September 27, 2010
The government has decided not to seek certiorari in the Deloitte case, thus leaving the law in some disarray with respect to the assertion of work-product privilege for tax accrual workpapers. Taxpayers in the First Circuit and the Fifth Circuit will have difficulty asserting the privilege; taxpayers in the D.C. Circuit will be on solid ground. If the IRS contests an assertion of privilege by a taxpayer located in another circuit, the parties will be left to duke it out and try to persuade the court of the relative merits of the Textron and Deloitte approaches.
As noted in our previous post, a government certiorari petition in Deloitte would have had to walk a fine line to avoid contradicting what the government had told the Court only a few months ago in opposing certiorari in Textron. A concern about undermining his credibility with the Court could have played a role in the Solicitor General’s decision not to seek certiorari in Deloitte. More likely, however, the decision was driven by a judgment that, in view of the ongoing initiative to require taxpayers to report their uncertain tax positions on their tax returns, resolving the Deloitte/Textron issue in the discovery context was not sufficiently important to the government to warrant asking the Court to step in. As discussed in this Miller & Chevalier Tax Alert, the IRS has just released its final schedule for reporting UTPs, along with other related announcements. The UTP initiative may well generate its own set of privilege disputes that could implicate the principles of Textron and Deloitte in another context.
September 20, 2010
The government has filed its opening brief (attached below) in the Fifth Circuit in Container, challenging the Tax Court’s decision to treat loan guarantee fees as foreign-source income. As discussed in our previous post, the Tax Court concluded that such guarantee fees are best analogized to compensation for services.
The brief is unusually concise, using barely half of the maximum available pages. As it argued in the Tax Court, the government maintains on appeal that the fees are better analogized to interest, which would result in treating them as U.S.-source income. It emphasizes three elements of the fees in urging this position: the guarantee fees payments (1) “were made to [the Mexican parent] for the use of its credit”; (2) “to compensate it for putting its assets at risk;” and (3) “for its assistance in enabling [the U.S. sub] to meet its obligations under the Notes.”
The government’s brief criticizes the Tax Court’s approach for failing to recognize that: (1) there was no evidence that the sub had rendered any services to the parent in exchange for the fees; and (2) the amount of the fees was calculated as a percentage of the loan amount and, indeed, was a standard percentage charged by the parent to guarantee loans of its various subs irrespective of any services provided. The government also argues that the two most relevant precedents — Centel Comm. Corp. v. United States, 920 F.2d 1335 (7th Cir. 1990) (involving stock warrants), and Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982) (involving commissions paid in connection with letters of credit) — strongly support its position.
The taxpayer’s answering brief is currently due on October 18, 2010.
September 17, 2010
On September 14, 2010, the tax matters partner (“TMP”) for Castle Harbour LLC filed its response brief in TIFD III-E Inc. v. United States, No. 10-70 (2nd Cir.) (brief linked below). For our prior coverage of this case, see here. As many readers are no doubt aware, this is the second time this case is before the Second Circuit.
In the response brief , the TMP frames the issues as: (1) whether the district court, upon remand, correctly determined the investment banks were partners under I.R.C. section 704(e)(1), (2) whether the IRS can reallocate income under I.R.C. section 704(b) despite the section 704(c) “ceiling rule,” and (3) whether the district court correctly decided that I.R.C. section 6662 accuracy-related penalties were not applicable.
First, the TMP argues that section 704(e)(1) creates an independent, objective alternative to the Culbertson test, with the critical issue being whether the purported partner holds a “capital interest.” The TMP contends that, because the banks’ interests were economically and legally equivalent to preferred stock, and because preferred stock is treated as equity for tax purposes even though it possesses many characteristics of debt, the banks held “capital interests” under section 704(e)(1). Accordingly, the TMP argues that the banks were bona fide partners in Castle Harbour, the Second Circuit’s application of Culbertson notwithstanding.
Second, the TMP contests the IRS’s ability to reallocate income under I.R.C. section 704(b) in spite of application of the section 704(c) ceiling rule (assuming the banks were bona fide partners). The regulations under section 704(c) were amended to allow such a reallocation for property contributions occurring after December 20, 1993, which is after the contributions at issue in the case. Accordingly, the TMP takes the position that the IRS is attempting an end-run around the effective date of the amended regulations.
Finally, the TMP also argues that victory at trial, based on the careful findings of fact by the district court, demonstrates that the transactions were primarily business-motivated, and furthermore, that substantial authority existed for the TMP’s return position. Accordingly, the TMP contends that accuracy-related penalties should not apply, even if the IRS’s adjustment is ultimately upheld.
September 13, 2010
We have been promising a post on the application of the section 6664 reasonable cause and good faith defense to tax penalties as it relates to reliance on tax advisers. Here it is.
There has been much activity in this area in the district courts and the Tax Court and not much winnowing or rule setting in the circuits. This is understandable; the application of the standards is highly factual and is well-placed in the hands of trial judges. We will analyze here some potential inconsistencies in two recent high-profile section 6664 decisions, Canal Corp. v. Commissioner, (Slip Op. attached) (August 5, 2010) (which found reasonable cause and good faith lacking) and NPR Invs., LLC v. United States, (E.D. Tex. Aug. 10, 2010) (which found reasonable cause and good faith met).
In Canal Corp., the Tax Court considered the application of section 6664 to a should-level PricewaterhouseCoopers opinion. (In the parlance, a “should-level” opinion means that the transaction “should” be upheld; it is a higher standard than more-likely-than-not, which means only that the transaction is more, perhaps only 51% more, likely to be upheld than not.) The Canal Corp. transaction emerged from the decision of a predecessor of Canal Corp., Chesapeake Corporation, to dispose of its tissue business, WISCO. After seeking advice from PwC and others, Chesapeake decided to dispose of the business by forming a partnership with Georgia Pacific to which WISCO would contribute its assets and liabilities and from which WISCO would receive a distribution of cash. The cash was funded by the new partnership borrowing money, and that debt was indemnified by WISCO. In essence, the substantive question presented to the court was whether the contribution/distribution amounted to the formation of a partnership (which would not trigger the built-in gain on the WISCO assets) or, rather, a sale of those assets to GP (which would).
In addition to helping structure and advise on the transaction, PwC was asked to prepare the aforementioned opinion. The partner writing the opinion was not the historic PwC engagement partner but rather an expert from the Washington National Tax group of PwC. PwC charged a flat fee of $800,000 for the opinion. Because the area of the law was relatively unclear, the opinion relied on analogy and analytics to reach its conclusions (including a withdrawn revenue procedure that set out tests to apply for advance rulings in a different area); there was apparently little direct authority available to cite. The parties effectuated the transaction on the day that PwC issued the opinion.
The Tax Court determined that the transaction was a disguised sale. This was based largely on the court’s conclusion that the indemnity by WISCO was illusory and thus that WISCO should not be allocated any amount of the partnership’s liabilities. If WISCO had been allocated these partnership liabilities then the transaction would be viewed as a financing transaction and not a sale. After all, you can’t call something a sale if the seller gets left holding the bag for the purchase price. But the court found WISCO’s bag empty and proceeded to penalties.
The Canal Corp. court began its analysis of section 6664 by recognizing that “[r]easonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and, in a manner consistent with ordinary business care and prudence, relies on the adviser’s professional judgment as to the taxpayer’s tax obligations.” Slip Op. at 31. However, the court noted that such advice “must not be based on unreasonable factual or legal assumptions” and cannot be relied upon when given by an advisor “tainted by an inherent conflict of interest.” Id. at 32. Citing Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), a case involving promoters of master recording leasing programs, the Court concluded that a “professional tax adviser with a stake in the outcome has such a conflict of interest.” Id.
Applying these conceptual standards to the PwC opinion, the Tax Court found it lacking. At the outset, the court thought it incredible that significant time had been spent on an opinion so “littered with typographical errors, disorganized and incomplete.” Id. at 33. The Court’s confidence in the opinion was further undermined by the fact that only a draft could be found and the author (even after presumably being prepared for trial) did not recognize parts of the opinion when asked about them in court. On the question of assumptions generally, the lack of specific citation in support of the opinion’s premises and the frequent use of terms such as “it appears” in the place of hard analysis was also troubling for the court, which found it unreasonable that anyone would issue a should-level opinion on analogy and analytics with no direct support for the position. The Court found the author’s testimonial responses to challenges on these points unsettling and bluntly concluded that the only reason the opinion was issued at the should level was that “no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion.” Id. at 35.
On the question of a conflict of interest, the Court found a large one. Commenting that it “would be hard pressed to identify which of his hats” the author was wearing when he rendered the opinion, the Court concluded that the author’s work in developing, planning, structuring, and implementing the transaction took away too much of his independence (which the Court found to be “sacrosanct to good faith reliance”) to allow him to objectively analyze the merits of the transaction. Slip Op. at 36-38. Given that the only hurdle to closing the transaction was, in the end, the $800,000 flat fee opinion, the Court found that Chesapeake was attempting to buy “an insurance policy as to the taxability of the transaction.” Id. at 37. The Court voided the policy.
NPR involved a transaction the IRS characterized as a “Son of BOSS” transaction involving offsetting foreign currency options. As explained by the Court, the IRS’s view of a Son of BOSS transaction is “a series of contrived steps in a partnership interest to generate artificial tax losses designed to offset income from other transactions.” Slip Op. at 2 n.3. It is fair to say that Son of BOSS transactions are considered by the IRS to be one of the “worst of the worst,” so much so that they are the only transaction that is specifically barred from being considered by IRS Appeals. See Announcement 2004-46, Sec. 5 (May 24, 2004). Indeed, NPR conceded the merits of the transactions at issue prior to the decision. Accordingly, the only items considered by the district court were a period of limitations issue (which we will not discuss here) and the penalties.
After working through the background elements of section 6662, the district court in NPR began its analysis in a similar way to the Tax Court in Canal Corp., setting out both the restrictions on relying upon unreasonable assumptions and on a conflicted adviser. Slip Op. at 24-26. The conclusion, however, was quite different. Finding that the taxpayers were “not tax lawyers” and were not “learned in tax law” the court held that their reliance on the more-likely-than-not opinion of R.J. Ruble (who, at the time of the court’s ruling, had already been convicted of tax evasion associated with the rendering of tax opinions) was reasonable based on its findings that the opinion reached “objectively reasonable conclusions” and detailed a “reasonable interpretation of the law” (albeit one that the taxpayers conceded before trial). Id. at 27-28. Critically, the Court found persuasive the taxpayer’s plea that they, as unsophisticated men, sought out the advice of professionals who they did not know were conflicted and followed that advice; “what else could we have done except follow their advice?” Id. at *28.
As shown above, the differences between Canal Corp. and NPR are not differences in legal standards but differences in fact-finding. Both courts invoked and applied the same standards and prior interpretations of those standards; they just applied them to different facts as each judge found those facts. That is exactly what trial courts are supposed to do; take legal standards and do the hard work of applying them to the myriad fact patterns that arise. Viewed from that perspective, there is nothing in conflict between the two rulings; different facts support different results.
In a sense, the “inconsistencies” give a certain comfort in the decisions of both courts. Judges say what the law is, that is true. But more relevant to a trial lawyer, in a bench trial, they say what the facts are. In both Canal Corp. and NPR, the judges reached a conclusion based on their common-sense perceptions of what happened in the courtroom. While they can (and likely will) be second-guessed, that is their job. The NPR court was not swayed by all of the IRS’s anti-Son-of-BOSS rhetoric. Rather, the court evaluated the honesty and integrity of the specific taxpayers before it, their options (not the foreign currency kind) and their knowledge, and decided that no more could reasonably be asked of them. Similarly, the Canal Corp. court wasn’t swayed by the involvement of a major accounting firm in a business transaction between two large, sophisticated companies. Instead, the court looked at the analytics and thoroughness of the opinion, the involvement of the author in the transaction (including what he was paid), and his credibility on the stand, and concluded that it was unreasonable for a sophisticated consumer of tax advice to rely on his opinion. Whether you agree with the fact-finding (which is tough to do if you didn’t sit through both trials), the fact-finding has to be separated from the analytics; the analytics were sound (and consistent).
Viewed from the perspective of the tax planner, however, justifying the different outcomes on the basis of different fact-finding does not provide much comfort. Most tax planners would turn up their nose at a Son of BOSS opinion given to a group of individual investors to generate relatively large foreign currency options losses on a relatively minor investment. Yet a significant number have criticized the Tax Court’s opinion in Canal. Perhaps the distinction is just based on an “I know [a good transaction] when I see it” analysis, but many view what Canal Corp. did as “legitimate” tax planning and believe that a PwC advisor from the esteemed Washington National Tax group should have been viewed as more credible than a convicted felon. However, when a judge looks into the eyes of the adviser and doesn’t like what she sees, the taxpayer is at grave risk on penalties. Similarly, when the written product is capable of being analytically questioned, even undermined, based on sloppiness and lack of support or detail, a judge can be expected to have a negative reaction to that work product. That negative reaction will carry over to the credibility of its author, particularly where a substantial fee was received. On the flip side of the coin, if the judge finds the taxpayer honest and forthcoming about what he believed and what he tried to do to confirm that belief, the judge is likely to find reasonable cause and good faith. In short, the way the judge perceives the facts determines the outcome; that is why they call it a facts and circumstances based test.
Asking for “consistency” in such matters amounts to nothing less than the neutering of the trial court. “The ordinary lawsuit, civil or criminal, normally depends for its resolution on which version of the facts in dispute is accepted by the trier of fact.” NLRB v. Pittsburgh S.S. Co., 337 U.S. 656, 659 (1949). Indeed, rather than chasing the siren song of legal consistency, it is better to accept that fact-based tests like section 6664 belong to the trial lawyers to prove and to the trial judges to find. While that may appear to create a lack of consistency, it doesn’t. As we have shown, the inconsistency some see in Canal Corp. and NPR does not flow from an inconsistency in the law. Rather, there is always unpredictability as to how the facts will be perceived by different decision-makers. That is merely the uncertainty of litigation: the risk that a given judge on a given day may or may not believe your witnesses or your theory of the case. This is necessarily so; “[f]indings as to the design, motive and intent with which men act depend peculiarly upon the credit given to witnesses by those who see and hear them.” United States v. Yellow Cab Co., 338 U.S. 338, 341 (1949). Said differently, what a lawyer (or a client) thinks the facts are doesn’t matter if they can’t convince the judge they draw to perceive the facts as they see them. Making choices between “two permissible views of the weight of evidence” (id.) is precisely what trial judges are supposed to do and precisely what both of the judges in these cases did. Appeals in both cases, if they are filed, will have to take this into account.
September 12, 2010
Lately, the IRS has had a successful run of attacking transactions involving purported securities loans. See Anschutz Co. v. Commissioner, 135 T.C. 5 (July 2010); Calloway v. Commissioner, 135 T.C. 3 (July 2010); Samueli v. Commissioner, 132 T.C. 4 (March 2009). Two of the cases, Samueli and Anschutz, involve the construction of I.R.C. section 1058, which provides for non-recognition treatment of a loan of securities that meets the following criteria: (1) the loan agreement provides for the return of securities identical to the securities transferred; (2) the agreement provides for payments to the transferor of amounts equivalent to all interest, dividends, and other distributions which the owner of the securities is entitled to receive during the period of the loan; and (3) the agreement does not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred.
In Samueli, the Tax Court held that a series of transactions between a taxpayer and a broker/dealer did not qualify for section 1058 treatment because the purported securities loan reduced the taxpayer’s opportunity for gain (the taxpayer was the lender of securities under the form of the transactions). The transactions consisted of: (1) taxpayer’s purchase of $1.7 billion in mortgage-backed interest strips on margin (the broker/dealer allowed the taxpayer to purchase the securities on credit); (2) a securities loan of the interest strips back to the broker/dealer, with a transfer of $1.7 billion in cash collateral to the taxpayer; and (3) the taxpayer paying interest on the cash collateral at a variable rate (with the broker/dealer paying a relatively small amount of interest on taxpayer’s funds deposited in its margin account). The arrangement further provided that taxpayer could recall the securities only on two specified dates during the term of the loan, or at maturity. Ordinarily, securities loans are callable at any time. The Tax Court determined that the limited ability of the taxpayer to retrieve its securities reduced the taxpayer’s opportunity for gain, because taxpayer did not have the right to take advantage of favorable swings in the price of the securities if they occurred at a time when taxpayer did not have the right to call the loan.
Interestingly, the Tax Court went a step further than merely holding that non-recognition treatment was improper under section 1058. Cursorily invoking the substance-over-form doctrine, the court also held that as a matter of economic reality there was no securities loan at all; rather, in the court’s view there was a wash sale at the outset (purchase of the securities by taxpayer immediately followed by a resale to the broker/dealer for no gain), and a subsequent purchase under a constructive forward contract followed by a resale to the broker/dealer, resulting in a modest short-term capital gain. Because there was no true indebtedness, the court held, taxpayer’s interest deductions were not allowable.
The taxpayer has appealed the Tax Court’s decision to the Ninth Circuit, and the case has been fully briefed. The Tax Court’s opinion and the appellate briefs are linked below. In the opening brief, the taxpayer argues that the Tax Court: (1) misinterpreted section 1058 by adding a “loan terminable upon demand” requirement, (2) erroneously construed the section 1058 requirements as the sine qua non of securities loans for federal tax purposes (cf. Provost v. United States, 269 U.S. 443 (1926) (for purposes of the stamp tax, the borrowing of stock and the return of identical stock to the lender are taxable exchanges)), (3) recharacterized the transactions in a manner inconsistent with their economic reality, and (4) even if the recharacterization stands, improperly treated the deemed disposition of the forward contract shares as short-term capital gain.
In its response, the government contends that the Tax Court correctly determined that the arrangement was not eligible for non-recognition treatment under section 1058 because it reduced the taxpayer’s opportunity for gain in the securities, contrary to section 1058(b)(3). Furthermore, the government argues, the court correctly held that the overall arrangement was not a loan in substance, and therefore the purported interest paid on the collateral is not deductible.
In the reply, the taxpayer changes tack somewhat and argues that the focus on section 1058 heretofore has been a mistake by all involved. The taxpayer contends that the tax treatment of the transactions should be the same regardless of the application of section 1058—long-term capital gain and deductible interest, based on the notion that taxpayer received basis in a contractual right at the outset, which was later disposed of at a gain, and that taxpayer’s payment of interest on the collateral was consideration for the broker/dealer’s forbearance of the use of the collateral.
We will continue to follow the case as it develops. According to news reports, the taxpayer in Anschutz intends to appeal the Tax Court’s decision as well, and we will post on that case as soon as the appeal is filed (which will likely be in the 10th Cir.).
September 8, 2010
Practitioners interested in the more interesting conceptual aspects of transfer pricing should mark October 27th on their calendars. On that day, the International Fiscal Association is sponsoring a debate on the usefulness of the income method to value intangibles in the transfer pricing context. Dubbed “The Great Debate” by IFA, this year’s event will pit the best transfer pricing practitioners in the world (including Miller & Chevalier’s Bob Kirschenbaum and Baker & McKenzie’s Jim O’Brien) against each other. Neither will know which position they are arguing prior to a coin toss. The gloves will surely come off and our current understanding is that the only thing missing will be a steel cage. Attendance is limited to IFA members and special guests (which you can become by being sponsored by an IFA member).
September 4, 2010
The government filed its reply brief in Virginia Historic Tax Credit Fund 2001, LLC v. Commissioner, No. 10-1333 (4th Cir.), on September 1, 2010. The brief is linked below.
In its reply, the government argues that the tax characterization of the investor transactions, i.e., whether the investments were equity contributions or merely the purchase of state tax credits, is subject to the de novo standard of review. Accordingly, the government contends that the Tax Court’s determination that the taxpayers were bona fide equity investors is a question of law not subject to the more deferential “clear error” standard of review, as argued by the taxpayers.
In addition to reiterating its positions presented in the opening brief, the government also contends that the IRS has the power to recharacterize, for tax purposes, a transaction according to its substance, in spite of the fact that the parties may have adopted the form of the transaction for purposes other than tax avoidance. The taxpayers argue that the form of the transactions was adopted in order to comply with state law limitations on the transfer of historic preservation tax credits, and therefore the form of the transactions should be respected for federal tax purposes.
The government also supplements its statutory disguised sale theory with the arguments that the transactions were “transfers” of “property” as those terms are employed in I.R.C. § 707 and the regulations thereunder, and that the taxpayers’ arguments regarding the existence of meaningful entrepreneurial risk are not supported by the record.
September 1, 2010
On August 30, 2010, the Ninth Circuit granted Petitioner’s Motion to Stay the Mandate in Kawashima. This stays the mandate in the case pending the filing of a petition for writ of certiorari and confirms our prior speculation that petitioner is going to try to make a run at the Supreme Court. We will be watching the case with interest and will post the petition when it appears.