Fifth Circuit Expands Tire Import Excise Tax – Houston Tax Attorneys

In the tax world, excise taxes are often the neglected step-child. They take a back seat to income and estate taxes. They do not make the headlines very often.

Excise taxes are largely transaction-based taxes that target specific industries or activities. The businesses that are subject to these taxes generally just pay them, and consider it a cost of doing business.

But the law and rules for these taxes are often not well developed and they can be very difficult to apply in practice. This can be problematic as a misstep with these taxes can be financially devastating for a business. It often spells the end for the business, or, at a minimum, a need to resolve a significant tax balance with the IRS.

The recent case of Texas Truck Parts & Tire, Inc. v. United States, No. 23-20588.(5th Cir. Oct. 8, 2024) provides an opportunity to consider the ill-defined tire import excise tax. This case resulted in a significant tax liability and expanded definition of who qualifies as an “importer” for this tax–which could be extremely problematic for businesses that import tires for sale in the United States.

Facts & Procedural History

The taxpayer (“Texas Truck”) is a wholesaler and retailer of truck parts and tires based in Houston, Texas.

From 2012 to 2017, Texas Truck purchased tires from Chinese manufacturers, which shipped and delivered the tires to Houston. Texas Truck believed that the Chinese manufacturers were the importers of the tires under applicable law and therefore did not file quarterly excise tax returns or pay any excise tax on the tires.

The IRS audited Texas Truck and determined that it, not the Chinese manufacturers, was the importer of the tires and therefore owed approximately $1.9 million in taxes. Texas Truck paid a portion of these taxes and filed an administrative claim for a refund. After the IRS failed to act on the claim, Texas Truck filed suit seeking a refund.

The district court determined on summary judgment that the Chinese manufacturers imported the tires and were therefore liable for the tax. The Government appealed to the Fifth Circuit, which resulted in the current court opinion.

About Excise Taxes on Imported Tires

Section 4071 imposes tax liability on manufacturers, producers, or importers of taxable tires for their sale. The “or” in the code means that the tax could be imposed on any one of these parties.

This leaves one wondering who qualifies as a manufacturer, producer, or importer? The implementing regulations provide definitions of these terms. As relevant to this case, the regulations define an “importer” as any person who “brings” a taxable article into the United States from a source outside the United States, or who withdraws such an article from a customs-bonded warehouse for sale or use in the United States. These rules are found in Treas. Reg. § 48.0-2(a)(4)(i).

The regulations go on to provide an exception for nominal importers. The regulations say that the beneficial owner, not the nominal importer, is liable for the excise tax. The regulations use the example of a broker who ships an item for the ultimate owner, saying that the owner and not the broker should be liable for the excise tax. As we’ll see below, it is not easy to square the “brings” rule with this exception for nominal importers.

As a side note, astute readers may note that the “sale” is what triggers the tax, not the act of importing the tires. They might wonder if this excise tax could be avoided by having an integrated foreign manufacturer-U.S. sales company so there is no “sale.” The statute addresses this. It says that if a manufacturer, producer, or importer delivers tires to its own store or outlet, it is liable for the excise tax in the same manner as if it had been sold when delivered. Thus, for an integrated manufacturer-sales company, the excise tax is essentially triggered on delivery to the United States.

Who “Brings” in the Taxable Item into the United States?

This tax dispute focused on who “brings” the taxable item into the United States as defined in the regulations. This is important as the regulation clearly says that the party who “brings” the taxable item into the United States is liable for the excise tax.

Let’s start with the IRS’s position. The IRS argued that the term “brings” means causing or making something come from abroad. Under this broad definition, any United States business that ordered tires manufactured abroad would be subject to the tax, regardless of who physically transported the tires into the country. This interpretation would cast a wide net.

The district court did not accept this broad definition. It concluded that the Chinese manufacturers were the parties who brought the tires into the United States, as they physically made the delivery. This interpretation aligns with a common-sense understanding of the word “brings”–i.e., the party that physically transports an item from one place to another.

On appeal, the Fifth Circuit agreed with the district court’s narrower interpretation of “brings.” The Chinese manufacturer was the party that brought the tires to the United States. However, the appeals court concluded that the focus should have been on the other language in the regulations regarding “nominal importer” and “beneficial owner” and that these terms basically overrule the language about who “brings” the tires into the United States.

Who is a Nominal Importer vs. Beneficial Owner?

Okay, so if we ignore who “brings” the tires to the United States, who is a “nominal importer” and who is a “beneficial owner?” These are concepts that are often used with trusts, and even foreign FBAR reporting obligations. The regulations provide a starting point.

A “nominal importer” is an entity that appears to be the importer on paper or in form, but doesn’t have the substantive benefits or risks associated with importing. In this case, the Chinese manufacturers were considered nominal importers because they merely handled the logistics of shipping the tires to the United States on Texas Truck’s behalf.

The “beneficial owner,” on the other hand, is the entity that derives the real economic benefit from the importation. The Fifth Circuit, drawing on previous case law and IRS rulings, defined the beneficial owner as the party who is “the inducing and efficient cause of the importation.”

In applying these concepts, the appeals court considered several factors:

Who initiated the order: Texas Truck placed specific orders with the Chinese manufacturers.
Who benefited from the importation: Texas Truck received the tires for resale in the U.S. market.
The nature of the transaction: The Chinese manufacturers didn’t import tires speculatively to sell in the U.S.; they shipped tires in response to Texas Truck’s orders.
The intent of the parties: The arrangement was set up for Texas Truck to receive tires for its business, not for the Chinese manufacturers to establish a U.S. presence.

The Fifth Circuit concluded that Texas Truck was the beneficial owner of the tires. Even though Texas Truck didn’t physically bring the tires into the country, it was “the inducing and efficient cause” of their importation. The Chinese manufacturers, while technically bringing the tires into the U.S., were merely acting as agents facilitating the transaction.

The Takeaway

Businesses importing tires for sale in the United States, particularly those in Texas and other states within the Fifth Circuit’s jurisdiction, should carefully review their importing practices in light of this decision. They may need to reassess their potential excise tax liabilities and ensure they are properly reporting and paying any applicable taxes. Factors such as who initiates the order, who benefits from the importation, and how the sales process is structured can all impact the determination of who is the “importer” for tax purposes. This interpretation may result in taxpayers needing to restructure their business or having to consider filing excise tax returns for the first time or amended returns to seek refunds.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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What is a Bona Fide Loan for Tax Purposes? – Houston Tax Attorneys

It is often said that a taxpayer is free to structure their affairs as they see fit and can even do so in a way to minimize or avoid paying taxes. While this is true, it is equally true that the IRS is not bound by the taxpayer’s characterization of transactions. The IRS has a number of theories, arguments, and legal tools that it can use to recharacterize and, in some cases, even reverse the taxpayer’s characterization of transactions or even ignore the legal entity altogether.

There are several different recurring fact patterns where we see this. Intercompany transactions are prime examples. Loans are particularly suspect in terms of intercompany transactions and are frequently at the heart of tax disputes with the IRS.

This begs the question: what constitutes a bona fide loan for federal income tax purposes? The recent Feathers v. Commissioner, T.C. Memo. 2024-88, provides an opportunity to consider this question.

Facts & Procedural History

This case involves an S corporation that was organized to find and secure loans. The S corporation, in turn, owned other legal entities that were tasked with making the loans. The lower-level entities were to pay fees to the S corporation for finding loans that were funded.

The individual owner of the S corporation is the taxpayer in this court case. He caused the funds to transfer money to the S corporation and then took out some of the funds from the S corporation for his personal use.

The taxpayer took steps to document that these transfers were loans from the lower-level entities to the S corporation.

The SEC conducted an investigation, which led to criminal charges for financial crimes. After the taxpayer served time in prison, the IRS resumed its audit. It conducted a bank deposit analysis and determined that the loans from the lower-level entities to the S corporation were not loans, but rather commissions.

The IRS issued a statutory notice of deficiency on this basis and closed its audit. The case then ended up in the U.S. Tax Court.

About S Corporations & Flow-Through Taxation

An S corporation is a corporation or LLC that files a Form 2553 to make an election.

Once the S corporation election is made, the S corporation files a Form 1120S to compute the flow-through items, but those items are then picked up on individual shareholder returns and subject to tax on personal shareholder returns. This is done by issuing a Schedule K-1 from the S corporation to the shareholders of the S corporation. As explained below, the income flows through even if distributions are not made to the shareholder.

In addition to having tax at the shareholder level and not the entity level, the S corporation is also used to avoid self-employment taxes. That is beyond the scope of this article, but you can read about self-employment taxes for S corporations here.

Flow-through entities owned by an S corporation are reported on the Form 1120S. They add to the items of income and expense that get reported on the Schedule K-1 that is issued by the lower-level entities to the S corporation. The combined amounts from these lower-level entities and the S corporation itself all end up on the individual S corporation shareholder’s personal income tax return.

Tax Treatment of Intercompany Loans

An intercompany loan between flow-through entities generally doesn’t trigger income tax at the federal level. The entity that receives the loan pays interest back to the entity that made the loan and may get an interest deduction for tax purposes. The entity that made the loan picks up the interest income when payments are received. While it does not appear to be at issue in this case, taxpayers do often structure loans with S corporations to increase their basis to allow tax losses from the entity to flow through to the shareholder’s individual income tax return. You can read about S corp loans for losses, here.

Absent being a loan, in a situation like this where a subsidiary lends money to a parent entity, the amounts may also be taxed as distributions of earnings and profits. This too would normally not trigger income taxes. The earnings and profits of flow-through entities are picked up as income for the parent entity regardless of whether distributions are made from the subsidiary. If distributions happen to be made, they are usually tax-free to the extent of the parent’s investment (i.e., tax basis) in the subsidiary. Amounts in excess of this are often treated as capital gain on the sale of the parent’s interest in the subsidiary. Note, there is an exception for distributions of appreciated property, which can trigger a tax.

Alternatively, as argued by the IRS in this case, the transfers could also be compensation or commissions for services rendered by the parent for the subsidiaries. With this scenario, the commissions would be picked up as taxable income by the S corporation parent and that income would flow through to the S corporation shareholders. However, the subsidiaries would also get a corresponding tax deduction for the amount of the commissions made. The tax deduction would also flow through to the S corporation return and eventually to the shareholder’s individual income tax returns.

It is not clear from the court opinion, but it appears that the reason why the taxpayer was taking the amounts as loans was (1) to be consistent with his original treatment with the SEC and (2) that he did not own 100% of the S corporation or the lower-level entities. Thus, if the payments were commissions as the IRS argued, and not loans, the S corporation would pick up 100% of the amounts the S corporation received, but it would only get a portion of the offsetting tax deduction that also flowed through from the S corporations for the payment of the commissions. It seems that the lower-level entities may have had outside investors who owned those entities, which would produce a tax deduction for those other investors.

What is a Bona Fide Loan?

This brings us to the central question in this case: What exactly is a bona fide loan? The factors that the courts consider vary based on the leading court cases in the various circuit courts. The U.S. Tax Court sets out the factors in this court case as stated by the Ninth Circuit Court of Appeals.

The Ninth Circuit Court has said that whether a transaction was a bona fide loan is determined by considering these factors:

whether the promise to repay is evidenced by a note or other instrument;
whether interest was charged;
whether a fixed schedule for repayments was established;
whether collateral was given to secure payment;
whether repayments were made;
whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and
whether the parties conducted themselves as if the transaction were a loan.

In this case, the tax court determined that the transfers were not loans. Given the documentation and evidence, the tax court found that most of these factors were not satisfied. According to the court, the notes were executed after the transfers occurred, there was no evidence of interest being charged or paid, no fixed repayment schedule was established, and there was no collateral. Furthermore, the tax court found that the borrower entity did not have a reasonable prospect of repaying the purported loans given its financial condition. The court did not say whether there was a personal guarantee for the loan by the shareholder, which might have helped with this last factor.

For those seeking to have an intercompany transaction characterized as a loan, these are the exact findings that one would want to try to avoid.

The Takeaway

This case demonstrates the importance of carefully documenting intercompany transactions–particularly if the parties want the transaction to be respected as a bona fide loan. This is true even if the transactions are with flow-through entities and the amounts may seem like they net out on the shareholder’s individual income tax return. There are common fact patterns, like this one, where not all of the offsetting tax deductions land on the same shareholder’s income tax returns. This can trigger tax for the shareholder if the IRS were to recharacterize the loan as a commission payment, as it did in this case.