion in Chevron U.S.A., Inc. v. Natural Resource s Defense Council, Inc., 467 U.S. 837, reh'g. denied, 468 U.S . 1227 (1984). Under Chevron, we must first ask "whether Congress has directly spoken to the precise question at issue." Id. at 8 42. If Congress' intent is clear from the plain language o f the statute, then our inquiry ends there. Id. If we conclude, however, that Congress has not directly addressed the precise que stion at issue or that the statute is silent or ambiguous regardin g the issue, then we must determine whether the agency's interpr etation "is based on a permissible construction of the statute. " Id. at 843. Inherent in the powers of an administrativ e agency is the authority to formulate policies and to promulga te rules to fill any gaps left, either implicitly or explicitly , by Congress. Id. (citing Morton v. Ruiz, 415 U.S. 199, 231 (1974 )). Where Congress has expressly delegated to an agency the p ower to "elucidate a specific provision of the statute by r egulation . . . . [s]uch legislative regulations are given contr olling weight unless they are arbitrary, capricious, or manifestl y contrary to the statute." Id. at 844 (footnote omitted). Applying the Chevron test, we find initial ly that Congress' intent is not clear from the plain langua ge of I.R.C.  267(a)(3). Congress specifically directed the Secr etary to adopt regulations applying the "matching principle of par agraph (2)" to foreign related persons. If, as the Tax Court foun d and amici suggest, the plain meaning of section 267(a)(3) req uires the Secretary to apply exactly the same matching princi ple of section 267(a)(2) to foreign persons, then the language of section 267(a)(3) is redundant. The Commissioner argues, m oreover, that if the matching principle of section 267(a)(2) was strictly applied here, the U.S. payor would never be entitle d to an interest deduction because the related foreign paye e would never
have to include interest in taxable income under a tax treaty with the United States. This unduly harsh result i s one of the inequities Congress was attempting to rectify when it enacted

I.R.C.  267(a)(2) in 1984. The rules of statutory construction mandat e that: . . . a statute is to be read as a whole, see Massachusetts v. Morash, 490 U.S. 107, 115 (1989), since the meaning of statutory language, plain or not, depends on context

. See, e.g., Shell Oil Co. v. Iowa Dept. of Revenue, 488 U.S. 19, 26 (1988). "Words a re not pebbles in alien juxtaposition; they h ave only a communal existence; and not only do es the meaning of each interpenetrate the oth er, but all in their aggregate take their purp ort from the setting in which they are used. .

. ." NLRB v. Federbush Co., 121 F.2d 954, 9 57 (CA2 1941) (L. Hand, J.) (quoted in Shell Oil, supra, at 25, n.6).10

_______________10 See also United States v. Hartwell, 6

Wall. 385, 396 (1868) (in construing statu te court should adopt that sense of words whi ch best harmonizes with context and promotes policy and objectives of legislature). . .

King v. St. Vincent's Hospital, 502 U.S. 215, 221 ( 1991). We do not believe that Congress would have enacted sectio n 267(a)(3) if it intended to apply the same matching principle of section 267(a)(2) to foreign persons. Thus, we find that i t is unclear from the plain meaning of section 267(a)(3) how Con gress intended the matching principle of section 267(a)(2) to appl y to foreign related persons. We turn to our second inquiry under Chevro n -- whether the Secretary's interpretation as promulgated in Tr eas. Reg.
 1.267(a)-3 is based on a permissible construction of section 267(a)(3). The legislative history of section 267( a)(3) reveals that Congress anticipated other reasons for the mis match of interest expense and income between related persons , which would defer the deduction of interest expense until actua lly paid. In the Committee Reports, Congress explained the need for section 267(a)(3), stating that section 267(a)(2), as enact ed in 1984, was unclear when the related payee was a foreign pe rson, which did not, "for many Code purposes," include foreign source income that is not effectively connected with a U.S. trade or business in gross income for U.S. tax purposes. S. Rep. No. 99-313, 99th Cong., 2nd Sess. 959; reprinted in 1986-3 C.B. (Vol . 3) at 959; H. Rep. No. 99-426, 99th Cong., 2nd Sess. 939, repr inted in 1986- 3 C.B. (Vol. 2) at 939. By way of example, the Committee described a situation where a foreign corporation, which was not engaged in a U.S. trade or business, performed services outside the U nited States for the benefit of a wholly owned U.S. subsidiary. As a result of performing these services, the related foreign p ayee had foreign source income which was not effectively con nected with a U.S. trade or business and, therefore, was not subj ect to U.S. tax. In this situation, the Committee explained th at the U.S. subsidiary could be required to use the cash method of accounting for the deduction of amounts owed to the foreign pa rent for the services rendered. Id. Although in this example t he facts are slightly different than those presented in the case before us, it is clear that Congress anticipated a situation wher e the required use of the cash method of accounting by the U.S. pa yor is not based on the foreign payee's accounting method sinc e, in the example, the foreign payee was not subject to U.S. tax on the income received from the related U.S. payor. In promulgating Treasury Reg.  1.267(a)-3, the Secretary followed the directives of the House and Senate reports. Both reports clearly indicate that Congre ss contemplated that section 267(a)(3) could be applie d to situations where the foreign related payee was not ultimately subject to tax on the amount received, and that the regulations could require the U.S. subsidiary to use the cash m ethod of accounting for the deduction of interest owed to it s foreignparent. We find that the rule adopted by the Secre tary,

requiring a U.S. taxpayer to use the cash method of accounting with respect to the deduction of interest owed to a related foreign person, is a permissible construction of se ction 267(a)(3). Having so found, we must also conclude tha t the regulation is not arbitrary, capricious or manifest ly contrary to section 267(a)(3). Nothing in the legislative hist ory convinces us to the contrary. While the Tax Court recognized that defere nce must be given to legislative regulations, it nonetheless in validated Treas. Reg.  1.267(a)-3 as being "manifestly beyond the mandate of [section 267(a)(3)]." 103 T.C. 656, 671 (1994). The Tax Court based its holding on the fact that the Commis sioner disallowed the taxpayer's interest deductions for r easons other than the method of accounting of PLC. Both the Tax Court and amici argued that because the plain meaning of sect ion 267(a)(3) was clear, there was no need to look to the legisla tive history. Accordingly, the Tax Court held there was no provis ion that permitted the Secretary to expand the reach of the regulations under section 267(a)(3) beyond the matching princip le of section 267(a)(2). We disagree. Recently, we reiterated t he general

rule on deference: In general, unless an issue is governe d by an unambiguous statutory provision, cou rts must defer to an agency's interpretation o f a
statute it has been entrusted to administe r. Thus, the function for the court is not to impose its own interpretation of the statu te, but simply to determine whether the agency 's interpretation "is based on a permissible
construction of the statute." INS v. Cardoza-Fonseca, 480 U.S. 421, 445 n.29, 1 07 S. Ct. 1207, 94 L.Ed.2d 434 (1987). The agency's interpretation will be "given controlling weight unless [it is] arbitrar y, capricious, or manifestly contrary to the

statute." Id.

Cavert Acquisition Co. v. NLRB, ___ F.3d ___, Nos. 95-3231 and 95-3293, 1995 WL 854489, at *3 (3d Cir. May 2, 1996 ). Having concluded earlier that the Secretary's interpretati on was based on a permissible construction of I.R.C.  267(a)(3), we must reject the Tax Court's finding that Treas. Reg.  1.267(a)-3 was manifestly beyond the mandate of the statute. In the alternative, the amici argue that T reas. Reg.
 1.267(a)-3 is not supported by the legislative his tory. Amici
contend that the Commissioner overlooks the fact th at the legislative history defines "matching principle" in terms of accounting methods. They further contend that beca use the sole example in the Committee reports was absent from th e final regulation, and because this example did not involv e income exempt from tax because of a treaty, we should find that the Secretary's interpretation is not supported by the legislativehistory. We believe, however, that the amici are i gnoring other

statements contained in the House and Senate Commit tee reports which clearly support the Secretary's interpretatio n. We agree with the Commissioner that the re gulation is not manifestly contrary to section 267(a)(3). We b elieve the Tax Court construed the language of section 267(a)(3) t oo narrowly, especially in light of the Supreme Court's holding in Chevron. Accordingly, we find that the Tax Court erred in ho lding that Treas. Reg.  1.267(a)-3 is invalid to the extent it requires accrual basis taxpayers to defer interest deduction s owed to a related foreign payee until the year the interest i s paid.

III. Having found that Treas. Reg.  1.267(a)-3 is a valid interpretation of section 267(a)(3), we must now co nsider whether the retroactive application of the regulation viola ted the Due Process Clause of the Fifth Amendment. The four-ju dge plurality found that the period of retroactivity in this case was excessive rather than modest, and therefore was und uly harsh and oppressive. In reaching this conclusion, the four- judge plurality relied on the Supreme Court's decision in United States v. Carlton, 114 S. Ct. 2018 (1994). There, the Sup reme Court set forth a two-part test for determining whether the r etroactive application of a tax statute violates due process. First, for retroactivity to be upheld, it must be shown that t he statute has a rational legislative purpose and is not arbitrary ; and second, that the period of retroactivity is moderate, not e xcessive. Id.at 2022. The Supreme Court in Carlton upheld the retroactive application of a tax law amending a statute which h ad been enacted only a year earlier, where the amendment ha d been proposed by Congress within a few months of the sta tute's original enactment. Id. at 2023. Based on the Supreme Court's holding in Ca rlton, the Tax Court found the six year period in this case ex cessive, and thus, violative of the Due Process Clause. We find , however, that Carlton is distinguishable: Carlton involved the retroactive application of a statute, and here we a re dealing with the retroactive application of a regulation. The retroactivity of treasury regulations is governed by I.R.C.  7805(b), which states: The Secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, sha ll be applied without retroactive effect.

Clearly Congress has determined that treasury regul ations are presumed to apply retroactively. The extent to whi ch newly promulgated regulations shall not apply retroactive ly is a matter of discretion left to the Secretary. Automobile Cl ub of Michigan v. Commissioner, 353 U.S. 180, 184-85, reh'g denied , 353 U.S. 989 (1957). The amici contend that the Secretary abuse d his discretion under section 7805(b) in failing to limi t the period of retroactivity. In support of this position, the amici citeGehl Co. v. Commissioner, 795 F.2d 1324 (7th Cir. 1 986); LeCroy

Research Sys. Corp. v. Commissioner, 751 F.2d 123 ( 2d Cir. 1984); and CWT Farms, Inc. v. Commissioner, 755 F.2d 790 ( 11th Cir. 1985), cert. denied, 477 U.S. 903 (1986). These ca ses, however, are distinguishable from the facts of this case. A ll of the cases cited by the amici involved a prior express r epresentation by the Commissioner in a DISC Handbook that the reg ulations, when adopted, would apply prospectively only. In C WT Farms, the court of appeals stated that "[a]n abuse of discret ion may be found where retroactive regulation alters settled p rior law or policy upon which the taxpayer justifiably relied a nd if the change causes the taxpayer to suffer inordinate har m." 755 F.2d at 802. The courts of appeals in these three cases found that the Commissioner abused his discretion by applying the regulations retroactively on the basis of their fin ding that the promise in the Handbook was binding. Here, there was no such promise by the Commissioner regarding Treas. Reg.  1.267(a)-3. Moreover, the taxpayer had adequate notice within a reasonable time that regul ations would be forthcoming which could alter the tax treatment of its interest deductions. Section 267(a)(2) was enacted on July 18, 1984, effective for tax years beginning after Decem ber 31, 1983. On October 22, 1986, section 267(a)(3) was added, a lso with the same effective date. On July 31, 1989, the Secreta ry announced rules in Notice 89-84, 1989-31 I.R.B. 8, which even tually became the proposed regulations, and were released on Marc h 19, 1991. Then, on January 5, 1993, the Secretary released th e final regulations applicable to section 267(a)(3), retroa ctive to tax years beginning after December 31, 1983. Thus, as early as October of 1986, the taxpayer had notice that regul ations would be forthcoming which could alter the tax treatment of its interest deductions for tax years 1985, 1986 and 19 86. Indeed, the Supreme Court has upheld the r etroactive application of tax regulations for a similar or lon ger period of retroactivity. See, e.g., National Muffler Dealers Ass'n, 440 U.S. at 478-82 (upholding the validity of a regulat ion which was issued six years after enactment of the statute and was subsequently modified ten years later). In E.I. du Pont de Nemours & Co. v. Commissioner, 41 F.3d 130, 139 & n . 37 (3d Cir. 1994), we upheld the validity of a regulation adopt ed thirteen years after enactment of a statute directing the Se cretary to promulgate regulations. We find, therefore, that the retroactive a pplication of Treas. Reg.  1.267(a)-3 to the tax years in question does not
violate the Due Process Clause of the Fifth Amendme nt. Based on the applicable legal standards and our earlier revi ew of the relevant legislative history, we are unable to conc lude that the Secretary abused his discretion in failing to limit the period of retroactivity for Treas. Reg.  1.267(a)-3.

IV. For the reasons set forth above, we will r everse the
decision of the Tax Court and remand this cause to the Tax Courtfor the entry of a decision upholding the tax defic iencies for

the years in question.