The Third Circuit of the US Court of Appeals in Swallows Holding, Ltd. (no. 06-3388, February 15, 2008) recently affirmed the denial of deductions to a foreign corporation for years for which the corporation failed to timely file US income tax returns. This newly added support by a Court of Appeals decision will reinforce the IRS's practice of denying US tax deductions and credits otherwise allowable to a Canadian corporation that fails to file its US return on time.

To secure compliance with US tax laws, the Internal Revenue Code denies deductions and credits otherwise permitted to a foreign corporation that fails to file a true and accurate income tax return. Treasury regulation 1.882-4 augments this rule. The return must not only be true and accurate, as required by the Code, but it must also be timely filed; otherwise, most of the forco's deductions and credits for the year of an untimely return are denied, with a few exceptions.

Whether a return is timely filed depends on the foreign corporation's filing history vis-à-vis its US income tax returns. If the forco filed a return for the immediately preceding year or if the current year is the first year for which it must file, the current return is timely filed if it is filed within 18 months of its due date. On the other hand, if the forco did not file a return last year and this is not the first year for filing, then the return is timely if it is filed on the earlier of (1) 18 months from its due date and (2) the date on which the IRS notifies the forco of the failure to file. The IRS may waive the timely filing requirement if a forco was genuinely unaware of its obligation to file a US income tax return and can establish that it acted reasonably and in good faith when it failed to file the return.

Many commentators have questioned the validity of the "timely filed" requirement since its creation, saying that the Treasury, which is responsible for promulgating regulations, overstepped its authority when it added a condition not contemplated by the Code. The Tax Court in Swallows Holding delivered a blow to the requirement in 2006 by declaring it invalid because the Treasury had exceeded its rule-making authority. The victory was short-lived: the Tax Court was reversed and the requirement upheld in February 2008 on the IRS's appeal to the Third Circuit of the Court of Appeals.

The Third Circuit's decision will generally be followed by any lower court whose decision could be appealed to the Third Circuit, but the future of the timely filing requirement in the other circuits is uncertain. However, it seems clear that the decision will embolden the IRS to continue denying deductions and credits to forcos for timely filing failures. Litigating the validity of the timely filing requirement in other circuit courts can be avoided altogether if a forco--including a Canco--timely files its US tax return. If a Canco concludes that it need not file a US return for a given year but is concerned that its determination may be challenged, it should consider timely filing a protective return. If it is later determined that the Canco should have filed a US income tax return, the timely filing of the protective return will allow the Canco to claim its deductions and credits attributable to that year.

Catherine B. Eberl
Hodgson Russ LLP, Buffalo