Supreme Court’s Clarke Decision Sets Forth General Guidelines for When Evidentiary Hearings Should Be Required in Summons Enforcement Proceedings
June 19, 2014
As expected, the Court this morning reversed the Eleventh Circuit’s decision in Clarke based on the Court’s agreement with the government’s position that the Eleventh Circuit erroneously had required an evidentiary summons enforcement hearing based on nothing more than the bare allegation of an improper purpose. See our previous report here. But the Court’s unanimous opinion, authored by Justice Kagan, went on to attempt to provide guidance for future disputes over the availability of such hearings, including the resolution of this case on remand, and that guidance could perhaps lead courts to allow such hearings more often than in the past.
The Court summarized the standard to be applied by a court in considering the summoned party’s request for a hearing as follows: “whether the [summoned party has] pointed to specific facts or circumstances plausibly raising an inference of improper motive.” It elaborated on that standard to some extent elsewhere in the opinion, although the general language still leaves considerable room for interpretation by the lower courts:
“[T]he taxpayer is entitled to examine an IRS agent when he can point to specific facts and circumstances plausibly raising an inference of bad faith. Naked allegations of improper purpose are not enough: The taxpayer must offer some credible evidence supporting his charge. But circumstantial evidence can suffice to meet that burden; after all, direct evidence of another person’s bad faith, at this threshold stage, will rarely if ever be available. And although bare assertion or conjecture is not enough, neither is a fleshed out case demanded: The taxpayer need only make a showing of facts that give rise to a plausible inference of improper motive. That standard will ensure inquiry where the facts and circumstances make inquiry appropriate, without turning every summons dispute into a fishing expedition for official wrongdoing.”
The immediate result of the decision is a remand to the Eleventh Circuit to determine whether the district court’s refusal to order an evidentiary hearing comported with this standard. The Court did not express a view on whether the evidence that the private parties had put forth (alleging retaliation for failure to agree to a statute of limitations extension and an ulterior motive to conduct the equivalent of discovery for the Tax Court case) met the standard, stating that whether those purposes would be improper was not within the question presented to the Court. But the Court did set forth some principles for how the Eleventh Circuit should go about reviewing the district court’s decision.
At the outset, the district court’s decision is entitled to deference and is reviewed for abuse of discretion. But the Court emphasized “two caveats” to that discretion. First, no deference is owed if the district court did not apply the correct standard. Second, no deference is owed to the district court’s decision on “legal issues about what counts as an illicit motive.”
In that connection, the Court proceeded to state that this second caveat encompassed the issue to which the private parties have attached considerable importance – namely, the contention that the IRS was seeking to enforce the summons only in order to obtain discovery for the Tax Court proceedings. The district court had agreed with the government that this would not constitute an improper purpose because the validity of a summons should be judged as of the time of issuance (which was before the Tax Court proceedings were initiated), not as of the time the IRS moves to enforce the summonses. The Supreme Court declined to endorse that argument, inviting the Eleventh Circuit to consider it as a legal issue on which it owes no deference to the Tax Court.
Thus, the government has dodged a bullet in Clarke, with the Supreme Court reversing the Eleventh Circuit and rejecting the proposition that IRS agents can be hauled into an evidentiary hearing on the basis of a bare allegation of improper purpose. But the government could well find itself facing a loss again on remand when the Eleventh Circuit applies the standard set forth in Clarke to the evidence in this case. There is nothing in the Supreme Court’s opinion to discourage the Eleventh Circuit (presumably the same judges who already voted once to afford an evidentiary hearing in this case) from concluding that the private parties here did make a sufficient showing because, as a matter of law, it is improper for the IRS to move to enforce a summons for the purpose of obtaining information to be used in pending Tax Court proceedings. It will be worth following the remand proceedings in the court of appeals to see how the Eleventh Circuit deals with this issue.
June 17, 2014
It is now six weeks since the Supreme Court heard argument in Clarke regarding the circumstances under which a court must convene an evidentiary hearing in a summons enforcement proceeding to allow IRS officials to be questioned regarded their reasons for issuing the summons. Based on the way the case was litigated and the questions at oral argument, the government is likely rooting for a relatively narrower opinion, whereas taxpayers who might someday be disputing a summons hope that the Court will take this opportunity to elaborate and provide new guidance on summons enforcement proceedings.
The dichotomy between a broad approach and a narrow approach has been reflected all through this case, beginning with the divergent ways in which the two parties framed the summons dispute in their questions presented. See our prior coverage here. The government has sought to focus narrowly on the precise holding of the court of appeals, while the private parties have asked the Court to look more broadly at all the circumstances of the case and to take a fresh look at how summons enforcement proceedings are generally conducted.
Specifically, the government contended from the start that the Eleventh Circuit had laid down an indefensible blanket rule that a party is entitled to an evidentiary hearing to challenge a summons so long as it alleges an improper purpose. That rule, according to the government, would dramatically increase the extent to which IRS agents are hauled into court for evidentiary hearings and is inconsistent with longstanding summons enforcement law. The parties challenging the summons enforcement proceeding, conversely, have argued that the Eleventh Circuit decision was narrower, pointing to the facts in this case that supported their allegations, albeit facts that for the most part were not relied upon by the court of appeals. Notably, the government has acknowledged that a district court has considerable discretion in deciding when an evidentiary hearing should be held and conceded that a district court appropriately could have scheduled a hearing here. The government objects only to the court of appeals ordering the district court to hold an evidentiary hearing when the district court had already exercised its discretion to deny the private parties’ hearing request.
The Justices inquired into both approaches to the case during the oral argument. It appeared that the Court was in harmony with the government’s narrow view of the Eleventh Circuit’s holding and thus of the bare minimum that has to be decided in the case. In fact, when government counsel began the argument by attacking the court of appeals’ specific statements, Justice Scalia quickly interjected to say that the other side “concedes all that” and that “nobody defends what the lower court said here.”
But the questioning also suggested that the Court might not be content to write an opinion that does the bare minimum – that is, one that just reverses the court of appeals for requiring an evidentiary hearing based on no more than a bare allegation of an improper purpose. Rather, the Court expressed plenty of interest in other aspects of the summons enforcement procedure and raised the possibility that it would use this decision as a way of giving more guidance to trial courts on when hearings would be appropriate in handling these proceedings. Indeed, Justice Alito criticized one of government counsel’s suggestions as not being “very helpful to a district judge” and the Chief Justice noted a desire to give “clearer guidance.” Thus, there appears to be a good possibility of a decision reversing the Eleventh Circuit, and thus ruling for the government, but containing language to guide district courts in the future that the government could find problematic.
In particular, the Justices showed interest in the point on which the private parties laid the most stress in arguing that they had evidence of an improper purpose – namely, the circumstances strongly indicating that the IRS was seeking to enforce the summonses as a way of developing evidence for the Tax Court proceeding rather than for the audit. The government had argued that this issue was not before the Court since the Eleventh Circuit did not rely on it, and also contended that there was no caselaw holding that this was an improper purpose. It also argued that the improper purpose determination relates to the issuance of the summonses and therefore is not to be based on the situation at the time of the enforcement proceedings. It is not apparent, however, that these arguments will carry the day. At least four Justices (Kennedy, Alito, Breyer, Ginsburg) showed interest in this point and evinced some degree of concern whether it would be proper for the IRS to enforce the summonses to aid its position in the Tax Court proceedings. Justice Breyer did question whether, given the posture of the case, the Court could decide the legal question whether aiding the Tax Court proceedings would be an improper purpose. Thus, there is a good chance that the Court’s opinion will leave this issue to be resolved on remand.
At the end of the argument, Justice Kagan asked government counsel to elaborate on what kind of evidence the government would agree would overcome the presumption that a summons was issued for a proper purpose. Counsel pointed to the two improper purposes identified in Powell – harassment and an attempt to pressure the taxpayer into settlement in a collateral matter – asserting that the taxpayer ought to have some evidence in its possession if the latter purpose existed. The Court may be tempted in Clarke to crack open the door a bit more for allegations of improper purpose, but it is unlikely to throw the door open as wide as the Eleventh Circuit appears to have done.
In any event, the answer will come soon. The Court could issue its decision as early as Thursday, and will almost certainly act by the end of June.
June 16, 2014
All of the briefs have now been filed in the Barnes case. The government’s response brief defends the Tax Court’s decision as a run-of-the-mill application of substance over form principles. Quoting from True v. Commissioner, 190 F.3d 1165 (10th Cir. 1999), it argues that the step-transaction doctrine applies because the “Bermuda/Delaware exchanges did not ‘make[ ] any objective sense standing alone’ without contemplation of the other steps.” In arguing that these steps served no business purpose, the government relies heavily on evidence that the “reinvestment plan” was based on tax planning that the taxpayer’s accountants had previously done for another client. The government asserts that “Barnes and PwC went to great lengths to create out of whole cloth a business purpose for a tax-avoidance plan that originated in PwC’s database.” Rather than a legitimate business plan, the government alleges that “the entire repatriation scheme consists of essentially nothing more than a circular flow of funds among Barnes and its wholly owned subsidiaries.”
The government’s brief also notes that, if the court of appeals is unpersauded by the Tax Court’s opinion, it should remand for additional factual determinations to resolve two alternative government arguments that were not reached by the Tax Court: 1) that the transaction had the principal purpose of tax evasion and therefore deductions could be disallowed under Code section 269; and (2) that the Delaware preferred stock was held under the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4).
With respect to the issue discussed in our previous post regarding the taxpayer’s argument that the government was prohibited from disavowing Rev. Rul. 74-503, the brief largely tracks the Tax Court’s discussion. In other words, the government does not question the soundness of the principle stated in Rauenhorst that the IRS cannot argue against its Revenue Rulings. Rather, the brief simply doubles down on the step-transaction point and argues that the taxpayer could not reasonably rely on that ruling here because this case does not involve “bona fide § 351 exchanges.”
With respect to the penalty issue, the government again criticizes PwC’s role, arguing that PwC had a “conflict of interest” in issuing an opinion regarding the transaction because it had an interest in a favorable tax result that would allow PwC to “market [the tax plan] to other corporations seeking to repatriate funds from a controlled foreign corporation.” Accordingly, the government argues that the taxpayer could not reasonably rely on the PwC letter for “objective advice.” The government also argues that the taxpayer could not reasonably rely on the opinion because “PwC did not opine on the integrated repatriation scheme as a whole.”
The taxpayer’s reply brief argues that the government’s brief “mischaracterizes the substance of the plan” because the Bermuda and Delaware subsidiaries did not operate as conduits for a dividend payment. Instead, it accuses the government of making a policy-based argument that would “impermissibly convert Section 956 into an anti-abuse rule.” The brief then disputes in detail the government’s description of the transaction and underlying facts.
With respect to the penalty issue, the reply brief states that the government “essentially rewrites the Tax Court’s factual findings” in criticizing reliance on the PwC opinion. The brief notes that PwC was Barnes’ long-time tax advisor and did not market the transaction to Barnes. It also states that the Tax Court held that the PwC advisor “was a competent professional who had sufficient expertise to justify reliance” and that Barnes “provided necessary and accurate information to the advisor.” In particular, the reply brief responds to the government’s “conflict of interest” accusation against PwC by noting that the Tax Court specifically observed that there was nothing “nefarious” about PwC keeping tax planning ideas in a database and by asserting that “the government’s unfounded assertions that PwC did not provide an adverse opinion in order to sell the transaction to others is ludicrous and without any factual basis.” The reply brief also argues that the government is incorrect in stating that the PwC opinion did not address the entire transaction, quoting the PwC opinion itself as stating that it “is premised on all steps of the proposed transaction.”
Oral argument has not yet been scheduled.
June 12, 2014
The government has now filed its reply brief in MassMutual. The brief begins by asserting that the taxpayer has abandoned on appeal an argument that had persuaded the trial court — namely, “reliance on its annual-dividend obligation to individual policyholders to establish the fact of its liability under the dividend guarantees.” In the government’s view, that “about-face is fatal to its case.” The reply brief then addresses the taxpayer’s reliance on the Washington Post case. See our previous report here. It argues that, “unlike the group obligations in Washington Post, the alleged group obligations in this case were not otherwise fixed as to liability in the years in which the dividend guarantees were adopted” for reasons unconnected to the indeterminate membership of the group. The rest of the brief hews more closely to the topics discussed in the government’s opening brief, including the Supreme Court’s decision in Hughes Properties and the Second Circuit’s decision in New York Life. See our previous report here. The reply brief also argues again that its economic performance regulation is entitled to Auer deference.
The Federal Circuit has not yet announced a date for oral argument.
May 6, 2014
The taxpayer has filed its response brief in the Federal Circuit in the MassMutual case. See our previous coverage here. With respect to the primary issue of whether its policyholder dividend guarantee was a “fixed liability” within the meaning of the “all events test,” the taxpayer relies heavily on Washington Post Co. v. United States, 405 F.2d 1279 (Ct. Cl. 1969). (The Court of Claims was the predecessor court to the Federal Circuit and its pre-1982 decisions are binding precedent in the Federal Circuit.) According to the taxpayer, Washington Post establishes that “a company can fix a liability to an existing class of beneficiaries, even though the class composition may change before the liability is ultimately satisfied.” In contrast to the government’s brief, the taxpayer does not dwell at length on the Supreme Court’s decisions in Hughes Properties and General Dynamics, but argues that both of those cases are fully consistent with the more-directly-on-point decision in Washington Post.
The brief also addresses the Second Circuit’s decision in New York Life, arguing that the cases are distinguishable. (The Second Circuit had suggested a distinction, but without great conviction, suggesting that it believed the Court of Federal Claims was wrong in MassMutual.) The critical difference, according to the taxpayer, is that “New York Life addressed thousands of separate liabilities to individual policyholders, any one of which could cease to be a policyholder at any time,” whereas MassMutual involves a guarantee to “a class of policyholders” that “does not depend on identifying individual policyholder liability.” Finally, the taxpayer rejects the government’s argument that the dividend guarantees were “illusory,” stating that the trial court correctly ruled that “Board resolutions can fix liability.”
With respect to the second issue of whether the liability fell within the “recurring item exception,” the taxpayer argues that its position comports with “the only sound interpretation of the regulation.” It further argues that the government’s administrative deference argument is waived for failure to raise it below and, in any event, fails because the government is seeking deference to what is no more “than a convenient litigating position” that has not been shown to have been approved at any level by IRS or Treasury.
The taxpayer’s brief is linked below. Also linked below is the government’s brief in opposition to the petition for certiorari filed by the taxpayer in New York Life. That petition was denied by the Supreme Court on April 28.
April 7, 2014
The parties resisting summons enforcement have filed their brief in the Supreme Court in Clarke responding to the government’s opening brief. Underlying the two sets of briefs is a fundamentally different perspective on the significance of holding an evidentiary hearing at which the agent issuing the summons can be questioned about his motives. For the government, such a hearing is a big deal, and the courts should not impose that burden on the IRS on the basis of a mere allegation of an improper purpose. For the summoned parties, such a hearing is a very limited intrusion that must be allowed upon a plausible allegation of bad faith if the notion of judicial oversight of summonses is to have any teeth at all. They argue that, “[f]or the judiciary to fulfill its function of safeguarding against abusive summonses, it cannot be entirely dependent on one-sided submissions by the government attesting in conclusory fashion that its summons is being pursued for a proper purpose.”
Thus, the summoned parties argue that the government’s position would “transform summons enforcement into an ex parte affair” because there would be no effective way to challenge the “pro forma showing” of government good faith made by an agent’s affidavit. The summoned party in most cases cannot realistically meet the government’s requirement that it show independent evidence of bad faith before having a hearing because that knowledge “is peculiarly within the knowledge or files of the Service”; the government’s proposed rule thus imposes a “circular burden” because the point of the hearing is give the summoned party the opportunity to develop that evidence. The brief rejects the government’s accusation that the Fifth Circuit has created a presumption of government irregularity. Rather, the brief argues that the presumption of regularity is intact, but the Fifth Circuit’s approach “simply allows the taxpayer an opportunity to overcome that presumption.” As the summoned parties see it, the government’s “position is not merely that it should receive the benefit of the doubt, but that in practice it should be immune from questioning.”
The brief then addresses why the Court should agree that the summoned parties have made a sufficiently plausible showing of bad faith to justify a hearing. As with its brief at the petition stage, this argument focuses primarily on the evidence showing that the government was interested in gettting information that would assist with the Tax Court litigation, not in conducting an administrative investigation into tax liability. As noted in our first report on this case, the court of appeals did not rely on that evidence, and the courts thus far have not held that a motivation to assist with Tax Court litigation is an improper purpose that justifies denying enforcement of a summons. Perhaps recognizing that it may be tough to win in the Supreme Court on the present state of the record, the summoned parties specifically request an opportunity to litigate that issue, stating “if this Court vacates the judgment below, it should remand so that the court of appeals can consider whether evidence that the IRS is using a summons only to circumvent Tax Court discovery rules provides grounds for denying enforcement of the summons.”
Oral argument is set for April 23.
March 25, 2014
The Supreme Court today ruled 8-0 in favor of the government in the long-running Quality Stores litigation, holding that severance payments are taxable FICA wages, even if they fall within the category of “supplemental unemployment compensation benefits” that are subject to income tax withholding under Code section 3402(o). See our prior coverage here. The Court’s opinion closely tracks the arguments made by the government in its brief.
The Court began by analyzing the definition of “wages” in the FICA statute, which it repeatedly characterizes as “broad.” That defintion — “remuneration for employment” — appears to encompass the payments at issue because “common sense dictates that the employees receive the payments ‘for employment.’” Specifically, they are paid only to employees and often vary according to the function and seniority of the particular employee who is terminated. The Court buttressed this statutory interpretation by pointing both to other aspects of the statutory definition and to its history. In particular, the Court noted that Code section 3121(a)(13(A) exempts severance payments made because of “retirement for disability” and that exception would appear superfluous if “wages” did not generally encompass severance payments. The Court also observed that in 1950 Congress had repealed a statutory exception for “dismissal payments,” thus suggesting that severance payments are not meant to be excepted from FICA “wages.”
The Court then turned to responding to the taxpayer’s argument that a contrary inference must be drawn from the treatment of SUB payments in the income tax withholding statute — specifically, that section 3402(o) directs that income tax should be withheld from such payments “as if” they were wages, which indicates that they are not in fact “wages.” The Court found this provision “in all respects consistent with the proposition that at least some severance payments are wages,” citing to the Federal Circuit’s analysis of the textual issue in the CSX case. The Court did not reject out-of-hand the taxpayer’s reliance on the heading of section 3402(o), which refers to “certain payments other than wages,” but said that the heading “falls short of a declaration that all the payments listed in section 3402(o) are not wages.”
The Court then embarked on a detailed discussion of the regulatory background against which section 3402(o) was enacted in order to demonstrate why it should not be understood as reflecting a Congressional determination that SUB payments are not FICA “wages,” despite the contrary inference that might logically be drawn from its text standing alone. Briefly, the Court explained that Congress was solely focused on solving a withholding conundrum created by the regulatory treatment of SUB payments when SUB plans proliferated in the 1950s. The IRS sought to impose income tax on these payments, but it did not want to characterize them as “wages” because that would have caused state unemployment benefit payments to stop in some cases (because some states would not pay unemployment compensation to people receiving “wages”). As a result, some individuals were being hit with big tax bills at the end of the year. Congress wanted to implement withholding for such payments and crafted section 3402(o) broadly so as to cover a spectrum of payments without regard to whether they qualified as FICA “wages.” Accordingly, the Court concluded that section 3402(o) sheds no light on the definition of FICA “wages.”
The Court added that its approach is consistent with its 1981 decision in Rowan, which had been invoked to support the taxpayer’s position. The Court stated that the government’s position, not the taxpayer’s, best advanced “the major principle recognized in Rowan: that simplicity of administration and consistency of statutory interpretation instruct that the meaning of ‘wages’ should be in general the same for income-tax withholding and for FICA calculations.”
Finally, the Court stated that it would not address the validity of the IRS’s currently applicable revenue rulings that exempt from both income-tax withholding and FICA taxation severance payments that are tied to the receipt of state unemployment benefits. As discussed in our report on the oral argument in this case, the government was questioned repeatedly about these rulings because they are hard to square with the broad reading of the FICA “wages” definition advanced by the government here and now adopted by the Court. Those rulings are more generous to taxpayers than would appear to be required under the broad FICA definition. It remains to be seen whether the IRS will revoke those rulings and try to collect FICA taxes on such payments and, if they do, whether that will have an effect on the payment of state unemployment benefits. With the Court having refrained from invalidating, or even directly criticizing, those rulings, it is possible that the IRS will let sleeping dogs lie and continue to abide by the rulings.
March 3, 2014
The government has filed its opening brief in Clarke. The brief, which is quite short for a Supreme Court brief, hews closely to the arguments made in the petition for certiorari. As we noted in our previous report, the government and the parties resisting summons enforcement took a very different view at the petition stage of the quantum of evidence that formed the basis for requiring the evidentiary hearing in this case. The private parties contended that they had made “substantial allegations” that the summonses were for an improper purpose, while the government referred to those allegations as “unsupported.”
The brief begins by emphasizing that, however the private parties choose to describe the evidence supporting their allegations, the holding of the Fifth Circuit was that a party is entitled to an evidentiary hearing at which it can question IRS officials about their motives in issuing a summons “whenever a taxpayer makes an ‘allegation of an improper purpose.’” Indeed, the government argues, the court of appeals specifically rejected the idea that the taxpayer’s allegations must be “substantial” or supported by evidence, pointing to the court’s statement that “requiring the taxpayer to provide factual support for an allegation of an improper purpose, without giving the taxpayer a meaningful opportunity to obtain such facts, saddles the taxpayer with an unreasonable circular burden.”
Thus, the government is willing to concede that, “if an objector presents evidence to support an inference of improper motive—or if a district court otherwise believes that such an opportunity for examination is appropriate—the district court may hold a hearing and require IRS agents to justify their actions.” But here, the government maintains, the court of appeals “erroneously reduced to zero the amount of evidence that is required to rebut a showing of good faith.”
With the question framed in this way, the government presents its arguments concisely. It argues that requiring an evidentiary hearing based on a mere allegation of improper purpose undermines Congress’s intent that summons enforcement proceedings be summary and expeditious. Instead, it would afford summoned parties the opportunity to “delay the resolution of summons-enforcement proceedings merely by alleging that the summons was issued for an improper purpose.” In addition, the government argues that the court of appeals’ approach infers wrongdoing on the part of a government official without evidence, which violates the “presumption of regularity” that public officials are presumed to have properly discharged their duties.
The response brief of the parties resisting the summons is due in mid-March. Oral argument has been scheduled for April 23.
February 27, 2014
The government has filed its opening brief in MassMutual contesting the Court of Federal Claims’ conclusion that the taxpayer could accrue the amount of certain policyholder dividends in the year before they were paid. See our prior post on this case and the New York Life case here. The government’s brief raises three distinct objections to the decision.
The primary argument is that the liability to pay the dividends was not “fixed” under the all-events test. The government contends that no individual obligation was fixed at the close of the year, even if all the premiums had been paid, because the dividend would not be paid unless the policy remained in force on the anniversary date. This is the same argument that was accepted by the Second Circuit in New York Life, and the government’s brief here argues that the cases are indistinguishable (asserting that the Second Circuit’s effort to distinguish them was based on a misperception of the facts in MassMutual).
The brief argues that the case “clearly fits the General Dynamics fact pattern,” which it describes as one where the “potential obligee has taken some action that renders him preliminarily eligible to receive the payment, subject only to some other condition that is within his exclusive control” – here, “forgoing the right to surrender the policy for its cash value prior to the next anniversary date.” It rejects the proposition argued by the taxpayer that this alleged final condition is not a genuine “event,” but rather just a continuation of the status quo. The government points to a comment in the Restatement (Second) of Contracts stating that “a duty may be conditioned upon the failure of something to happen . . ., and in that case its failure to happen is the event” that constitutes a condition precedent. And it rejects the contrary suggestion in Burnham Corp. v. Commissioner, 878 F.2d 86 (2d Cir. 1989), as misguided. Finally, the brief argues that the taxpayer’s all-events-test interpretation proves too much because its logical implication is that the amount of the dividend could be accrued even if the company had not passed a board resolution in the taxable year guaranteeing an aggregate dividend – a position that the taxpayer has not argued.
Second, the government argues that the dividend guarantees did not even give rise to an obligation, fixed or otherwise, because they were not communicated to the persons who were to benefit from them. Thus, the government argues, the taxpayer could have walked away from the guarantees at any time. In addition, the government argues, the guarantees were not a meaningful “substantive undertaking” because, based on the historical data, the guaranteed payments were “already virtually certain to occur in the ordinary course of the companies’ business operations, independent of any ‘guarantee’ to that effect.” There is some degree of irony in this argument; on its face, certainty that the amounts will be paid would appear to be an argument in favor of accrual, not against it. But the certainty of which the government speaks refers to the aggregate amount of payment; it is not a concession with respect to an individual obligation being fixed.
Third, the government contests the Court of Federal Claims’ holding that the dividends fell within the “recurring item” exception. The government’s primary point here is that this determination turns on the meaning of “rebate, refund, or similar payment” in Treas. Reg. § 1.461-4(g)(3), and therefore the court should have deferred to the IRS’s interpretation of that regulation – even if that interpretation did not conclusively emerge until this litigation and is at odds with some earlier internal guidance on the regulation’s meaning. The general principle of so-called Auer or Seminole Rock deference to an agency’s interpretation of its own regulations has come under fire recently, with Justice Scalia stating that it should be abandoned and Chief Justice Roberts and Justice Alito indicating that they are at least open to reconsidering it. See Decker v. Northwest Environmental Defense Center, No. 11-338 (Mar. 20, 2013). So it will be interesting to see how the Federal Circuit responds to this argument, which presents a relatively weak case for deference because the claimed agency interpretation is just based on its litigation position.
The taxpayer’s brief is due April 4.
Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash
February 21, 2014
In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates. As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions. For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt. Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.
The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware. The Delaware subsidiary then loaned the cash to Barnes. Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received. (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.) Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.
The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes. The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons. First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant. Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case. The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation. In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations. The court, however, devoted little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here. Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.
The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such. According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.” The court stated that the doctrine applies if any of three tests are satisfied: (1) the binding commitment test; (2) the end result test; and (3) the interdependence test. Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.” The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.” This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.
The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.
Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.
The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty. The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter. The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight. In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.” Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.
With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends. In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”
The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous. The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes. In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.” For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend. Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.
Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503. The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings. It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.
It will be interesting, and instructive for other cases, to see how the government deals with this point. If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling. There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503. Will the government question the premise of the taxpayer’s argument in any way? Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of Rev. Rul. 74-503 cannot reasonably be applied here? Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?
Third, the taxpayer contests the court’s penalty determination. With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling. With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction. It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion. Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”
The government’s brief is due May 15.
February 12, 2014
The Federal Circuit is preparing to consider a government appeal in Massachusetts Mutual Life Ins. Co. v. United States, on an issue involving accrual of annual dividends paid by a mutual insurance company to its policyholders. This issue was also recently addressed by the Second Circuit, and it turns on an application of the “all events test.”
First, a quick refresher course. The “all events test” is described as the “touchstone” for determining when a liability has been incurred and a deduction can be accrued. Dating back to United States v. Anderson, 269 U.S. 422, 441 (1926), and now codified at I.R.C. § 461(h)(4), it originally provided for accrual when “all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.” In the mid-1980s, litigation over the application of this two-pronged test yielded two Supreme Court decisions in rapid succession, with the taxpayer prevailing in the first one and the government prevailing in the second.
In United States v. Hughes Properties, Inc., 476 U.S. 593 (1986), the Court held that a casino could treat as a fixed liability the amounts shown on the jackpot meters of its progressive slot machines at the close of the taxable year. In United States v. General Dynamics Corp., 481 U.S. 239 (1987), the Court held that a self-insuring employer could not accrue amounts that it had reserved for payment of employee medical claims not yet filed for services already performed, even assuming that the amount of the liability had been determined with reasonable accuracy. The Court held that the fact of liability was not established until the employee filed a claim for reimbursement, which it termed a “condition precedent” to the establishment of liability that was not “a mere technicality” or a mere “ministerial” act. Id. at 242-45 & nn.4-5. Three dissenters argued that the case was essentially indistinguishable from Hughes Properties, where the Court had rejected the government’s argument that the fact of liability did not arise until the winning patron pulled the handle because until then it was possible that the jackpot would never be paid – for example, if the casino went out of business or declared bankruptcy. Id. at 248-49. The majority, by contrast, held that failing to file a claim was not “the type of ‘extremely remote and speculative possibility’” that was found in Hughes Properties not to “render an otherwise fixed liability contingent.” Id. at 244-45.
In 1984, Congress codified the traditional all events test in Code section 461(h)(4) and added a third prong for future years by enacting section 461(h)(1), which provides that generally “the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.” The Code, however, contains an exception from the economic performance requirement for “certain recurring items” if economic performance occurs within a reasonable period after the close of the taxable year and certain other conditions are met. I.R.C. § 461(h)(3). In the case of policyholder dividends issued by mutual insurance companies, the taxpayers have contended that the section 461(h)(3) exception is satisfied and therefore that their right to accrue those dividend payments turns on whether the original two-pronged all events test has been satisfied.
The insurer in MassMutual adopted Board Resolutions before the close of the taxable year guaranteeing an aggregate amount of policyholder dividends that would be paid in the upcoming year on each individual policyholder’s anniversary date. The government argued that the all events test was not satisfied until the year in which the dividends were paid because the Board Resolution could be revoked (though government counsel apparently charcterized this as a “weak argument” at oral argument) and also because no precise dividend amounts could be allocated at the time of the resolution to an identifiable policyholder, since any individual policy might not still be in force on the anniversary date.
After a trial, the Court of Federal Claims rejected these arguments and allowed the taxpayer to accrue the amount of the dividends in the year before they were paid. Citing to Hughes Properties, the court said that it was not necessary that the identity of the individual recipients be known at the time of accrual. The court also stated that, “[a]lthough a condition precedent can prevent a liability from being fixed, if the only event(s) still to occur are the passage of time and/or the payment, the liability is considered fixed.” The court added that “the group of policyholders with paid-up policies were not at risk for their policies lapsing,” so the company “had an unconditional obligation” to those policyholders “to pay the guaranteed amounts of policyholder dividends.” The court then ruled that the dividends were “rebates” or “refunds” falling within the “recurring item” exception of section 461(h)(3), and therefore “economic performance” was not required before the expenses could be accrued.
After the Court of Federal Claims decision issued, but before it was ripe for appeal, the Second Circuit came to the opposite conclusion in a case involving policyholder dividends accrued by New York Life. That mutual insurance company also paid annual dividends on the anniversary date, but only if the policy was still in force and fully paid up (payment was required a month in advance). The taxpayer sought to accrue dividend payments due in January of the following year, since those policies had been fully paid up in December. The Second Circuit, however, ruled that the all events test was not satisfied for the January anniversary date policies, because of the possibility that the policyholder might choose to cash in the policy in January before the anniversary date and thus the policy would no longer be in force when the dividend came due.
The Second Circuit reasoned that the case was analogous to General Dynamics, stating that “‘the last link in the chain of events creating liability’—the policyholder’s decision to keep his or her policy in force through the policy’s anniversary date—did not occur until January of the following year.” The taxpayer argued that an “event” that would defeat accrual must be something that marks a change in the status quo, rather than a non-event like the policyholder’s failure to cash in a policy. The court, however, rejected this position, stating that the fact of liability “depend[ed] upon an actual choice by the third-party policyholder: her decision not to redeem her policy for cash, for example, and invest her money elsewhere.”
The court suggested that the MassMutual decision was distinguishable on its facts because there “the policy was considered ‘in force’ simply ‘if the premiums for the policy [had been] paid through its anniversary date,’” whereas in New York Life the company defined eligibility as “requiring both that the policyholder have paid all premiums and that she not have surrendered her policy for cash prior to the policy’s anniversary date.” Recognizing that this distinction might be viewed as less than compelling, the Second Circuit added that, “to the extent the reasoning of the MassMutual court is at odds with ours . . ., we respectfully disagree with that court’s approach.”
New York Life has filed a petition for certiorari seeking review of the Second Circuit’s decision. The petition focuses on the court of appeals’ reliance on the possibility that the policyholder might not receive a dividend because she chose to cash in her policy before the January anniversary date. The question presented in the petition is whether the court erred in holding that “the continuation of the status quo is a required event, and thus a ‘condition precedent,’ needed to establish the fact of liability under the all-events test.”
The petition’s main contention is that the Second Circuit’s decision cannot be squared with Hughes Properties. Because MassMutual is just a trial court decision, the cert petition rests its claim of a circuit conflict primarily on older cases that predate General Dynamics, arguing that the Second Circuit’s decision “recreates a multi-circuit conflict resolved by this Court in Hughes Properties.” The timing of the respective decisions is such that MassMutual is not likely to provide much help in this regard; the Supreme Court can be expected to act on the cert petition by the end of May at the latest, well before a Federal Circuit decision is likely in MassMutual.
The government’s opening brief in MassMutual is due February 20. Its opposition to the petition for certiorari in New York Life is due, after one extension, on March 20.
February 3, 2014
The Supreme Court has granted certiorari in United States v. Clarke, No. 13-301, to explore the circumstances under which an entity is entitled to an evidentiary hearing before an IRS summons is enforced, so that it can question IRS officials about their motives for issuing the summons. The parties’ different views of the case are aptly captured by the dueling questions presented. The government says the case presents the question “whether an unsupported allegation” that the IRS issued a summons for an improper purpose entitles an opponent to examine IRS officials at an evidentiary hearing. The entities contesting the summons say the case presents the question whether the court erred in ordering such an evidentiary hearing “in light of [their] substantial allegations that the IRS had issued summonses to them for an improper purpose.”
The basic summons enforcement rules are long established, but the devil can be in the details. Under United States v. Powell, 379 U.S. 48 (1964), a summons is to be enforced if the IRS demonstrates that: (1) “the investigation will be conducted pursuant to a legitimate purpose”; (2) “the inquiry may be relevant to the purpose”; (3) the IRS does not already have the information; and (4) the IRS followed the proper administrative steps. The IRS generally carries its initial burden simply by producing an affidavit from the investigating agent, which then shifts the burden to the party contesting the summons. At that point, it gets a little murkier. If the party contesting the summons raises a “substantial question” as to whether the summons is an abuse of process, then it is entitled to an “adversary hearing” at which it “may challenge the summons on any appropriate ground.” Id. at 58.
What happened here is that the IRS wanted to look more carefully into a partnership’s tax returns, particularly its claim of $34 million in interest expenses over two years. Although the partnership agreed to two extensions of the statute of limitations, it declined to extend the period a third time. Shortly thereafter, the IRS issued six summonses to third parties connected to the partnership, but those parties did not comply with the summonses. Just before the limitations period closed, the IRS issued a notice of Final Partnership Administrative Adjustment (FPAA) to the partnership, and the partnership challenged the FPAA by filing a petition in the Tax Court. A couple of months later, the IRS filed summons enforcement actions.
The summoned parties, who are the respondents in the Supreme Court, responded by contending that the summonses were not issued for a legitimate purpose and requesting an evidentiary hearing and discovery. They basically made two arguments. First, they contended that the summons was issued in retaliation for the partnership’s refusal to extend the statute of limitations, pointing to the fact that the summonses were issued very soon after that refusal was communicated. Second, they contended that the summonses were designed to circumvent the Tax Court’s restrictions on discovery. They advanced some evidence to support this contention, including the IRS’s request for a continuance in the Tax Court on the ground that the summonses were outstanding.
The district court (for the Southern District of Florida) ordered the summonses enforced, stating that a hearing is not required based on a “mere allegation of improper purpose” to retaliate. With respect to respondents’ second contention, the district court said that a finding that the IRS was using the summons process to avoid discovery limitations in the Tax Court would not be a valid ground for quashing a summons.
The Eleventh Circuit reversed in an unpublished opinion. It ordered the district court to hold an evidentiary hearing at which respondents could question the IRS examining agent about his motives for issuing the summonses (though the court declined to authorize discovery). The court explained that the district court had abused its discretion because the respondents were entitled to a hearing “to explore their allegation” that the summonses were issued “solely in retribution for [the partnership’s] refusal to extend a statute of limitations deadline.”
The difference in the way the two parties have phrased the question presented reflects the two different grounds on which the respondents challenged the summonses. The allegation that the summonses were a form of retaliation or punishment, instead of for a legitimate investigative purpose, is pretty close to an “unsupported allegation.” That the summons followed closely on the heels of the decision not to extend the statute of limitations is weak evidence of an improper retaliatory purpose, though, as the respondents point out, it is hard to have strong evidence of a retaliatory purpose without having discovery or a hearing. Thus, the respondents may have a hard time defending the court of appeals decision on its own terms.
On the other hand, the respondents will be able to advance their second basis for challenging the summonses as an alternate ground for affirmance, even though the court of appeals did not rely upon it. On that ground, the respondents have more than an “unsupported allegation” – they are more like “substantial allegations” – that the summonses were designed to obtain evidence for use in the Tax Court proceedings that could not have been obtained through discovery. The government’s response on this point is the same as that of the district court – namely, that these allegations, if true, would not demonstrate an illegitimate purpose and would not be grounds for quashing the summons. Two courts of appeals have reached this issue and have agreed with the government. On the other hand, respondents have a logical argument that a summons is an investigative tool and the investigation phase is over by the time the FPAA has issued and the case has been docketed in the Tax Court. Respondents note in this connection that the IRS’s own Summons Handbook states that, “[i]n all but extraordinarily rare cases, the Service must not issue a summons” after a notice of deficiency is mailed because at that point “the Service should no longer be in the process of gathering the data to support a determination because the [notice of deficiency] represents the Service’s presumptively correct determination and indicates the examination has been concluded.” This second ground not reached by the court of appeals thus may prove to be the more interesting and closely contested aspect of this case.
To add a little more spice to this case, the Court’s determination to revisit summons enforcement comes at a time when the IRS may significantly increase its use of its summons power. On January 2, 2014, a new policy went into effect for audits of the largest taxpayers that threatens the issuance of a summons when a taxpayer fails to timely respond to requests for documents and/or information. The new policy sets out a mandatory timeline for warning letters and a drop-dead due date, after which the examining agent will initiate procedures for the issuance of a summons. This policy could well lead to many more summons enforcement proceedings. For more information on the IRS’s new IDR enforcement policy, please contact George A. Hani (firstname.lastname@example.org) or Mary W. Prosser (email@example.com).
The government’s opening brief is due February 24. The case will be argued in late April and a decision is expected by the end of June.
January 31, 2014
The Fifth Circuit has finally issued its opinion in NPR (as reflected in our prior coverage, this case was argued almost two years ago), a case involving a Son-of-BOSS tax shelter in which the district court absolved the taxpayers of penalties. The taxpayers were not as fortunate on appeal, as the Fifth Circuit handed the government a complete victory.
The court’s consideration of the two issues before the court of broadest applicability were overtaken by events — specifically, the Supreme Court’s December 2013 decision in United States v. Woods. See our report here. In line with that decision, the NPR court held that the penalty issue could be determined at the partnership level and that the 40% penalty was applicable because the economic substance holding meant that the basis in the partnership was overstated. This latter holding reversed the district court, which had relied on the Fifth Circuit precedents that were rejected in Woods.
The other issues resolved by the Court were mostly of lesser precedential value. First, the court affirmed the district court’s conclusion that a second FPAA issued by the IRS was valid because NPR had made a “misrepresentation of a material fact” on its partnership return.
Second, the court rejected the district court’s holding that the taxpayers could avoid penalties on the ground that there was “substantial authority” for their position. It criticized the district court for basing its “substantial authority” finding in part on the existence of a favorable tax opinion from a law firm (authored by R.J. Ruble who eventually went to prison as a result of his activities in promoting tax shelters). The court explained that a legal opinion cannot provide “substantial authority”; that can be found only in the legal authorities cited in the opinion. Here, the legal opinion had relied on the “Helmer line of cases,” which establish that contingent obligations generally do not effect a change in a partner’s basis. The court of appeals held that Helmer did not constitute substantial authority in a situation in which the transactions lack economic substance and in which the partnership lacked a profit motive. The court also observed that the IRS was correct in arguing that its Notice 2000-44 should be considered as adverse “authority” for purposes of the “substantial authority” analysis — albeit entitled to less weight than a statute or regulation.
Finally, the court overturned the district court’s finding that the taxpayers had demonstrated “reasonable cause” for the underpayment of tax. With respect to the partnership, the court stated flatly that “the evidence is conclusive that NPR did not have reasonable cause.” With respect to the individual partners, the court left a glimmer of hope, ruling that an individual partner’s reasonable cause can be determined only in a partner-level proceeding. Thus, the court merely vacated the district court’s finding of reasonable cause and left the individual partners the option of raising their own individual reasonable cause defenses (whatever those might be) in a partner-level proceeding.
January 15, 2014
The Supreme Court heard oral argument on January 14 in Quality Stores. Whether it was because of a lack of interest in the subject matter or because it was the third argument of the day at the unusually late hour of 1:00 (the Court’s usual schedule in recent years calls for two (sometimes only one) arguments in the morning that finish before lunch), the Court was less active than usual in its questioning. Indeed, the government’s counsel began to sit down after using only five of his alloted 30 minutes for his opening argument (though he was then persuaded to remain at the podium by some additional questions). By the end, all of the Justices except Justice Thomas participated, and the advocates for each side had to deal with some hostile questions. The questioning was not so one-sided as to make the outcome a foregone conclusion, but the Court seemed to be leaning more towards the government’s position than the taxpayer’s. On the other hand, the Court seemed to be learning some of the nuances of the case as the argument proceeded, so there is the possibility that the views of some Justices could yet shift from where they appeared to be at oral argument.
Eric Feigin began the argument for the government, and he was allowed to make his basic presentation without interruption – namely, that the severance pay here comes within the broad definition of FICA wages and the Court should not have to worry about the text of section 3402(o), the income tax withholding statute on which the taxpayer relies. On the latter point, Justice Ginsburg interrupted to ask about the statement in Rowan indicating that wages should be interpreted the same way for FICA and income tax withholding. Mr. Feigin gave two responses: 1) Rowan does not say that the income tax statute should govern the substance of the FICA statute; and 2) the basic principle of Rowan is to establish congruence between FICA “wages” and income tax withholding “wages” for purposes of administrability, and that goal would be advanced by adopting the government’s position.
After Mr. Feigin described the background of the 1969 income tax withholding legislation, Justice Kennedy asked about the history of FICA withholding of supplemental unemployment benefits. Mr. Feigin responded that there is no FICA withholding of SUB payments, apparently referring to the government’s narrow definition of SUB payments that the revenue rulings exempt from FICA wages, rather than the broader concept of SUB payments as defined in section 3402(o). The Chief Justice then asked him to clarify the reason for the enactment of section 3402(o), and Mr. Feigin explained that the benefits were considered to be taxable income even if not subject to withholding. At that point, Mr. Feigin stated that he was prepared to sit down unless there were further questions. That suggestion proved to be premature, as it turned out that there were several Justices who still had questions.
Justice Ginsburg began by asking about the effect on state unemployment compensation. That question arises from the fact that some states will not pay unemployment compensation if the employee is receiving “wages,” even if the employee is out of work. To avoid having individuals in those states lose their state unemployment benefits as a result of receiving SUB payments from their employer, the IRS has drawn a strange distinction in its revenue rulings, currently providing that SUB payments must be “linked to state unemployment compensation in order to be excluded from the definition” of FICA wages. Rev. Rul. 90-72. That distinction is policy-driven, but makes no logical sense as an interpretation of the statutory text. Mr. Feigin sought at first to steer away from this problem by saying that the government was arguing for the status quo, so nothing would change. He added, however, that “if the court were to reach some other conclusion in this case than the one the government is urging” (which appears to be a reference to the possibility that the Court’s decision would wipe out the distinction in the revenue ruling), then that might have an effect on state unemployment benefits. The states, he argued, could then cure any problems by amending state law.
After a short response to Justice Kennedy’s question about whether some employees might prefer to have these payments treated as FICA wages, Mr. Feigin again began to sit down. This time Justice Alito asked whether it would make a difference if the payments were not keyed to length of service. Mr. Feigin responded that the government’s position would be the same. Justice Alito then followed up by citing the Coffy case and asking why the distinction drawn there “between compensation for services and payments that are contingent on the employee’s being thrown out of work” was not applicable. Mr. Feigin replied that the cases involved different issues and different definitions. He went on to argue that FICA does not distinguish “between payments that are part of the continuing employment and payments that occur at the end of the employment relationship,” stating that FICA wages include retirement pay and dismissal payments. At that point, Mr. Feigin again offered to end his presentation and was permitted to sit down after 12 minutes of argument.
Robert Hertzberg argued for the taxpayer and began by arguing that the SUB payments were not “remuneration for services” – and hence not FICA wages – because, as stated in Coffy, they were contingent on losing one’s job. Justice Sotomayor asked the first question, inquiring whether the taxpayer could prevail if the Court invalidated the government’s “regulation” (likely a reference to the applicable IRS revenue rulings). This question appears to have been prompted by the heavy criticism of the IRS rulings, particularly in the amicus briefs, with Justice Sotomayor wanting to put aside the rulings and focus on the statute. Mr. Hertzberg replied that the taxpayer should prevail because the statutory language is clear, and the FICA and income tax withholding statutes should have the same meaning under Rowan. Both Justices Sotomayor and Ginsburg then suggested that it would be simpler and more appropriate to have the SUB payments treated the same way under the two statutes. Mr. Hertzberg replied that they were not “wages” under the statute. He added that different treatment made sense because the SUB payments are provided as a “safety net” and logically ought not to be reduced by FICA taxation in order to fund Medicare and Social Security.
Justice Scalia pointed out that the payments are “for faithful and good past services” because they are paid only to employees, and this comment led to a bevy of questions from all sides. Justice Ginsburg remarked that there “are some severance payments that do count for FICA purposes,” even under the taxpayer’s position. Justice Alito asked what would happen if section 3402(o) did not exist. Mr. Hertzberg replied that the term “supplemental unemployment benefits” has its own definition, going back to 1960 legislation dealing with trusts, and those benefits have not been regarded as FICA wages, even in the 1977 revenue ruling. He then emphasized that Congress reenacted the FICA statute in 1986 against that backdrop, and therefore that payments falling within the existing definition of SUB payments should not be within FICA wages.
Justice Breyer then objected that the FICA definition is very broad. With respect to income tax withholding, he questioned whether section 3402(o) shouldn’t be viewed as just being enacted to be on the safe side, but not necessarily indicating that Congress had concluded that SUB payments were not FICA wages. Mr. Hertzberg responded that it was clear from the text, the title of the section, and the legislative history that Congress did not understand SUB payments to fall within FICA wages. This triggered Justice Ginsburg to ask again what is the distinction between “dismissal payments” that are subject to FICA and those that are not. After Mr. Hertzberg described that distinction (that SUB payments must come from a plan and follow a mass layoff or plant closing), Justice Breyer came back to his question. Acknowledging now that Congress in 1969 probably did not view the SUB payments as FICA wages when it passed section 3402(o), he asked why that should be given weight in construing the FICA statute passed earlier by a different Congress. Mr. Hertzberg replied that the statutes were reenacted together in 1986, and therefore it was not just a matter of a later Congress commenting on what an earlier Congress had passed. Justice Breyer’s followup comment, however, indicated that he either did not understand or was not persuaded by this answer, as he noted that the statute was passed because there was “authority saying it wasn’t wages,” but the authority was not necessarily correct.
Justice Alito then asked about the government’s argument that the “treated as” language in section 3402(o) was necessary because the IRS had ruled that some SUB payments are not wages, but it did not mean that all such payments were not wages. Mr. Hertzberg replied that the language of 3402(o) was clear, particularly the title, which addresses payments “other than wages.” The argument closed with Justice Scalia promising to ask the government on rebuttal about Mr. Hertzberg’s point that, given the reenactment of both statutes at the same time, it appeared that section 3402(o) is superfluous under the government’s position.
Mr. Feigin begin his rebuttal by addressing Justice Sotomayor’s question about how the Court should approach the case if the IRS revenue rulings are invalid. He said that this would not affect the outcome of this case because the defect in the rulings would be that they exclude some SUB payments from wages, when in fact all such payments should be included. That is, any problem would be cured by making even more SUB payments subject to FICA taxation. Justice Sotomayor replied that this answer was “touching at what I was thinking,” and then asked Mr. Feigin to address Justice Scalia’s point about 3402(o) being superfluous. Mr. Feigin began by acknowlegding that “the revenue rulings are not consistent with the statutory text of FICA.” He attributed this defect to the fact that the rulings trace back to a “more freewheeling time in the history of statutory interpretation.”
Justice Scalia then jumped in to bring the discussion back to whether section 3402(o) was unnecessary, stating that the statute “contradicted itself” if the government’s position were correct. Mr. Feigin responded by making the same point that Justice Alito had made earlier (also reflected in the Federal Circuit’s CSX decision) that there was no contradiction if section 3402(o) was drafted as it was because there were some SUB payments that were not wages under the revenue ruling. Justice Scalia found that response unsatisfying since the title clearly refers to payments “other than wages.” Mr. Feigin answered by saying that the title refers to “certain payments” and the statute provides that they should be “treated as wages for a payroll period.” He then went on to reiterate his prior points about the history of the development of section 3402(o) and argued that it was drafted as it was to cover the possibility that the IRS would draw different distinctions in the future regarding which SUB payments constitute “wages.”
Finally, this discussion prompted Justice Ginsburg and Chief Justice Roberts to revisit the IRS revenue rulings, which the Chief Justice characterized as taking a narrower view of the FICA definition than the government was arguing for. Mr. Feigin responded that the rulings were not directly at issue here, but if the Court thought it had to rule on them, it should follow the government’s current arguments regarding the statutory text “notwithstanding the revenue rulings.” He then again assured Justice Ginsburg that the states could fix any bad results related to their own unemployment compensation schemes that might ensue from invalidating the revenue rulings.
It is always tricky to forecast a Supreme Court decision based on the oral argument. Still, it cannot have been encouraging for the taxpayer that its counsel was the recipient of most of the difficult questioning, with Justices Sotomayor and Breyer in particular seeming to exhibit agreement with the government’s position. On the other hand, as noted above, the Court appeared still to be digesting some of the complexities of this case, so the positions reflected at oral argument are not set in stone. For example, Justice Scalia showed more skepticism of the government’s position during rebuttal than he did during Mr. Feigin’s opening argument. Time will tell. A decision is expected this spring, likely issuing sometime between late March and early June. If the vote on the Court is 4-4, however (with Justice Kagan being recused), then the Court will announce that outcome as early as next week. That is because there will be no need to write an opinion; the result will just be a one-line announcement that the decision has been affirmed by an equally divided Court.
January 8, 2014
A court can lead the parties to mediation, but can’t make them drink. We reported last month that, after oral argument, the Ninth Circuit had suspended its consideration of the Bergmann case so that the parties could pursue court-sponsored mediation. Apparently, that effort never got off the ground. Yesterday, the Ninth Circuit entered a new order: “We previously withdrew submission pending an opportunity for mediation. Because mediation has not resolved this appeal, the case is ordered resubmitted as of the date of this order.” The Court will now proceed to write an opinion and issue its decision in due course. When that happens, one of the parties likely will be sorry that it wasn’t more flexible with the mediation process and the other will feel vindicated.
January 2, 2014
The government’s reply brief has now been filed in Quality Stores, completing the briefing. The Court will hear oral argument on January 14.
Also linked below are three amicus briefs that have been filed in support of the taxpayer. The brief filed by the ERISA Industry Committee comprehensively addresses the question presented, examining the relevant statutes, legislative history, administrative pronouncements, and judicial precedents. The brief filed by the American Payroll Association engages in a statutory analysis and examines the administrative pronouncements, concluding that the government’s position “would replace the straightforward definition provided by Congress with a cumbersome and essentially unadministrable definition.” The brief filed by the American Benefits Council focuses almost exclusively on the IRS’s Revenue Rulings. Admittedly “derived from an article” previously published by the brief’s author, the amicus brief argues that the regime established by the Revenue Rulings is “incoherent and unsupported” and should be rejected by the Court in favor of the taxpayer’s position, which is “coherent, sensible, and easily understood.”
December 16, 2013
The taxpayer has filed its responsive brief in Quality Stores, setting forth both its basic position that SUB payments are not FICA “wages” and responding in detail to the government’s contrary arguments. The taxpayer’s affirmative case begins with the income tax withholding provisions that the government has argued are irrelevant. The taxpayer argues that the payments are not “remuneration . . . for services” within the meaning of Code section 3401(a) and, in particular, cannot be “wages” because they fall within the category of payments that section 3402(o) describes in its title as “certain payments other than wages” and in the text provides that they “shall be treated as if [they] were a payment of wages.” That statutory argument is supplemented by examination of the legislative history of the passage of section 3402(o) and by a detailed parsing of other statutory provisions suggesting that Congress did not regard these payments as “wages.” The taxpayer also points to statements made by the Court about SUB benefits in another context in Coffy v. Republic Steel Corp., 447 U.S. 191 (1980), to the effect that such payments are not “compensation for work performed” because “they are contingent on the employees being thrown out of work.”
The brief also responds to the arguments made by the government. It dismisses the broad definition of FICA wages in Social Security Bd. v. Nierotko, 327 U.S. 358 (1946) — made in the context of back pay to a current employee – as not probative here where the recipient is not in a current employment relationship with the employer. The taxpayer also takes issue with the government’s reliance on the historical treatment of “dismissal payments,” arguing that these payments are not synonymous with SUB payments.
The taxpayer invokes the Court’s Rowan decision in support of its basic position that “wages” must be construed the same for both FICA purposes and income tax withholding purposes. As noted in our previous report, the government has chosen to oppose this argument without relying on the so-called “decoupling amendment” that Congress enacted in the wake of Rowan. The taxpayer disputes the government’s argument that the consistency rationale of Rowan is best served by treating SUB payments as “wages” for both purposes. To the contrary, the taxpayer argues, there is a sound policy reason for treating such payments as “wages” for income tax withholding (preventing a heavy year-end tax burden), but no corresponding policy reason to do so in the FICA context.
The taxpayer’s brief devotes considerable attention to arguing that no deference should be paid to the IRS’s Revenue Rulings defining what kind of severance payments constitute “wages.” This topic is also the focus of an amicus brief filed by Professor Kristin Hickman, which asks the Court to hold that such rulings are not entitled to Chevron deference because they are not promulgated in compliance with the Administrative Procedure Act. This focus is a bit surprising since the government’s brief does not argue for deference to its Revenue Rulings, and government officials have previously publicly stated that the Justice Department will no longer argue in court that Revenue Rulings are entitled to Chevron deference. The government’s brief, however, does discuss its relevant Revenue Rulings in some detail, in the nature of background for why it believes Congress addressed income tax withholding in the way that it did. The taxpayer treats this discussion as reflecting an “implicit (and incorrect) presumption” that the Court must defer to the Revenue Rulings and, taking no chances, the taxpayer tackles that presumption head-on.
Oral argument is scheduled for January 14.
December 9, 2013
In a somewhat unusual move, the Ninth Circuit issued an order last week suggesting that the parties pursue mediation in the Bergmann case. The order came two days after the court heard oral argument. The order states that “the court believes this case may be appropriate for mediation” and therefore it is being referred to the Ninth Circuit’s Mediation Office. A mediator will then contact the parties to determine their interest, but the parties are not required to elect mediation. The Circuit Mediator is directed to report back to the panel by January 4. In the meantime, the court will not act on the appeal.
The oral argument in this case was held on December 3 before Ninth Circuit Judges Gould, Paez, and District Court Judge Marilyn Huff, sitting by designation. As we have previously reported, the issue in this case is whether the taxpayer was insulated from penalties for participating in a tax shelter because he filed a qualified amended return. The outcome turns on the applicability of Treasury regulations that delineate when it is, in effect, too late for a taxpayer to save himself by filing an amended return because it is understood that he is doing so only because IRS actions have tipped him off that the shelter is being audited. As the parties framed the issue at oral argument, the dispute boils down to whether the current Treasury regulation (which describes what IRS actions are to be understood as tipping off the taxpayer) was merely a clarification of the previous regulation that was in effect at the time that the taxpayer filed his amended return. The taxpayer’s counsel conceded that applying the terms of the current regulation would have terminated the right to avoid penalties by filing an amended return; government counsel conceded that it is the older regulation, not the current one, that applies.
A couple of questions were asked at oral argument of each side, but nothing unexpected arose that obviously should have prompted the panel to suggest mediation. Towards the end of the argument, however, after the panel had established that few, if any, taxpayers remain governed by the terms of the older regulation, District Judge Huff asked government counsel whether the parties had considered mediation (noting that she did not even know if the Ninth Circuit had a mediation program). Not surprisingly, both government counsel and later taxpayer counsel said that they would not rule anything out and would be willing to entertain mediation.
The Ninth Circuit, of course, has an established mediation program — to which this case is now being referred — but that program ordinarily kicks in at the outset of the appeal, not after briefing and oral argument. In fact, in this case the parties participated in the first stage of that process, a telephone settlement assessment conference, back in March 2012. Thereafter, on March 15, 2012, the Court issued an order stating that the case was not selected for the mediation program, and it then proceeded to briefing.
The panel is now suggesting that the parties take a fresh look and decide whether they can reach a middle ground. There is no middle ground if the appeal proceeds to a decision: either the qualified amended return was timely and effective to protect against penalties or the taxpayer’s ability to achieve that protection was terminated before he filed the amended return. The panel perhaps decided that a fairer result lies somewhere in the middle — given that the text of the older regulation appears to lean towards the taxpayer but resolving the case on that basis might be regarded as allowing the taxpayer to benefit from a poorly drafted regulation when it should have been too late, as a policy matter, to avoid penalties by filing an amended return. Whatever the court was thinking, the oral argument and this order have given each side reason for concern that it might lose if the appeal proceeds to judgment. On the one hand, the judges did not question the government’s assertions that its interpretation of the regulation was entitled to deference and that it would be a bad policy result to allow the taxpayer to escape penalties here. On the other hand, the court — particularly Judge Gould who questioned government counsel on this point — did not appear entirely convinced that the current regulation can be viewed as a “clarification” because the text of the older regulation is not easily read to support the government’s position. It is entirely possible that both sides will seize this opportunity to split the baby and will reach a settlement through the mediation process.
December 3, 2013
The Supreme Court this morning ruled 9-0 in favor of the government on both issues in Woods, holding that: (1) there is partnership-level TEFRA jurisdiction to consider the appropriateness of a penalty when the partnership is invalidated for lack of economic substance; and (2) the 40% valuation overstatement penalty can apply in that setting on the theory that the basis of a sham partnership is zero and therefore the taxpayers overstated their basis. See our prior coverage here. The opinion, authored by Justice Scalia, is concise and appears to resolve definitively both issues that had previously divided the lower courts.
On the jurisdictional issue, the Court began by pointing to Code section 6226(f), which establishes partnership-level jurisdiction for “the applicability of any penalty . . . which relates to an adjustment to a partnership item.” Accordingly, the Court found, the question “boils down to whether the valuation-misstatement penalty ‘relates to’ the determination” that the partnerships were shams. On that point, the Court agreed with the government’s “straightforward” argument that “the penalty flows logically and inevitably from the economic-substance determination” because the trigger for the valuation overstatement calculation is the conclusion that a sham partnership has zero basis.
The Court rejected the taxpayer’s argument (previous adopted by the Federal and D.C. Circuits) that there can be no partnership-level determination regarding “outside basis” because some partner-level determinations are necessarily required to conclude that outside basis has been overstated. The Court found that this approach is inconsistent with TEFRA’s provision that the applicability of some penalties must be determined at the partnership level. If the taxpayer’s position were correct, the Court stated, it “would render TEFRA’s authorization to consider some penalties at the partnership level meaningless.” The Court stressed that the partnership-level applicability determination is “provisional,” meaning that individual partners can still raise partner-level defenses, but the partnership-level proceeding can determine an overarching issue such as whether the economic-substance determination was categorically incapable of triggering the penalty. In the Court’s view, “deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy: duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.”
With respect to the merits issue of the applicability of the 40% penalty, the Court relied on what it regarded as the “plain meaning” of the statute. The text applies the penalty to tax underpayments attributable to overstatements of “value . . . (or the adjusted basis)” of property. Finding that the parentheses did not diminish or narrow the import of the latter phrase, the Court concluded that a substantial overstatement of basis must trigger the 40% penalty and that such an overstatement occurred in this case. Because the term “adjusted basis” “plainly incorporates legal inquiries,” the Court was unpersuaded by the taxpayer’s argument that the penalty applies only to factual misrepresentations of an asset’s value or basis. As we have previously noted (see here and here), both the taxpayer and an amicus brief filed by Prof. David Shakow set forth considerable evidence that the intent of Congress in enacting the 40% penalty was to address factual overstatements, not overstatements that flow from legal errors. The Court, however, stated that it would not consider this evidence, which is found in legislative history and in the IRS’s prior administrative practice, because “the statutory text is unambiguous.”
In addition, the Court rejected the reasoning of the Fifth Circuit that the underpayment of tax was “attributable to” a holding that the partnership was a sham, not to an overstatement of basis. The Court instead adopted the reasoning of Judge Prado’s opinion in the Fifth Circuit (which had questioned the correctness of binding circuit precedent) that, “in this type of tax shelter, ‘the basis understatement and the transaction’s lack of economic substance are inextricably intertwined.’”
At the end of the opinion, the Court addressed an issue of statutory interpretation that has broader implications beyond the specific context of Woods. The taxpayer had relied on language in the Blue Book, and the Court stated in no uncertain terms that the Blue Book is not a relevant source for determining Congressional intent. Rather, it is “post-enactment legislative history (a contradiction in terms)” that “is not a legitimate tool of statutory interpretation.” The Court acknowledged that it had relied on similar documents in the past, but suggested that such reliance was a mistake, stating that more recent precedents disapprove of that practice. Instead, the Blue Book should be treated “like a law review article”— relevant only if it is persuasive, but carrying no special authority because it is a product of the Joint Committee on Taxation.
November 20, 2013
The government has filed its opening brief in the Quality Stores case, which involves the question whether severance payments made pursuant to an involuntary reduction in force are subject to FICA taxation. See our prior coverage here. The brief is considerably shorter than the page limit, as the government has sought to take a relatively simple approach to an issue that in the past has generated complex and detailed briefs and opinions.
The government’s primary submission is that the Court needs to focus its attention on the FICA statute and not be distracted by the income tax withholding statute that formed the basis for the Sixth Circuit’s opinion. The FICA statute broadly defines “wages” for FICA purposes as “remuneration for employment,” and that language assertedly encompasses the severance payments at issue here. To support the argument that this language should be read broadly, the government points to current Treasury regulations and to the Supreme Court’s decision in Social Security Board v. Nierotko, 327 U.S. 358 (1946). The government also relies on the history of the FICA definition of wages, pointing out that it originally contained an exception for discretionary “dismissal payments” like those at issue here, but that exception was repealed in 1950.
The brief then moves on to respond directly to the Sixth Circuit’s reliance on 26 U.S.C. 3402(o), the income tax withholding provision stating that severance payments should be “treated as . . . wages” (and therefore, according to the taxpayer, must be something different from “wages.”) The government states that, by its terms, this provision applies only to income tax withholding and can provide no inference for determining whether the severance payments are subject to FICA taxation. Even if that basic point does not prevail, however, the government argues that the inference drawn by the Sixth Circuit is incorrect. Adopting the analysis of the Federal Circuit in CSX, the government argues that the term “wages” and the class of payments included in section 3402(o) are not mutually exclusive; the latter section is broadly drafted and can encompass payments that also fall within the category of “wages.” The brief then embarks on a fairly detailed account of the history of the IRS’s administrative rulings on the scope of “wages,” seeking to explain why Congress was motivated to enact section 3402(o) as it did and, correspondingly, why that action should not carry any logical inference for the definition of FICA wages. In particular, the government argues that Congress was concerned that the IRS had determined that certain payments were includible in gross income, but not subject to income tax withholding, thus leaving taxpayers with an unexpectedly high tax bill when it came time to file their return. In acting to solve that problem, the government maintains, Congress was not saying anything about FICA nor was it defining “wages” even for income tax withholding purposes.
For those that have followed this issue over the years, we note one subissue that has receded in importance under the government’s current approach — namely, the relevance of legislation enacted by Congress in the wake of the Court’s decision in Rowan Cos. v. United States, 452 U.S. 247 (1981). Taxpayers have pointed to Rowan as indicating that terms in the FICA statute and income tax withholding statute generally ought to be interpreted harmoniously. In the Sixth Circuit and in other litigation, the government has defended against the citation of Rowan by pointing to later legislation in which Congress codified the specific result in Rowan but also enacted a “decoupling amendment” establishing that nothing in the income tax withholding regulations providing an exclusion from “wages” “shall be construed to require a similar exclusion from ‘wages’” in the FICA regulations. 31 U.S.C. § 3121(a). The legislative history described this provision as broadly decoupling the FICA definition of wages from the income tax withholding definition. See our reports on the Sixth Circuit briefing here and here. The Sixth Circuit, however, was unpersuaded by the “decoupling amendment” argument because applying decoupling to statutory definitions of “wages” is based entirely on the legislative history; the decoupling amendment itself expressly addresses only regulations. The Federal Circuit in CSX similarly rejected the government’s position on the decoupling amendment, even though it agreed with the government on the ultimate issue of including severance pay in FICA wages.
The government apparently has concluded that the “decoupling” argument will fare no better in the Supreme Court. Instead, it makes other arguments to defend against the taxpayer’s reliance on Rowan. First, it argues simply that Rowan is irrelevant because it was addressing a different issue — the validity of a Treasury regulation providing that the value of meals and lodging should be included in FICA wages. More substantively, the government argues that its position is consistent with the rationale of Rowan. The Court stated there that Congress intended to coordinate the FICA and income tax withholding systems to advance Congress’s interest in “simplicity and ease of administration” (452 U.S. at 257). According to the government, that interest is disserved by the Sixth Circuit’s decision because Congress has provided that the supplemental benefits included in the section 3402(o) definition are to be treated as wages for income tax withholding purposes.
The taxpayer’s response brief is due in mid-December, and oral argument is scheduled for January 14.
November 5, 2013
The Supreme Court has scheduled oral argument in the Quality Stores case for the afternoon of Tuesday, January 14. Two other cases will be argued in the morning session, and the Court will then break for lunch and reconvene at 1:00 for the Quality Stores argument, in which each side is given 30 minutes for argument. A decision is expected no later than the end of June.
October 22, 2013
We recently reported on the oral argument before the D.C. Circuit in Loving, in which the court considered the validity of the recently promulgated Treasury regulations addressing registration of tax return preparers. Subsequent to that argument, former IRS Commissioner Lawrence Gibbs published an article defending the IRS’s authority to promulgate those regulations and discussing their importance to tax administration. The government has now filed a FRAP Rule 28(j) letter bringing the article to the attention of the court and highlighting some points made in the article. The plaintiffs have responded to that letter, arguing that the article is not the kind of supplemental authority that is covered by Rule 28(j) and briefly addressing some of the points made in the article. Copies of the letters are attached below (the article itself is appended to the government’s letter).
[Note: Lawrence Gibbs is a member of Miller & Chevalier.]
October 15, 2013
We have previously reported on the Ninth Circuit’s consideration of the qualified amended return regulation in the Bergmann case. Several months after the close of the briefing, the court has now scheduled the case for oral argument on December 3 in San Francisco. The identity of the three-judge panel will be announced at a future date.
October 11, 2013
The Supreme Court held oral argument in United States v. Woods on October 9. As we have previously reported, the case presents two distinct questions: (1) a TEFRA jurisdictional question concerning whether the court could determine the applicability of the valuation overstatement penalty in a partnership-level proceeding; and (2) the merits question whether the 40% penalty applied when the partnership was found not to have economic substance and therefore the basis claimed by the taxpayers in the partnership was not recognized.
Most of the argument time for both advocates was spent on the jurisdictional issue, as the Justices often seemed genuinely confused about how TEFRA is generally supposed to work and about the respective positions of the parties on how the statutory provisions should be interpreted in the circumstances of this case. [For example, Justice Sotomayor: "what is this case a fight about?" "Could you give me a concrete example, because I'm not quite sure about what you're talking about." Justice Breyer: "I am genuinely confused. I have read this several times."] Thus, a higher percentage of the Justices’ questions than usual appeared designed simply to elicit information or alleviate confusion, rather than to test the strength of the advocate’s position.
Justice Sotomayor began the questioning by suggesting to government counsel, Deputy Solicitor General Malcolm Stewart, that there was an “incongruity” in its position in that it was acknowledging that there were partner-level issues that precluded a final determination of penalty liability until the partner-level proceeding, yet it was insisting that the penalty could be imposed without a notice of deficiency prior to the partner-level proceedings. Mr. Stewart responded that a taxpayer would have an opportunity before the penalty is imposed to make the kinds of broad objections that are at issue in this case. He would have to file a partner-level refund suit only if he had undeniably partner-specific issues like a good faith reasonable cause defense, and Congress contemplated that there would not be a prepayment forum for those kinds of issues.
Justice Kagan suggested that the government’s position essentially was “what you do at the partnership level is anything that doesn’t require looking at an individual’s tax return”; Mr. Stewart agreed, but he said that he preferred to state the position as “any question that will necessarily have the same answer for all partners should presumptively be resolved at the partnership level.”
Chief Justice Roberts asked Mr. Stewart about the D.C. Circuit’s reasoning in Petaluma that the penalty issue related to outside basis and therefore could not be resolved at the partnership level even if the answer was obvious. Mr. Stewart began his response by agreeing (as the government has throughout the litigation) with the proposition that “outside basis, in and of itself, is not a partnership item,” but this observation triggered some questions looking for clarification. Justice Scalia asked why outside basis would vary from partner to partner, and Justice Kennedy suggested that the government was arguing that “outside basis in this case is necessarily related to inside basis” – a formulation that Mr. Stewart rejected. The result was that the last few minutes of Mr. Stewart’s argument on the jurisdictional point were diverted into explaining that the government was not making certain arguments being suggested by the Court.
When Gregory Garre began his argument for the taxpayers, Justice Kagan zeroed in on the statutory text and asked if the case didn’t just boil down to whether the “related to a partnership item” language in the statute required that the relationship be direct [taxpayers’ view] or could be satisfied if the relationship were indirect [government’s view]. Mr. Garre responded by arguing that the government’s position was more at variance with the statutory text than she had suggested because the statute gives a partnership-level proceeding jurisdiction over “partnership items” and outside basis concededly was not a partnership item. Justice Scalia, and later Justice Kagan, pushed back against that answer by noting that the statute establishes jurisdiction over more than partnership items. Justice Kennedy chimed in to note that penalties are always paid by the partners, not the partnership itself, yet TEFRA contemplates that some penalties are determined at the partnership level.
Mr. Garre then emphasized that this penalty could not be determined at the partnership level because “outside basis isn’t reported anywhere at all on the partnership” return. Justices Scalia and Breyer both blurted out “so what” in response. There followed a long colloquy in which Mr. Garre argued to Justice Breyer that the difference between overstatements of outside basis and inside basis was of jurisdictional significance. Justice Breyer appeared unconvinced, suggesting instead that the partnership itself is a partnership item, and therefore the penalty based on shamming the partnership should also be regarded as a partnership item. Mr. Garre replied that the penalty was for overstating outside basis, which concededly is not a partnership item.
Justice Ginsburg showed great interest in the recently enacted economic substance penalty, asking about it on three different occasions. Although that new penalty is not applicable to the tax years at issue in this case, the taxpayers had argued that its enactment showed that Congress did not agree with the government’s position – namely, that the valuation overstatement penalty already on the books would apply when partnerships are found to lack economic substance. With respect to jurisdiction, Mr. Garre confirmed that the new penalty could be imposed at the partnership level because it is based on shamming the transaction, a partnership-level determination. With respect to the merits, the advocates unsurprisingly responded differently to Justice Ginsburg’s questions. Mr. Stewart stated that, although there was some overlap between the new penalty and the overstatement penalty at issue in this case, the overlap was not total, and it is not anomalous to have some degree of overlap. Therefore, enactment of the new penalty was not inconsistent with the government’s position. Mr. Garre, by contrast, asserted that the new penalty “that Congress passed to cover this situation here solves all the problems,” and thus it would be wrong for the Court “to fit a square peg into a round hole” by applying the valuation overstatement penalty to this situation. Chief Justice Roberts later asked about how the new penalty operates as well.
Mr. Garre then emphasized the “practical consequences” of resolving the penalty issue at the partnership level – specifically, that it would allow the government to impose the penalty without making a prepayment forum available for the taxpayer to contest it. Justice Sotomayor had begun the argument by asking Mr. Stewart about this point, and now she switched sides and asked Mr. Garre why that was inappropriate when it was “obvious” that the partner was going to claim a nonzero basis. Mr. Garre responded that, obvious or not, the court could not create jurisdiction by “assuming a fact necessary to the penalty.”
Justice Scalia had asked Mr. Stewart whether pushing the penalty determination to the partner level would open the door to inconsistent outcomes on the same legal issue. That was a friendly question, and Mr. Stewart happily agreed. When Justice Scalia asked Mr. Garre the same question, it led to a more extended discussion with several Justices. Mr. Garre initially responded that there was no danger of inconsistent outcomes on the merits issue because the Supreme Court’s resolution of that issue would be binding on everyone. Although different outcomes could occur because different partners have different outside basis, that is what Congress intended and is the reason why TEFRA provides for partner-level proceedings. Justice Scalia then asked about the possibility of different results on whether the partnership was a sham, but Mr. Garre pointed out that this determination was properly made at the partnership level and would apply equally to all partners. Chief Justice Roberts, however, questioned whether the asserted need for a partner-level determination of outside basis was mostly theoretical, asking: “does your case hinge on the perhaps unusual situations where you have one of these partners having a fit of conscience and decides to put down the real number or has some other adjustment to it?” Mr. Garre responded “largely, yes,” but added that the statute did not allow these determinations to be made at the partnership level even if they are obvious, and that where individual transactions are shammed (instead of the entire partnership), it will not be obvious that the basis is overstated. Justice Sotomayor remarked that she was confused by the individual transaction point, but she did not press Mr. Garre on the point after he explained it a second time.
The jurisdictional discussions left so little time for the advocates to address the merits that the argument did not shed much light on the Justices’ views on the applicability of the valuation overstatement penalty. During the government’s argument, Justice Ginsburg finally moved the discussion to the merits by asking the question about the new economic substance penalty discussed above. One other question followed from Chief Justice Roberts in which he asked Mr. Stewart to respond to one of the taxpayers’ main arguments – namely, that there is not an overvaluation of an amount here but instead a determination wiping out the entire transaction. Mr. Stewart responded that it was appropriate to apply the valuation overstatement penalty because “the whole point of the avoidance scheme was to create an artificially inflated basis.”
Mr. Garre also moved to the merits issue late in his argument. He began by emphasizing that Congress clearly aimed this penalty at the fundamentally different situation where the taxpayer misstated the amount of the value. Justice Kagan interjected to say that he was describing “the prototypical case,” but that didn’t have to be the only case, and the statute was drafted more broadly. Mr. Garre responded that “context, punctuation, pre-enactment history, post-enactment history and structure” supported the taxpayers’ position, but Justice Kagan rejoined skeptically that “you’re saying they have text, and you have a bunch of other things.” Mr. Garre then expanded on his answer, stating that the reference to “basis” in the statute “comes in a parenthetical, subordinate way” and thus must be related to an overvaluation, not to a situation where “the thing doesn’t exist at all.” He then ended his argument by noting that tax penalties are to be strictly construed in favor of the taxpayer and by inviting the Court to review the amicus brief filed by Prof. David Shakow for examples of other situations that would be mistakenly swept into the valuation overstatement penalty if the government were to prevail.
On rebuttal, Justice Breyer quickly interrupted to ask about his theory that the jurisdictional issue must be resolved in the government’s favor because the existence of the partnership is a “partnership item,” noting his concern that this approach might be too “simple” given that three courts had gone the other way and that he did not “want to say that you are right for the wrong reasons.” Before Mr. Stewart could respond, however, Chief Justice Roberts asked if he could “pose perhaps a less friendly question.” He then asked Mr. Stewart to comment on an analogy drawn by Mr. Garre to a taxpayer who claims a deduction for donating a $1 million painting when in fact he never donated a painting at all. That situation would involve a misstatement, but not a valuation misstatement, and Mr. Garre argued that in both situations the valuation misstatement penalty would be inapplicable. Mr. Stewart, however, sought to distinguish the painting example from this case because the IRS did not determine that the underlying currency transactions did not occur, just that the partnerships were shams. Chief Justice Roberts appeared unpersuaded by this distinction, commenting that calling the partnerships shams was “like saying that there were no partnerships,” so it seemed that the situations were “pretty closely parallel.”
Given the nature of the questioning, it is harder than usual to draw any conclusions from the oral argument, except perhaps that the Court (or at least the Justice who is assigned to write the opinion) is regretting its decision to add the jurisdictional question to the case. Justice Scalia appeared solidly on the side of the government on the jurisdictional question. Justice Breyer appeared to be leaning that way as well, but on a theory not espoused in the briefs that he himself seemed to recognize might not withstand more rigorous analysis. Conversely, Chief Justice Roberts referred several times to the D.C. Circuit’s Petaluma decision, perhaps indicating that he finds its reasoning persuasive. In the end, most of the Justices seem still to be figuring the case out, and we will have to wait to see where they come out.
October 2, 2013
It has been almost two years since the Fifth Circuit heard oral argument in the NPR Investments case, which involves a “son-of-BOSS” tax shelter and associated questions regarding penalties and jurisdiction under TEFRA. See our previous reports on the oral argument and describing the issues. Last week, the court issued an order directing the parties to file short “letter briefs,” answering some specific questions involving TEFRA jurisdiction over penalties. In particular, the court asked the parties to address how NPR compares to the Petaluma (D.C. Cir.) and Jade Trading (Fed. Cir.) cases in which the courts found a lack of jurisdiction in partnership-level proceedings to impose a valuation misstatement penalty where a basis-inflating transaction was found to lack economic substance. As we have reported, the Supreme Court is preparing to hear argument in U.S. v. Woods, which involves the validity of such a penalty and the same jurisdictional issue addressed in Petaluma and Jade Trading.
It is not clear whether the Fifth Circuit panel considering NPR was aware that the Supreme Court is poised to decide these questions in Woods (though Woods is a case that comes from the Fifth Circuit), but it certainly is aware of it now. The government’s response to the court’s order points the court to the government’s brief in Woods and explicitly states that “the issue whether Petaluma and Jade Trading were correctly decided is at the heart of the jurisdictional issue before the Supreme Court in Woods, scheduled for argument on October 9.” Given that a Supreme Court decision will be coming down in the next several months that, at a minimum, will bear closely on the issues in NPR Investments and quite possibly resolve them definitively, it is hard to see why the Fifth Circuit would press ahead to decide the NPR case. Most likely, it will continue to sit on the case until Woods is decided. But that is not certain. The responses to the court’s request for supplemental briefs demonstrated some level of agreement between the government and the taxpayer. If the Fifth Circuit has an opinion almost ready to go, but for a couple of areas of uncertainty that have now been cleared up by the supplemental briefs, it might go ahead and issue its opinion. If it does, however, the ultimate result in the case likely will still remain in play until the Supreme Court speaks in Woods.
October 1, 2013
The Supreme Court, not surprisingly, granted cert this morning in the Quality Stores case. As we have previously reported (see our prior coverage here), the Court is now poised to resolve a conflict between the Sixth Circuit and the Federal Circuit regarding whether severance payments paid to employees pursuant to an involuntary reduction in force are “wages” subject to FICA taxation. Notably, Justice Kagan did not participate in the order granting the petition, perhaps because she had some involvement in the case during her tenure as Solicitor General. Her recusal creates the theoretical possibility that the Court could ulitmately divide 4-4 on the case and thus be unable to resolve the conflict.
The government’s opening brief is due November 15. Oral argument will likely be scheduled for January 2014.
September 25, 2013
The D.C. Circuit heard oral argument on September 24 in the government’s appeal in Loving from the district court decision enjoining the IRS from enforcing its new registration regime for paid tax return preparers. The panel consisted of Judges Sentelle, Williams, and Kavanaugh. The court was active, jumping in with questions in the first minute of the government’s opening presentation. The court asked several questions of the plaintiffs’ counsel as well, but those questions seemed to evince less skepticism of the advocate’s position. While it is always hazardous to predict the outcome based on the oral argument, the court of appeals certainly seemed to be leaning towards affirming the district court.
As we have previously discussed, the government’s position relies heavily on Chevron deference to its new tax return preparer regulations. It argues that the statutory authority to regulate practice before Treasury is sufficiently broad to encompass tax return preparers — specifically, that the term “practice of representatives of persons before the Department of the Treasury” is ambiguous and could reasonably be construed by the regulations to include persons who prepare tax returns. The relevant language is currently codified at 31 U.S.C. § 330(a)(1), but it dates back to 1884, when Congress responded to complaints about misconduct by claims agents who represented soldiers with claims for lost horses or other military-related compensation from the Treasury.
Just 30 seconds after the argument began, Judge Sentelle stepped in to challenge the premise of government counsel Gil Rothenberg that the Treasury regulations were valid because the statute did not “foreclose” them. Judge Sentelle maintained that the question instead was whether the statute “empowered” Treasury to regulate in this area, and the case could not be analyzed by assuming that Treasury had unlimited power except to the extent that Congress had explicitly foreclosed it. Shortly thereafter, Judge Williams questioned the government’s failure, in his view, to provide any support for the notion that the ordinary use of the statutory terms, like “representative” or “practice,” could encompass a tax return preparer who merely helps a taxpayer “fill out a form” that he is obliged to file with the IRS. Mr. Rothenberg responded that, although there were no cases on point, return preparers do more than “fill out a form” and that the statutory term “representative” cannot be limited to an agency relationship because the term was intended to retain the same meaning as the original 1884 statute, which applied to “agents, attorneys, or other persons representing claimants.”
Judge Sentelle then suggested that the fact that Treasury had not claimed any authority to regulate tax return preparers until now, even though the statute had been on the books for more than a century, cast some doubt on the existence of that authority. Judge Kavanaugh added that Congress’s enactment of legislation regulating tax return preparers during that period also suggested that Congress did not think that it had delegated that authority to the Treasury Department. Mr. Rothenberg responded that the administrative process is an “evolving process,” and Treasury was free to “choose” not to regulate for many years and then later to invoke its latent authority to regulate. Later, he added that the need to regulate the competence of tax return preparers is greater today than it was decades ago when taxpayers could more easily avail themselves of direct assistance from the IRS in filling out their return. With respect to the legislation, Mr. Rothenberg distinguished laws that impose after-the-fact sanctions on return preparers from the Treasury initiative to impose up-front “admission” requirements. Judge Sentelle questioned why the regulations are limited to paid return preparers, but do not cover persons who prepare tax returns for free. Mr. Rothenberg responded that Treasury was tackling the problem one step at a time and reasonably believed that the biggest problem was with unqualified persons marketing their ability to prepare returns.
Judge Kavanaugh then zeroed in on the statutory text, pointing out that section 330 (a)(2)(D) states that Treasury “may . . . require” that “representatives” demonstrate their “competency to advise and assist persons in presenting their cases.” That language indicates that Congress understood that the “representatives” who could be regulated were persons who would assist in “presenting cases,” not just filling out returns. Mr. Rothenberg disagreed, arguing that Treasury was not compelled to impose all of the requirements set forth in subsection (a)(2) and that the other three requirements could apply to tax return preparers. Judge Sentelle expressed some doubt whether that position was consistent with the statutory use of the conjunctive “and” in joining the four subsections of (a)(2). Judge Williams then suggested that these were four different characteristics of representatives, but that the language of (a)(2)(D) in that case still bore some relevance to interpreting the term “representatives” in (a)(1). Mr. Rothenberg again disagreed, stating that the discussion was now focused on what he believed to be the fundamental error of the district court — namely, treating all four characteristics of section (a)(2) as mandatory, because that would exclude otherwise able practitioners from representing taxpayers before Treasury simply because they lacked advocacy skills. He also noted the position taken in the amicus brief of former IRS Commissioners that the “presenting a case” language could encompass preparing a tax return, but Judge Sentelle retorted that this would be an “awfully strange” use of the language.
Mr. Rothenberg then closed his argument by reiterating the government’s position that the district court erred in reading (a)(2) as limiting the language of (a)(1) and that (a)(1) itself did not foreclose Treasury from regulating tax return preparers. Therefore, Chevron deference is owed to those regulations.
Counsel for the plaintiffs, Dan Alban, began his argument by maintaining that there was no statutory authorization for the regulation. He described the statute as clearly focused on Treasury’s controversy and adjudicative functions, such as examination of returns and appeals before the agency, and not on what he described as “compliance” functions like filing a tax return. He also pointed to the “presenting their cases” language in subsection (a)(2), stating that no “case” exists until there is a dispute over the taxpayer’s return. Judge Williams asked about evidence that the scope of the original 1884 statute was limited to claims that were being resisted by the government — that is, controversies. Mr. Alban replied that it was clear that the statute was addressing claims that the claimants chose to bring, rather than a mandatory function like filing a tax return. In addition, he noted, the legislative history indicates that these were “contested” claims and that the representatives were standing in the shoes of the claimants. Here, by contrast, tax return preparers are not “representatives” before the agency. Judge Kavanaugh then asked who the preparers are representing. Mr. Alban replied that they are not representatives of anyone; they are just performing a service in assisting preparation of the return, but the taxpayer himself has to sign it. He noted in that connection that tax return preparers are not required to obtain a power of attorney, unlike taxpayer representatives in agency proceedings.
The court challenged Mr. Alban when he argued that the “level of policy decision” here warranted caution in allowing an agency, rather than Congress, to implement this new regulatory regime. Judge Sentelle noted that counsel couldn’t get much “traction” with that argument when the D.C. Circuit frequently deals with “sweeping regulations” that create major changes in the regulatory landscape. Judge Kavanaugh observed that, even if counsel was merely stating that the significance of the change ought to color the court’s approach to finding ambiguity, the suggestion was unworkable because it is hard for a court to decide what is “major.”
Finally, Judge Sentelle asked about the impact of the Supreme Court’s recent decision in City of Arlington holding that Chevron deference is owed to an agency’s determination of the scope of its jurisdiction. Mr. Alban stated that the decision was not directly applicable, but in any case the Supreme Court had made clear in that case the importance of seriously applying the limitations on Chevron deference. Here, because the statute was not ambiguous, Mr. Alban stated, the government’s position fails at Chevron Step 1, and therefore no deference is owed. Putting aside the discussion of broader administrative law principles, it was not apparent that any of the judges on the panel disagreed with the plaintiffs on that basic point regarding section 330(a).
Mr. Rothenberg began his rebuttal with a general discussion of Chevron principles, stating that all the prior cases in which the D.C. Circuit had invalidated regulations at Chevron Step 1 were situations where the agency action was more clearly foreclosed by a specific Congressional determination found in the statutory text, but he was met with considerable resistance. The judges observed that his list did not appear to be “exhaustive.” In particular, Judge Sentelle suggested that this case was perhaps analogous to the American Bar Ass’n case, which he described as invalidating FTC regulations directed at the legal profession on the ground that Congress had not empowered the FTC to regulate that profession. When Mr. Rothenberg answered in part that Chevron Step 1 sets a “low bar,” Judge Kavanaugh disagreed, stating that a court is to use all the tools of interpretation at Step 1 and that City of Arlington did not reflect a “low bar.”
Finally, Judge Kavanaugh asked Mr. Rothenberg to respond to Mr. Alban’s point that the IRS does not require tax return preparers to obtain a power of attorney. He replied that the power of attorney is required for “agents,” and tax return preparers are not agents. Mr. Rothenberg then repeated the point made in his opening remarks that the original 1884 statute covered “agents,” but other persons as well. Judge Williams interjected that the government appeared to be placing too much weight on the statutory reference to “other persons,” because canons of statutory construction provide that the scope of broad language like that is limited by the specific terms that precede it — here, “agents” and “attorneys.” Mr. Rothenberg noted that he disagreed, but his time expired before he could elaborate.
The case was heard on an expedited schedule, and therefore it is reasonable to expect that a decision will issue in the next couple of months.
Attached below is the plaintiffs’ response brief and the government’s reply brief, which were not previously posted on the blog. The government’s opening brief and two amicus briefs in support of the government were previously posted here and here.
September 3, 2013
Linked below is the government’s reply brief in support of its petition for certiorari. The reply attempts to counter the taxpayer’s argument that the conflict between the Sixth Circuit and the Federal Circuit is unimportant because all taxpayers will choose to avoid the Federal Circuit in the future. See our previous report here. The government criticizes this argument for seeking to preserve a “forum shopping” opportunity and also remarks that “there is no reason to assume that other courts of appeals” faced with this issue will follow the Sixth Circuit’s reasoning rather than that of the Federal Circuit. The government also dismisses the taxpayer’s suggestion that the issue can be resolved by promulgating new regulations, thus obviating the need for Supreme Court review. The government asserts that the Sixth Circuit’s opinion suggests that the IRS has no authority to treat the severance payments as subject to FICA taxation and therefore the Sixth Circuit likely would not be swayed by new regulations.
As previously noted, the Court is scheduled to consider this petition at its September 30 conference and could announce whether it will grant certiorari as early as that afternoon.
August 28, 2013
The government has filed its reply brief in the Supreme Court in Woods. See our reports on the opening briefs here and here. The discussion of the jurisdictional issue focuses less on the textual analysis set forth in the government’s opening brief and more on the policy implications of adopting the taxpayers’ position. The government asserts that the taxpayers’ reading of the statute would effectively “negate Congress’s grant of authority to courts in partnership-level proceedings to determine the applicability of penalties.”
On the merits, the reply brief devotes most of its attention to responding to the taxpayers’ threshold argument that the penalty is inapplicable because there was no valuation misstatement to begin with, which was not the rationale of the court of appeals’ opinion. The government relies heavily on the statutory reference to “adjusted basis,” noting that it is stated in the disjunctive and therefore should be read to apply to basis overstatements that have nothing to do with “fact-based” valuation misstatements. The merits discussion also adverts to policy, stating that there is nothing “objectionable about the fact that basis overstatements arising from sham transactions will nearly always trigger the 40% penalty for gross misstatements.” That is because “the most egregious misconduct–engaging in phony transactions to create an artificial basis–warrants the most severe sanction.”
We also link to an amicus brief inadvertently omitted from our previous report. This brief, filed by Penn Law School Professor David Shakow because the issue is one “in which he has a special interest and about which he has been engaged for some time in writing,” supports the taxpayers’ primary argument on the merits. The brief analyzes the statutory language in context, and examines the history of the statute — both the legislative history and its application before tax shelters became rampant — and concludes that the valuation misstatement penalty should not apply in the absence of an actual valuation misstatement. According to Professor Shakow, the IRS, with the acquiescence of many courts, is improperly “using the valuation misstatement penalty as a surrogate for a ‘tax shelter’ penalty that Congress has not authorized.”
Oral argument is scheduled for October 9.
August 15, 2013
The taxpayer has filed its brief in opposition in the Supreme Court in Quality Stores. (See our earlier report on the certiorari petition here.) The government has the option of filing a reply brief, which has no specific due date, but likely would be filed no later than early September.
The brief in opposition argues at length that the Sixth Circuit’s decision is correct on the merits. With respect to the government’s reliance on a circuit conflict, the taxpayer describes this as a “shallow conflict” that does not justify a grant of certiorari. Specifically, the taxpayer acknowledges a conflict with the Federal Circuit’s decision in CSX, but argues that the other decisions from regional circuits cited by the government do not conflict “because they all involved payments made to employees who had accepted some form of voluntary separation from employment or payments otherwise materially different in character from SUB payments.” The taxpayer argues that the conflict with the Federal Circuit “may have no practical effect” because taxpayers can always choose to seek a refund in district court and thus avoid the CSX precedent. The taxpayer also suggests that “it is possible” that the Federal Circuit could reconsider its position in light of information about the IRS’s prior administrative practice that was presented to the Sixth Circuit but not to the CSX court.
The Court has scheduled the certiorari petition for consideration at its September 30 conference. Although the Court does not formally begin its new Term until the following Monday (the traditional “First Monday in October”), it has adopted the practice in recent years of announcing grants of certiorari in advance of that date, in order to give the lawyers an opportunity to start on the briefing. Thus, if cert is granted in Quality Stores, an order could issue as early as the afternoon of September 30.
July 31, 2013
The taxpayers have filed their response brief in the Supreme Court in the Woods case, contending first that the courts lacked jurisdiction to impose the penalties requested by the IRS and, second, that, if jurisdiction exists, the Fifth Circuit correctly held that the valuation misstatement penalty could not be imposed.
On the jurisdictional point, the brief emphasizes the same basic point made by the courts that have questioned jurisdiction in similar partnership cases (see our previous report here) – namely, that the statute allows for partnership-level jurisdiction in a TEFRA proceeding only over a penalty that relates to adjustment of a “partnership item.” It is undisputed that outside basis is not a partnership item, and the taxpayers contend that the “penalty at issue in this case undeniably relates to the adjustment of a nonpartnership item—outside basis—not to a partnership item.” The taxpayers’ brief dismisses the government’s argument on this point as having “an Alice-in-Wonderland feel to it” and, at any rate, as proving too much. The taxpayers concede that the outside basis determination does relate to the adjustment of a partnership item, specifically, whether the partnership transaction should be disregarded for lack of economic substance. But the brief maintains that, if that attenuated connection were enough for jurisdictional purposes, then the statute’s jurisdictional limitation “would be rendered essentially meaningless and could be readily circumvented.” The result would be to “rewrite Section 6226(f) to create precisely the jurisdiction that Congress withheld.”
On the merits of the penalty, the brief begins with a different argument from the one relied upon by the Fifth Circuit – maintaining that “there was no ‘valuation misstatement’ to begin with.” Pointing to the common meaning of the word “valuation” in the statutory text, and to the legislative history, the taxpayers argue that “Congress meant the penalty to address misstatements about valuation—an inherently factual concept concerning the worth or cost of property.” Therefore, the penalty should not be “triggered by transactions that are accurately reported but deemed not to exist based on a legal conclusion that they lack economic substance,” even if the result of that legal conclusion is to restate the basis claimed by the taxpayer.
The government argues, of course, that the text of the penalty provision is not limited strictly to classic “valuation” misstatements, because the statute defines those misstatements as occurring when “the value of any property (or the adjusted basis of any property)” is overstated on the return. The taxpayers argue, however, that the government is overreading the parenthetical “adjusted basis” reference and, read in context, it should apply “only when basis is incorrectly reported due to a factual misrepresentation of a property’s worth or cost.” For the government to read this language as authorizing application of the valuation overstatement penalty to cases where there is a “basis overstatement that is in no way dependent on a valuation error” – that is, one that is traceable to a legal conclusion that the transaction creating the basis was devoid of economic substance – is in the taxpayers’ view “essentially blowing [the penalty provision] up and transforming it into a penalty scarcely recognizable to the one Congress intended.”
The taxpayers also point to the penalty provision added in Congress’s recent enactment of an economic substance provision. They argue that the penalty associated with that provision (see Code section 6662(b)(6) and (i)) could impose a 40% penalty for the reporting in this case and therefore its enactment indicates that the existing valuation misstatement penalty should not be construed to cover economic substance cases.
As a fallback argument, the taxpayers argue for adopting the rationale of the Fifth Circuit – namely, that the underpayment of tax is “attributable to” a finding of no economic substance and hence is not attributable to a basis overstatement. Finally, the taxpayers rely on language from Supreme Court decisions in the 1930s to argue that doubts about the meaning of ambiguous tax statutes should be resolved in favor of the taxpayer.
An amicus brief in support of neither party was filed by Professor Andy Grewal. That brief discusses the state of the law in the courts of appeals regarding the substance of the economic substance doctrine, but urges the Court to “reserve its opinion on the broader economic substance issues implicated in this case.” Four amicus briefs were filed in support of the taxpayers, on either one or both issues, by other taxpayers involved in pending litigation that would potentially be affected by the Court’s holding. See here, here, here, and here.
The government’s reply brief is due August 18. Oral argument has been scheduled for October 9.
July 12, 2013
The Fifth Circuit has issued its opinion in Rodriguez, unanimously affirming the Tax Court in an opinion authored by Judge Prado. As forecasted in our earlier report on the oral argument (see here), the Court saw no way for the taxpayer to get around the technical obstacle that a section 951 inclusion is neither an actual dividend nor expressly denominated by Congress to be a “deemed dividend.” On the first point, the court stated that “actual dividends require a distribution by a corporation and receipt by the shareholder; there must be a change in ownership of something of value.” Hence, “Section 951 inclusions do not qualify as actual dividends because no transfer occurs.” On the second point, the court stated that the taxpayers’ “deemed dividends” argument was “unpersuasive . . . because, when Congress decides to treat certain inclusions as dividends, it explicitly states as much,” pointing to several provisions where Congress has explicitly stated that certain amounts should be treated as dividends.
The court did not express much angst over the unfairness argument made by the taxpayers — namely, that they could have obtained qualified dividend treatment through the formal declaration of a dividend had they only known that Congress was going to implement a more favorable rate for such dividends. The court recognized that fact, but did not agree that it led to a “harsh and unjust result.” To the contrary, the court said that the taxpayers had the opportunity to declare a dividend, or take other steps with the accumulated earnings, and those would have carried different tax implications. But they could not “now avoid their tax obligation simply because they regret the specific decision they made.” The court also gave short shrift to the taxpayers’ reliance on language in earlier legislative history and IRS pronouncements that described “a conceptual equivalence” between section 951 inclusions and dividend income.” The court said that these pronouncements carried little weight because the distinction between these inclusions and formal dividends “was treated loosely at the time because it did not carry tax implications” until 2003 when the preferential rate for qualified dividends was implemented.
The taxpayers have 45 days from the July 5 date of decision to seek rehearing, and 90 days to seek certiorari, though there is no reason to believe that either of those avenues for further review would prove to be fruitful.
July 3, 2013
The taxpayer has obtained an extension until July 31 to respond to the government’s petition for certiorari in Quality Stores.
June 28, 2013
The Fifth Circuit held oral argument in the Rodriguez case before Circuit Judges DeMoss, Dennis, and Prado. As we have previously reported here and here, the issue in this case is whether the taxpayers can receive qualified dividend income treatment for amounts included in their income under section 951. Taxpayers’ counsel stated that he had three main arguments: (1) section 951 is just an anti-deferral statute, not concerned with characterizing the income as dividend or ordinary income; (2) Private Letter Rulings and other Executive Branch announcements had previously characterized section 951 inclusions as “deemed dividends”; and (3) it was unfair, akin to a penalty, to deny dividend treatment to these income inclusions when the taxpayers concededly would have received qualified dividend treatment if they had actually made the distribution that was being imputed.
The court’s questioning at first focused on challenging the taxpayers’ basic point that the section 951 inclusion is essentially indistinguishable from a dividend. The court pointed out that at best what was involved was something “similar” to a dividend, not an actual dividend, noting that there was no actual distribution. When taxpayers’ counsel argued that the Code deems other kinds of income to be dividends even in the absence of a distribution, the court rejoined that these examples were distinguishable because they involved explicit statutory language providing that the income should be treated as a dividend. The taxpayers’ argument appeared to get more traction on the fairness point. The court observed that the taxpayers probably received legal advice and ought to suffer the consequences if they failed to make a dividend distribution and instead allowed the money to stay in the CFC and be subject to section 951 inclusion. But this position appeared to soften when taxpayers’ counsel explained that this choice would not have been apparent at the relevant time because it was not until the Bush-era tax cuts were enacted (including the reduced tax rate for qualified dividends) that it made any difference whether the inclusion was treated as a dividend or not.
Government counsel was met with questions as soon as she took the podium and overall had to entertain more questions than did taxpayers’ counsel. The court initially focused on the fairness point, remarking that the taxpayers had just done what was normally done at the time (before the Bush-era tax cuts) and wondering why they ought not to get the same treatment as if they had actually distributed the dividend. Government counsel acknowledged that Congress had no specific intent to impose a penalty on people in the taxpayers’ situation, but maintained that there was no basis for giving the taxpayers the relief they seek. Congress wanted to establish a reduced rate for dividends, but this was not a dividend nor any kind of distribution; it was just imputed income. Later, government counsel emphasized that there were other respects (apart from the reduced qualified dividend rate) in which the income included under section 951 is not treated as a dividend, such as the effect on earnings and profits. In response to a question about Congress’s understanding, she argued that Congress did understand that section 951 inclusions were not being treated as dividends and chose not to change that, pointing to a bill that did not get very far that would have explicitly treated them as dividends. Before the government’s argument concluded, however, the court returned to its starting point, and government counsel conceded that the taxpayers would have received the reduced tax rate if they had just formally distributed the included amount as a dividend.
On rebuttal, the court suggested to taxpayers’ counsel that the taxpayers perhaps ought to live with the consequences of their failure to take advantage of the option of declaring a dividend. The court also confirmed that the taxpayers could not cite to any binding precedent on point, but instead relied primarily on district court decisions from other jurisdictions.
Given the relative balance in the court’s questioning, neither affirmance nor reversal would be startling. If I were to hazard a guess, however, the most likely outcome appeared to be the conclusion that the reduced rate applies to “dividends,” and section 951 inclusions, while they may be similar, are not technically “dividends” nor have they been deemed dividends by statute. If so, the taxpayers may be out of luck.
June 18, 2013
[Note: Miller and Chevalier represented the taxpayer Exxon Mobil Corp. in this case.]
We previously reported on the Second Circuit’s consideration of the interest netting issue that had been resolved against the taxpayer by the Federal Circuit in FNMA v. United States, 379 F.3d 1303 (2004). Although we did not follow up with a timely report on the Second Circuit’s decision in that case in favor of the taxpayer, the decision is now final, with the government having allowed the time to seek certiorari to expire. To close the loop, we provide here a summary of the decision and a link to the opinion.
As explained in our prior post, the issue concerned a “special rule” enacted when Congress passed the interest netting rule of section 6621(d) in 1998. The statute operates prospectively, but Congress also allowed taxpayers to file interest netting claims for pre-1998 periods subject to a statute of limitations constraint. The dispute was over the scope of that constraint, with the taxpayer arguing that interest netting is available so long as the statute of limitations was still open on the 1998 effective date for either of the years used in the interest netting calculation. The government, by contrast, argued that the statute of limitations must have been open on the relevant date for both the underpayment and overpayment years that are used in the interest netting calculation. The Federal Circuit in Fannie Mae had ruled for the government, reasoning that the statutory text is ambiguous and should be construed narrowly in favor of the government because the “special rule,” the court concluded, is a waiver of sovereign immunity. The Tax Court, however, declined to follow Fannie Mae in this case and ruled for the taxpayer.
The Second Circuit affirmed the Tax Court in a comprehensive decision that closely tracked the taxpayer’s brief. The court rejected the sovereign immunity argument and then concluded “that the structure, context, and evident purpose of section 6621(d) and the special rule indicate that the special rule is to be read broadly, such that global interest netting may be applied when at least one leg of the overpayment/underpayment overlapping period is not barred by the applicable statute of limitations.”
The court did not dwell on the statutory text, finding that “the provision is susceptible to both proffered interpretations and that the intended meaning of the special rule cannot be derived from the text alone.” Therefore, the court stated that it was necessary “to consult the provision’s structure, historical context, and purpose–as well as applicable canons of statutory construction–in order to determine its meaning.” The court added that it would be “particularly mindful” of one pro-taxpayer canon of construction that is sometimes mentioned by courts but also often ignored in favor of competing pro-government canons – namely, “where ‘the words [of a tax statute] are doubtful, the doubt must be resolved against the government and in favor of the taxpayer,’ United States v. Merriam, 263 U.S. 179, 188 (1923).”
The court then stated that it agreed with the portion of the Fannie Mae opinion that rejected the government’s requests for deference to the relevant Revenue Procedure or to the “Blue Book” summary of the special rule. It is a bit surprising that the court addressed these arguments since the government had not made them in its brief in ExxonMobil; the court noted that “it appears . . . that the Commissioner has abandoned these arguments in this appeal.” Apparently, the court wanted to make sure that its opinion left no room for further litigation of the interest netting issue.
The court then turned to the main bone of contention, the holding in Fannie Mae that the special rule was a waiver of sovereign immunity that must be narrowly construed in favor of the government. The court’s analysis was succinct, observing that a “waiver of sovereign immunity is a consent on the part of the government to be sued,” and “[t]he special rule at issue here does no such thing.” Specifically, the special rule “does not create jurisdiction or authorize claims against the United States. Other provisions of the tax code perform that function.”
If the case was not to be resolved on the basis of sovereign immunity, the court explained, it should be resolved using the basic rules of statutory interpretation, which pointed towards a ruling for the taxpayer. First, “[t]he structure of § 6621(d) as a whole–and particularly its use of interest equalization–strongly suggests that the special rule is meant to apply whenever the period of limitations for at least one leg of the overlapping period of reciprocal indebtedness remains open.” Under that approach, it is “not necessary to adjust the computation of interest” for both legs “to achieve the zero net rate,” and therefore “it is not necessary for the limitations period to be open for both legs.” The court also noted that the government conceded that only one leg needed to be open when the statute was being applied prospectively, and it saw no reason for different treatment for retrospective interest netting claims. Finally, the court found support for the taxpayer’s position by examining “the historical context from which section 6621(d) emerged.” Given Congress’s repeated efforts to urge the IRS “to ameliorate the inequitable effects of the interest rate differential,” the court found that section 6621(d) and the special rule are “best understood as remedial provisions, and should therefore be interpreted broadly to effectuate Congress’s remedial goals.”
The Second Circuit’s holding in ExxonMobil is of limited significance to other taxpayers going forward. This is likely why the government chose not to seek certiorari despite the clearest circuit conflict imaginable. The holding applies only to the availability of interest netting for periods ending before July 22, 1998, so the number of remaining interest netting claims governed by the special rule at all is not large. And even within that universe, for many taxpayers the only available jurisdictional route will be through a refund suit in the Court of Federal Claims, where Fannie Mae remains binding precedent.
The court’s reasoning, however, could come into play in other settings, particularly where the government seeks to invoke sovereign immunity principles to support its position in a tax case. See, e.g., Ford Motor Co. v. United States, 2013-1 U.S. Tax Cas. (CCH) ¶ 50,102 (6th Cir. Dec. 17, 2012). The Second Circuit’s thoughtful approach to the definition of waivers of sovereign immunity will stand as a strong counterweight to the exceedingly expansive approach taken by the Fannie Mae court.
June 5, 2013
The government has filed its opening brief in the Supreme Court in the Woods case, which involves whether the 40% gross valuation overstatement penalty applies in the context of a basis-inflating transaction held not to have economic substance. See our earlier report here.
The government’s arguments on the question whether the penalty can be applied in these circumstances are similar to those discussed here previously and addressed in several court of appeals decisions. It relies on the “plain text” of the statute, arguing that “[t]he word ‘attributable’ means ‘capable of being attributed’” and therefore a finding of lack of economic substance does not defeat the conclusion that the tax underpayment is “attributable” to a basis overstatement. And the brief responds at length to the Fifth Circuit’s reliance on the “Blue Book” to justify a narrower interpretation of the statute. The government characterizes the court’s approach as reflecting “a misinterpretation of the relevant passage” in the Blue Book and goes on to say that, “[i]n any event, the Blue Book, a post-enactment legislative report, could not trump the plain text of Section 6662.” Finally, the government asserts that a contrary rule “would frustrate the penalty’s purpose of deterring large basis overstatements.”
The brief also addresses a question not presented in the petition for certiorari, but instead added to the case by the Supreme Court – namely, whether the district court had jurisdiction under Code section 6226 to decide the penalty issue. This issue concerns the two-level structure established by TEFRA for judicial proceedings involving partnerships. Partnerships are not taxable entities themselves; tax attributes from the partnership flow through to the tax returns of the individual partners. Accordingly, before 1982, tax issues raised by a partnership tax return could be resolved only through litigation with individual partners, leading to duplicative proceedings and often inconsistent results. The TEFRA scheme calls for proceedings at the partnership level to address “the treatment of any partnership item,” which would be issues common to all the individual partners. Adjustments that result from those proceedings flow down to the individual partners, and the IRS can make assessments on the individual partners based on those partnership-level determinations without having to issue a notice of deficiency or otherwise initiate a new proceeding. Issues that depend on the particular circumstances of individual partners, however, are determined in separate partner-level proceedings.
In this case, the penalty determination was made at the partnership level. That seems logical in one sense because the conclusion that the transaction lacked economic substance – and therefore did not have the effect on basis claimed by the taxpayer – was a partnership-level determination that would not depend on an individual partner’s circumstances. The Tax Court agrees with that approach, but the D.C. Circuit and the Federal Circuit have stated that such determinations do not involve “partnership items” within the meaning of TEFRA and hence a penalty determination like the one in this case should be made at the individual partner level. See Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010); Petaluma FX Partners, LLC v. Commissioner, 591 F.2d 649 (D.C. Cir. 2010). The reason is that the basis at issue here is an “outside basis,” that is, the partner’s basis in his or her partnership interest. A partner’s outside basis is not a tax attribute of the partnership entity (unlike, for example, the basis of an asset held by the partnership). These courts did not dispute the assertion that outside basis is an “affected item” (that is, an item affected by a partnership item) and that the conclusion underlying the penalties obviously follows from the partnership item determination; it is obvious that there is zero outside basis in a partnership that must be disregarded on economic substance grounds. But these courts ruled that obviousness is not a good enough reason to get around the jurisdictional limitations of the statutory text; “affected items” must be determined in a partner-level proceeding.
In its brief in Woods, the government argues that the statutory text allows the penalty determination to be made at the partnership level because the text affords jurisdiction over a penalty that “relates to an adjustment to a partnership item.” I.R.C. § 6226(f) (emphasis added). According to the government, “[w]hen a partnership item is adjusted in a way that requires an adjustment to an affected item and triggers a penalty, the penalty ‘relates to’ the adjustment to the partnership item.” The statute thus should be understood as providing that “the court [considering the partnership-level issues] should decide whether an error with respect to a partnership item, if reflected in a partner’s own return, could trigger the penalty.” The government’s brief then argues forcefully that its interpretation “best effectuates the objectives” of TEFRA because requiring this kind of penalty determination – involving “a pure question of law whose resolution does not depend on factors specific to any individual partner” – to be made at the partner level “would restore the inefficient scheme that Congress intended to do away with.”
The taxpayer’s brief is due July 22.
June 2, 2013
The government has finally filed its long-awaited cert petition in Quality Stores, asking the Supreme Court to review the Sixth Circuit’s ruling that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes. In our previous coverage, we have noted why this case is a strong candidate for Supreme Court review, and the cert petition sets those forth succinctly: (1) “the Sixth Circuit’s decision in this case squarely conflicts with the Federal Circuit’s decision in CSX Corp.”; and (2) “the question presented here is both recurring and important.” The petition elaborates on that latter point by stating that the question presented “is currently pending in eleven cases and more than 2400 administrative refund claims, with a total amount at stake of more than $1 billion. That figure is expected to grow.”
The petition goes on to address the merits of the underlying issue in some detail, even though there will be another opportunity to brief the merits if certiorari is granted. In essence, the government argues that the court of appeals went astray by drawing an inference about FICA taxation from Code section 3402(o)(2), which addresses income tax withholding. The government asserts that the “court of appeals’ chain of reasoning reflects significant misunderstandings of Section 3402(o)’s text, history, and purpose.” To the government, that section “simply directs that payments encompassed by the statutory definition will be subject to income-tax withholding whether or not they would otherwise be ‘wages.’” Therefore, it “has no logical bearing on the determination whether particular payments to terminated employees are subject to FICA taxation.”
Instead, according to the government, the FICA taxation issue should be resolved simply by asking whether the severance payments were “wages.” Looking to Social Security Board v. Nierotko, 327 U.S. 358 (1946), and other authorities, the government concludes that they are “wages” and therefore should be subject to FICA taxation.
The taxpayer’s response is currently due in early July. Because of the Court’s summer recess, however, a decision on whether to grant certiorari will not be announced before late September.
May 30, 2013
The Court this week denied the government’s petition for certiorari in the Entergy case. As explained in our prior post on the PPL decision, this ruling was inevitable in the wake of the Court’s decision for the taxpayer in PPL. The denial of certiorari now cements Entergy’s victory in the Fifth Circuit.
The Court also denied certiorari in Historic Boardwalk, the historic rehabilitation tax credit case decided in the government’s favor by the Third Circuit. See our previous reports here.
May 20, 2013
[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]
The Supreme Court this morning unanimously ruled in favor of PPL in its case involving the creditability of the U.K. Windfall tax. See our prior coverage here. The opinion was authored by Justice Thomas, with Justice Sotomayor adding a separate concurring opinion.
The Court’s opinion is fairly succinct. Viewing the government’s position as more formalistic, the Court stated that it would “apply the predominant character test [of the foreign tax credit regulations] using a commonsense approach that considers the substantive effect of the tax.” The Court stated that the regulatory test looks to “the normal manner is which a tax applies,” and “the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis.”
Applying this approach, the Court held that “the predominant character of the windfall tax is that of an excess profits tax,” which makes it creditable. By contrast, the Court found that the government’s attempt to characterize the tax as being imposed on the difference between two values was unrealistic, noting that the U.K. statute’s “conception of ‘profit-making value’ as a backward-looking analysis of historic profits is not a recognized valuation method,” but instead “is a fictitious value.” The Court agreed with PPL’s argument that the equivalency of the tax with a more typical excess profits tax could be demonstrated through an algebraic reformulation of the formula for computing the tax. The Court addressed this point in some detail, putting this opinion near or at the top of the rankings in the category of most algebraic formulas found in a single Supreme Court opinion. Declaring that it must look at “economic realities, not legal abstractions,” the Court concluded that it must “follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.”
Justice Sotomayor’s separate concurring opinion focused on an issue that featured prominently in the oral argument (see our report here) — namely, how the analysis is affected by the way the tax applied to a few “outlier” taxpayers who did not operate for the full four-year period governed by the tax. Echoing the position taken in an amicus brief filed by a group of law school professors, Justice Sotomayor stated that the treatment of these outliers indicated that “the windfall tax is really a tax on average profits” and ought to be viewed as a tax on a company’s value, not net income. Justice Sotomayor acknowledged, however, that her position “cannot get off the ground” unless the Tax Court was wrong in stating in Exxon Corp. v. Commissioner, 113 T.C. 338, 352 (1999), that “a tax only needs to be an income tax for ‘a substantial number of taxpayers’ and does not have to ‘satisfy the predominant character test in its application to all taxpayers.’” Since the government indicated at oral argument that it did not disagree with the Tax Court on that point, Justice Sotomayor concluded that she should not base her analysis of the case on her “outlier” argument and instead would join the Court’s opinion. Interestingly, Justice Kagan did not join the concurrence even though she was the Justice who appeared at the oral argument to advocate most strongly for the “outlier argument” made in the amicus brief.
For its part, the majority briefly noted this argument in a footnote at the end of its opinion, and stated that it would “express no view on its merits” since the government had not preserved the argument. Notwithstanding that disclaimer, the body of the Court’s opinion provides ammunition for persons who might wish to oppose Justice Sotomayor’s position in future cases. The Court stated that the predominant character test means that “a foreign tax that operates as an income, war profits, or excess profits tax in most instances is creditable, even if it may affect a handful of taxpayers differently.” Another item in the opinion that could find its way into briefs in future foreign tax credit cases is the Court’s observation that the 1983 regulation at issue “codifies longstanding doctrine dating back to Biddle v. Commissioner, 302 U.S. 573, 578-79 (1938).” In its court of appeals briefing in PPL, the government had denigrated the relevance of pre-regulation case law, stating that the regulations merely “incorporate certain general standards from those cases,” and arguing that PPL “cannot rely on pre-regulation case law—to the exclusion of the specific regulatory test—to make its case.” The Court’s opinion will lend support to litigants who want to rely on pre-regulation case law in future foreign tax credit cases.
The Court’s opinion in PPL effectively resolves the Entergy case as well. As we have reported, the government filed a protective petition for certiorari in Entergy, but it has never suggested that PPL and Entergy should be decided differently. Thus, in the near future, probably next Tuesday, the Court can be expected to issue an order denying that certiorari petition and thereby finalizing Entergy’s victory in the Fifth Circuit.
May 10, 2013
We previously reported on the Court’s grant of certiorari in Woods, noting that the government’s opening brief would be due on May 9. If you are looking for the brief, be advised that the Court has extended the filing date until May 30. The taxpayer’s brief will be due July 22.
May 9, 2013
The government has filed its brief opposing certiorari in Historic Boardwalk. The government characterizes the decision as resting “on a fact-bound examination of the agreements between the parties” that presents no legal issue of broad applicability warranting Supreme Court review. The brief responds at length to the taxpayer’s argument that the court of appeals misapplied Commissioner v. Culbertson, 337 U.S. 733 (1949), maintaining instead that “the court of appeals properly applied the framework set forth in Culbertson.”
As we previously noted, the taxpayer faces an uphill battle because the Court rarely hears technical tax cases over the government’s opposition in the absence of a circuit conflict. The Court is expected to act on the petition on May 28.
May 3, 2013
The Chief Justice has granted the government a second extension of time to file its petition for certiorari in Quality Stores. See our previous coverage here. The petition is now due May 31. By statute, the time to petition for certiorari can be extended for a maximum of 60 days, so the government is now about at the end of its rope, and it will surely fish or cut bait by the current May 31 deadline.
April 3, 2013
The Supreme Court has granted the government’s request for a one-month extension to file its petition for certiorari in Quality Stores, extending the due date from April 4 to May 3. As we have previously observed, we believe there is a strong likelihood that the government will petition in this case and that the Court will grant certiorari to resolve the circuit conflict on the treatment for FICA purposes of supplemental unemployment compensation benefits. See our previous coverage here.
With this extension, however, the Court likely will not decide whether to grant certiorari until early October, after the summer recess. If Quality Stores were to file its response to the cert petition early, however, without taking its full 30 days to respond, then the petition could still be ready for a ruling by the Court before the summer recess. In either event, if the Court were to grant certiorari, the case would probably be argued in late 2013, with a decision on the merits expected by June 2014.
March 28, 2013
The D.C. Circuit (Rogers, Tatel, and Brown, JJ.) has denied the government’s request for a stay of the district court’s injunction of the new registration regime for paid tax-return preparers. The court did not give an elaborate explanation, simply stating that “[a]ppellants have not satisfied the stringent requirements for a stay pending appeal.” Thus, the court did not indicate whether the government fell short because its motion was not sufficiently convincing that the district court was likely to be reversed on the merits or because it did not make a sufficiently compelling case of irreparable harm.
In any case, it is now likely that the government will not be able to implement the regulatory scheme in full at this time, but will remain bound by the injunction until the D.C. Circuit rules on the merits of its appeal in due course (and, of course, even after that if it is unable to persuade the D.C. Circuit to reverse). The government does still have the option of asking the Supreme Court to stay the district court’s order pending resolution of the appeal in the court of appeals. It is unusual for the government to ask the Court for that kind of relief, and for the Court to grant it, but pursuing that route remains a possibility if the government feels strongly enough about the adverse consequences of leaving the injunction in place for the time being.
March 25, 2013
The Court this morning granted the government’s petition for certiorari in United States v. Woods, No. 12-562. As we recently reported, the issue presented in the petition concerns the applicability of the valuation overstatement penalty — specifically, whether tax underpayments are “attributable to” overstatements of basis when the inflated basis claim has been disallowed based on a finding that the underlying transactions lacked economic substance.
The Court also added a second question for the parties to brief — “Whether the district court had jurisdiction in this case under 26 U.S.C. section 6226 to consider the substantial valuation misstatement penalty.” This issue involves the general question under TEFRA of which issues are to be resolved in a partner-level proceeding and which should be resolved at the partnership level. See Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 655-56 (D.C. Cir. 2010).
The government’s opening brief is due May 9. Oral argument will likely be scheduled for late 2013, with a decision expected by June 2014.
March 18, 2013
The Court this morning denied Union Carbide’s petition for certiorari that sought review of the Second Circuit’s denial of claimed research and experimentation credits for the costs of certain supplies used in production process experiments. The petition had also asked the Court to consider the court of appeals’ application of Auer deference priniciples. See our prior reports here.
The Court also entered an order denying a motion by the National Association for Manufacturers to file an untimely brief as amicus curiae in support of the petition. Although the Court routinely grants motions for leave to file timely amicus briefs, it does take its time limits seriously. In this case, the amicus brief was due January 3 and the brief was actually filed (with an accompanying motion for leave to file out of time) on January 15.
The Court took no action on the government’s petition for certiorari in Woods, a penalty case. See our prior report here. It was scheduled to consider the case at last Friday’s conference, but apparently decided that it needed more time to decide what to do. The case will be rescheduled to be considered again at a future conference, possibly this Friday. So there could be an order in the case next Monday.
March 13, 2013
The government has asked the Supreme Court to resolve a longstanding conflict in the circuits on the applicability of the penalty for valuation misstatements in United States v. Woods, No. 12-562.
The Code contains a variety of civil penalty provisions for conduct connected with underreporting of tax. The basic penalty is found in section 6662, which imposes an accuracy-related penalty for underpayments of tax “attributable to” different kinds of conduct, including negligence, substantial understatements of tax, and substantial overvaluations. The penalty is 20% of the portion of the underpayment “attributable to” the misconduct. I.R.C. § 6662(a), (b). Section 6662(e) applies the 20% penalty in the case of a “substantial valuation misstatement,” which is defined as occurring when “the value of any property (or the adjusted basis of any property) claimed on any [tax return] is 150 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.” I.R.C. § 6662(e)(1)(A). That 20% penalty is doubled, however, to 40% in the case of a “gross valuation misstatement,” which is defined in the same way, except that the overvaluation is 200% or more of the correct amount. I.R.C. § 6662(h)(2)(A)(i). (Prior to 2006, the relevant percentages were 200% for a substantial valuation misstatement and 400% for a gross valuation misstatement.)
Congress’s focus in originally enacting this penalty was to address a specific problem of overvaluation. It found that many taxpayers were severely overvaluing difficult-to-value assets like artwork, anticipating that the dispute would ultimately be resolved by “dividing the difference.” Thus, the severe penalties were enacted as a deterrent to these overvaluations. See generally H.R. Rep. No. 97-201, at 243 (1981).
In the last decade or so, however, the government has most frequently invoked this penalty regime in its efforts to combat tax shelters. Oversimplifying a bit, many tax shelters work by using a series of transactions that have the effect of creating a high basis in some particular asset. Disposal of that asset then generates a large tax loss. The IRS often argues in these cases that the high basis is artificially inflated because the transactions lack economic substance. If that argument succeeds, the high basis and attendant tax loss goes away. In such cases, the government also frequently argues that the 40% gross valuation overstatement penalty applies on the theory that the taxpayer claimed a high basis in an asset ultimately found to have a much lower basis; hence, the adjusted basis “claimed on” the return exceeded by more than 200% or 400% “the amount determined to be the correct amount of” the adjusted basis. I.R.C. § 6662(h)(2)(A)(i). The government has not been able to apply this approach in a uniform way across the country, however, because of a persistent disagreement in the circuits over how to construe the penalty statute.
The crux of the dispute centers on the “attributable to” language in the statute. More than 25 years ago, the IRS contested certain taxpayers’ deductions and credits claimed as a result of transactions involving the purchase of refrigerated containers. It argued both that the taxpayers had overstated their bases in the property and that the containers had not been placed in service in the years in which the deductions had been taken. The court ruled for the IRS based on the latter argument. The Fifth Circuit held that, in these circumstances, the valuation overstatement penalty did not apply because the tax underpayment was not “attributable to” the valuation overstatement; even if there were such an overstatement, the deductions were completely disallowed for a reason independent of the overstatement. Todd v. Commissioner, 862 F.2d 540, 541-45 (5th Cir. 1988). Two years later, the Fifth Circuit applied Todd to a case where the two grounds for disallowance were more closely connected, the IRS having contended that the units were overvalued and that the taxpayers did not have a profit motive for the transactions. Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990).
The Fifth Circuit has continued to apply Heasley in tax shelter cases, holding that when an asset is found to have an artificially inflated basis because transactions lack economic substance, the tax underpayment is “attributable to” the economic substance conclusion, not to an overvaluation. Last year, it reaffirmed its adherence to that approach in Bemont Invs. L.L.C. v. United States, 679 F.3d 339 (5th Cir. 2012), although the judges indicated that they thought the Fifth Circuit precedent was probably wrong. Shortly thereafter, a different panel rejected the government’s position in a one-paragraph per curiam opinion in Woods v. Commissioner, No. 11-50487 (June 6, 2012), that describes Todd, Heasley, and Bemont as “well-settled,” and the court denied a petition for rehearing en banc. As a result, the 40% penalty is unavailable in the Fifth Circuit in the typical tax shelter case, although a 20% penalty usually will still apply because of negligence or a substantial understatement of tax (I.R.C. §§ 6662(c), (d)(1)).
The government asks the Court to grant certiorari in Woods, contending in its petition that “[t]here is a lopsided but intractable division among the circuits over whether a taxpayer’s underpayment of tax can be ‘attributable to’ a misstatement of basis where the transaction that created an inflated basis is disregarded in its entirety as lacking economic substance.” Although the Ninth Circuit has followed the Fifth Circuit’s approach, the petition states that eight other circuits have gone the other way. Several of those decisions have expressly disagreed with the Fifth Circuit precedent. The petition says the circuit conflict is “ripe for resolution” given that the Fifth and Ninth Circuit have recently denied petitions for rehearing en banc asking them to reconsider their minority view on this issue.
The case is a strong candidate for Supreme Court review, unless the Court concludes that the issue is “overripe.” In 2010, Congress passed section 6662(i), which imposes a 40% penalty on any underpayment of tax attributable to a “nondisclosed noneconomic substance transaction” entered into after March 30, 2010. That new section would make the penalty applicable in such economic substance situations even in the Fifth and Ninth Circuits, and thus makes resolution of the conflict less important for future years. The cert petition addresses this concern, stating that the new statute “has no application to the thousands of taxpayers who engaged in abusive, basis-inflating tax shelters before the provision’s effective date.” In addition, the government argues that the new provision will not affect cases “where value- or basis-related deductions are disallowed in full on a ground other than lack of economic substance.”
In its brief in opposition, the taxpayer does not deny the existence of the circuit conflict. He argues, however, that the issue does not warrant the Court’s attention, largely because the 2010 legislation has resolved the issue presented for future years. In addition, the taxpayer argues that “the imposition of the 40% penalty in cases where the 20% penalty applies is not an important matter” and expresses skepticism about the government’s “sensationalized claim” that “hundreds of millions of dollars” in penalties are riding on this issue. In response, the government identifies a group of eight cases docketed within the Fifth Circuit that involve aggregate basis misstatements of approximately $4 billion.
The Court is expected to announce whether it will hear the case on March 18.
February 27, 2013
The Fifth Circuit has scheduled oral argument in the Rodriguez case for April 3 in New Orleans. As discussed in our prior posts, the issue in the case is whether section 951 inclusion income should be taxed at the lower rate applicable to qualified dividends. The identities of the three judges who will hear the case will be announced the week before the argument.
February 25, 2013
[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]
Seven Justices (all but Justices Thomas and Alito) asked questions in the oral argument in PPL on February 20, but they did not obviously coalesce around any particular view of the case. Even in cases where the questioning can be more neatly categorized, it is always hazardous to try to predict the outcome based on the questioning at oral argument. At this point, the parties’ work is done, and they are reduced to waiting for a decision, which is likely to come down in May or June — certainly no later than the end of June.
Former Solicitor General Paul Clement argued first on behalf of PPL. Justice Sotomayor began the questioning of Mr. Clement and asked him the most questions. She pressed him on why the tax could not be regarded as a tax on value. She also expressed “fear” over what she saw as the breadth of the taxpayer’s position, characterizing PPL as seeking a rule that a tax is creditable “anytime a tax uses estimates of profits.” Mr. Clement responded that this “emphatically” was not the taxpayer’s position, explaining that normal valuation is prospective and hence taxes that use future estimates for valuation will always fail the realization requirement for creditability. In response to Justice Sotomayor’s suggestion that using actual profits was a reasonable way to “find the original flotation value,” Mr. Clement responded that “you would never do that in any normal valuation” because “the first rule of thumb” for those kinds of historical valuations “is to avoid hindsight bias.”
Several other Justices also asked questions of Mr. Clement, focusing on different issues of interest to them. Justice Kennedy asked a series of questions exploring the significance of the tax being labeled as a tax on value, or reasonably viewed in part as “a tax on low value,” notwithstanding that it is also logically seen as a tax on profits. Mr. Clement responded that the substance of the tax is “exactly like a U.S. excess profits tax” but did not “look at a normal rubric of value” because “the only measure of value here is by looking at retrospective earnings over a 4-year period.” Justice Ginsburg asked whether there were other examples of taxes like the U.K. Windfall Tax. Justice Breyer asked a series of questions exploring the operation and rationale of the tax as it applied to companies that had not been in operation for the full four-year period in which historical profits were measured. Mr. Clement stated that even these companies did not pay an amount of tax that exceeded their profits and, moreover, that creditability is to be determined by the “normal circumstances in which it applies,” not by the outliers.
One perhaps surprising aspect of the argument was the attention paid to the amicus brief filed by a group of law professors. Justice Kagan’s extensive questioning of Mr. Clement focused on an argument introduced by that amicus brief – namely, that the tax should not be treated as an income tax because of the way it treats the “short-period” outliers by looking to their average profits, not total profits, in determining the amount of the taxable “windfall” received. Specifically, the tax rate on those few companies who did not operate for the entire four-year period was higher than for the vast majority of the companies. Mr. Clement noted that the reason for this was because the taxing authorities “were trying to capture the excess profits during a period in which there is a particular regulatory environment” conducive to excess profits; for the short-period taxpayers the way to do this was to “hit them with a reasonably tough tax in year one but year two, three, and four they were in a favorable regulatory environment and they get no tax at all.” (Justice Breyer later stated that, “because time periods vary, rates will vary, but I don’t know that that matters for an income tax.”) Mr. Clement also emphasized here, as he did later to Justice Breyer, that the outlier case does not control creditability, which is determined based on the normal circumstances in which the tax applies. The amicus brief was also mentioned briefly by Justice Sotomayor.
After Assistant to the Solicitor General Ann O’Connell took the podium, Chief Justice Roberts engaged her on the amicus brief as well, pointing out that the argument discussed by Justice Kagan was “not an argument that you’ve made.” When Ms. O’Connell agreed, but pointed to the amicus brief, the Chief Justice remarked that “I don’t think we should do a better job of getting money from people than the IRS does.” In response to Justice Sotomayor, Ms. O’Connell sought to clarify the government’s position by distinguishing between two different points made in the amicus brief. With respect to the “aspect of the amicus brief that says if it’s bad for one, it’s bad for all,” that is not the government’s position; the government agrees with PPL that outliers do not control credibility. But with respect to the argument of the amicus that Justice Kagan had discussed in connection with the outliers – namely, that “it taxes average profits, not total profits” – Ms. O’Connell maintained that she was not saying that the argument was wrong, only that the government’s “principal argument” was that the predominant character of the tax “is not an income tax because of the way that it applies to everybody else.” Justice Kagan took the opportunity to state that she believed the argument developed in the amicus that had formed the basis for her questioning was “the right argument.”
Apart from the amicus brief discussion, Ms. O’Connell was questioned by Justices Scalia and Breyer on whether true valuations are based on historical profits, rather than direct market evidence of value. She responded that this was a good way to determine the value of the companies at the time of flotation. In response to questioning from the Chief Justice about how to treat a tax laid on income, Ms. O’Connell stated that a tax just “based on last year’s income” would be an income tax regardless of its label, but if the income were multiplied by a price/earnings ratio, it would be a tax on value. The topic of deference also made a brief appearance, with Justice Breyer suggesting that deference might be owed to the experts at the Tax Court and Justice Ginsburg wondering whether deference was owed to the government’s interpretation of its own regulations. The Chief Justice responded to the latter point by remarking that there did not appear to be a major dispute about the meaning of the regulatory language and hence that sort of deference “does not seem to move the ball much.”
Justice Breyer chimed in with a detailed discussion of the mechanics of the tax, suggesting that this indicated that the “heart of the equation in determining this so-called present value is nothing other than taking average income over the four-year period.” Ms. O’Connell disagreed, and after considerable back-and-forth, Justice Breyer remarked that he had “said enough” and he would go back and study the transcript to decide who was right.
Towards the end of the argument, Justice Ginsburg asked whether the regulation could be changed “so it wouldn’t happen again” if the taxpayer prevailed. Ms. O’Connell said that perhaps it could be made “even more clear than it already is,” but Justice Breyer wondered why it should be changed to make American companies “in borderline cases have to pay tax on the same income twice.” Ms. O’Connell disputed that characterization, stating that the taxpayer did get a foreign tax credit for payments it made of the standard British income tax and it would still get a deduction for the U.K. Windfall Tax payments if the government prevailed. Ms. O’Connell closed her argument by stating that the tax was “written as a valuation formula, and it’s not just written that way, but that’s the substance of what it’s trying to do.”
February 20, 2013
To close the loop on yesterday’s post on the Union Carbide certiorari petition, the taxpayer has now filed its reply brief in support of the petition. The reply brief focuses primarily on the Auer deference issue, distinguishing the cases cited by the government in its defense of the application of Auer deference. The reply brief also vigorously disputes the government’s contention that the Second Circuit would have reached the same result if it had not deferred to the government’s interpretation of the regulation.
February 19, 2013
The government has filed a brief in opposition to Union Carbide’s request for review of the Second Circuit’s decision denying its research credit claim. See our prior reports on the cert petition and the court of appeals’ decision here and here. With respect to the basic legal issue, the government’s concise analysis tracks that of the Second Circuit, arguing that the taxpayer would get a “windfall” if it received “a credit for the cost of supplies that the taxpayer would have incurred regardless of any qualified research.” The government emphasizes that there is no circuit conflict on this issue that warrants Supreme Court review, describing this as “the first case since the enactment of the research credit in 1981 that has presented the question of what supply costs are eligible for the credit when a taxpayer simultaneously performs research on a production process and produces products for sale in the ordinary course of its business.”
The government spills more ink addressing Union Carbide’s argument that Supreme Court review is appropriate in order to reject the Second Circuit’s allegedly overbroad application of “Auer deference” to the government’s interpretation of its research credit regulations. Clearly unenthused about the prospect of the Court re-examining this issue, the government gives a plethora of reasons why it should stay away: (1) the taxpayer did not raise in the court of appeals its objection that the government should not be entitled to Auer deference when it has a financial interest in the outcome of the case (because the government had not explicitly requested Auer deference in its brief); (2) no other court of appeals has “expressly addressed” this argument; (3) although the Second Circuit invoked Auer deference, that did not affect its decision because it would have interpreted the regulation the same way even without resort to deference principles; (4) Union Carbide’s argument is wrong; and (5) Union Carbide did not claim the credit in question on its tax return and therefore the agency could not apply its interpretation of the regulations until after litigation had commenced.
Given the absence of a conflict and the government’s strong opposition, Union Carbide’s petition faces a steep,a nd likely insurmountable, uphill climb. The Court is expected to act on the cert petition on March 18.
February 13, 2013
[Note: Miller & Chevalier filed an amicus brief in this case on behalf of American Electric Power Co. in support of PPL.]
PPL has filed its reply brief in the Supreme Court, thus completing the briefing. The brief responds at length to the government’s contention that the U.K. Windfall Tax should be viewed as a tax on value because it assertedly resembles “familiar” and “well-established” methods of measuring value. In fact, the reply brief maintains, the tax “is a tax on value in name only.” The reply brief observes that the tax involves “a backward-looking calculation driven entirely by actual, realized profits” and that it is “imposed on the income-generating companies themselves,” rather than on “the holder of the valuable asset.” The reply brief then states that the rest of the government’s arguments “all depend on the flawed premise that form trumps substance when it comes to the base of a foreign tax.” The difficulties with that premise were addressed extensively in PPL’s opening brief and are further addressed in the reply brief.
Oral argument is set for February 20.
February 11, 2013
[Note: Miller & Chevalier filed an amicus brief in the Third Circuit in this case on behalf of National Trust for Historic Preservation]
We have previously reported extensively (see previous reports here) on the Third Circuit’s decision in Historic Boardwalk denying a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. Although the Third Circuit declined to rehear the case, the taxpayer has now filed a petition for certiorari seeking Supreme Court review (docketed as No. 12-901).
With no conflict in the circuits on the issue presented, the petition argues that Supreme Court review is needed because of the issue is new and has potentially broad ramifications, stating: “This is the first litigated case in the country where the Internal Revenue Service has made a broad based challenge to the allocation of Congressionally-sanctioned federal historic rehabilitation tax credits by a partnership to a partner.”
The petition elaborates by proffering three reasons why the case should be viewed as presenting tax law issues of exceptional national importance. First, the Third Circuit’s ruling that the taxpayer was not a bona fide partner is asserted to squarely conflict with Commissioner v. Culbertson, 337 U.S. 733 (1949). Second, the petition criticizes the court of appeals’ holding that the allocation of tax credits “should be considered a ‘sale’ or ‘repayment’ of ‘property’” as “utterly baseless” and at odds with Supreme Court precedent. Third, the petition criticizes the Third Circuit for considering the credits themselves as a component of the substance over form analysis.
The petition urges the Court to hear the case because of its importance, stating that it undermines Congress’s intent “to encourage private investment in the restoration of historic properties” and that the issues “bear broadly on . . . thousands of [historic rehabilitation tax credit] partnership investment transactions across the nation involving billions of dollars.” The breadth of the impact of a decision is an important factor in the Court’s consideration of whether to grant review, but the petition still faces an uphill battle, as the Court rarely grants certiorari in technical tax cases in the absence of a circuit conflict – unless the government urges it to do so. Here, there is every reason to expect that the government will oppose the petition.
The government’s brief in response is currently due, after one 30-day extension, on March 25.
February 3, 2013
[Note: Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in support of PPL in both the Third Circuit and the Supreme Court.]
A group of legal academics, led by Professor Michael Graetz of Columbia who authored the brief, has filed an amicus brief in PPL in support of the government. The brief argues that the UK tax should be treated as a tax on value, in line with the labels attached to it by Parliament, because it “was designed to redress both undervaluation at privatization . . . and subsequent lax regulation.” Maintaining that adopting PPL’s position “would open the door to claims of foreign tax credits for foreign levies based on value, not income,” the brief advances a somewhat creative policy rationale for affirming the Third Circuit that goes beyond anything argued by the government. Taking a perhaps unduly optimistic view of the political process, the brief claims that a reversal by the Supreme Court “would provide a road map to foreign governments, encouraging them to shift the costs of privatization to U.S. taxpayers by initially undervaluing public assets and companies sold to private interests and subsequently imposing a retroactive levy to compensate for the previous undervaluation.”
Although he has spent most of his career in academia (serving stints at Treasury from 1969-72 and 1990-92), Professor Graetz is not without Supreme Court experience. He briefed and argued Hernandez v. Commissioner, 490 U.S 680 (1989) on behalf of the taxpayer, arguing (unsuccessfully) for the position that adherents of the Church of Scientology were entitled to a charitable contribution deduction for payments made to the Church for “auditing” and “training” services.
Also linked below is the amicus brief filed by Patrick Smith, et al., which was noted in an earlier post, but was not available in an electronic version at the time.
January 15, 2013
[Note: Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in support of PPL in both the Third Circuit and the Supreme Court.]
The government has filed its response brief in the Supreme Court in PPL. The arguments in the brief do not closely track the analysis of the Third Circuit’s opinion. Indeed, the government pointedly distances itself from the Third Circuit’s heavy reliance on Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3. The Third Circuit had suggested that PPL’s position was foreclosed by Example 3, but the government’s Supreme Court brief suggests only that the example provides a “useful analogy,” while acknowledging that “the example is not directly applicable because it analyzes imputed gross receipts rather than actual gross receipts.” [See our prior observations on Example 3 here.]
Instead, the government’s brief asks the Supreme Court to accept the characterization of the U.K. Windfall Tax as “a tax on value,” rather than an income tax. According to the government, “[t]hat is so both because the U.K. government wrote it as a tax on value and because a company’s windfall tax liability is determined pursuant to a method of valuing property that is familiar to U.S. tax law,” where “it is common to calculate the value of property by taking into account the property’s ability to generate income.” The brief stops short of declaring that the label attached to the tax by Parliament is “determinative,” but asserts that “the ‘labels’ and ‘form’ that a foreign government uses to formulate a tax are relevant.”
PPL’s reply brief is due February 13, with oral argument scheduled for February 20.
January 7, 2013
Acting promptly after receiving the taxpayer’s response, the Sixth Circuit has denied the government’s petition for rehearing en banc in Quality Stores. Even though the government’s petition pointed to a direct circuit conflict and alleged tension with the Sixth Circuit’s own precedent (see our report here), the court’s order recites that no judge on the Sixth Circuit requested a vote on the petition.
The court’s order puts the ball back in the government’s court to decide whether to seek Supreme Court review. Given the conflict and the apparent importance of having a uniform nationwide rule, there is a significant possibility that the government will ask the Supreme Court to step in.
A petition for certiorari would be due on April 4.
January 4, 2013
[Note: Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in both the Third Circuit and the Supreme Court.]
The taxpayer has filed its opening brief in the Supreme Court in PPL Corp. v. Commissioner, No. 12-43, a foreign tax credit case that we have covered extensively on its journey to the Court. PPL’s brief heavily criticizes the formalism of the government’s position, stating that “the Commissioner would have the labels and form a foreign country employs, and not the substance of the tax it imposes, determine how the tax should be treated for purposes of U.S. tax law.” Once that formalistic approach is rejected, PPL argues, this becomes an “easy case” because “[t]here is no real dispute that the U.K. windfall tax is, in substance, an excess profits tax in the U.S. sense.”
Two other companies with current disputes regarding the creditability of the U.K windfall tax — Entergy Corp. and American Electric Power Co. — filed amicus briefs in support of PPL. The Entergy brief contains a detailed description of how the U.K. windfall tax came to be enacted in its particular form, and it states that the Third Circuit decision “disregards the real operation of the tax at issue.” The AEP brief contains a detailed description of the prior administrative treatment of excess profits taxes and argues that the operation and effect of the U.K. windfall tax is akin to that of a traditional U.S. excess profits tax that has always been regarded as creditable.
Another amicus brief was filed by the Southeastern Legal Foundation, the Chamber of Commerce, the Cato Institute, and the Goldwater Institute. That brief criticizes the government’s position as “opportunistic and inconsistent with the government’s usual emphasis on substance over form.” Patrick Smith also filed an amicus brief focusing on the operation of the regulations.
The government’s brief in response is due January 14. Oral argument has been scheduled for February 20.
January 3, 2013
We previously reported on the Court of Federal Claims’ decision in Magma Power that allowed an interest netting claim when the taxpayer was a member of a consolidated group for one leg of the overlap period but not during the other leg. The government had argued that such a claim did not fall within the statutory language requiring that the overlapping interest payments involve the “same taxpayer.” The government filed a protective notice of appeal from the decision, but it has now voluntarily dismissed the appeal in the Federal Circuit. The Court of Federal Claims’ decision therefore will stand, and it is likely that the government will not contest future interest netting claims on this ground.
December 28, 2012
In addition to providing analysis and updates on pending tax appeals, this blog is intended to serve as a resource where readers can easily access the briefs and relevant opinions in those cases. Because of the press of business and other reasons, the posting of a couple of the opinions in cases we have discussed has slipped through the cracks. So we are providing links to those opinions here, even though the opinions are long past the point of “breaking news”:
The Second Circuit’s decision in TIFD (“Castle Harbour”), once again reversing the district court and holding that the banks did not qualify as partners under § 704(e)(1), and that the government could impose a penalty on the taxpayer for substantial understatement of income.
The Eleventh Circuit’s decision in Calloway, affirming the Tax Court and holding that the transaction in question was properly treated as a sale, not a loan, and upholding the penalties. The decision approves the multi-factor approach employed by the Tax Court majority, and notes infirmities in the alternative analytical approaches suggested by Judges Halpern and Holmes in their respective concurring opinions.
The Supreme Court’s decision upholding the Affordable Care Act (linked below). The opinion was eventually entitled NFIB v. Sebelius, although we had covered it using the caption of one of the companion cases, HHS v. Florida. The discussion of the Anti-Injunction Act, the issue that was covered in the blog, is found at pages 11-15 of the Court’s slip opinion. Our prior coverage (linked here only so that I can show off my against-the-mainstream prediction that the legislation would survive) can be found here and here. The majority’s key holding that the individual mandate could be upheld as an exercise of the Taxing Power is found at pp. 33-44.
December 27, 2012
Union Carbide has filed a petition for certiorari, docketed as No. 12-684, asking the Supreme Court to review the Second Circuit’s rejection of its research credit claim. See our prior reports describing the issue and reporting on the decision.
The petition articulates two questions presented: 1) the basic substantive tax question whether, in the context of a production process experiment, the research credit is limited to the costs of supplies that would not have been incurred but for the experiment; and 2) whether the court erred in deferring to the IRS’s proffered interpretation of its own research credit regulations. These two questions are related, of course, as the taxpayer argues that the court’s error in deferring to the IRS’s interpretation led it to misapply those regulations and deny the credit.
With respect to the first question, the petition emphasizes the importance of the decision. It states that production process experiments must be done in the production plant itself and create the risk that the output will be “off-grade scrap” if the experiment does not go well. Therefore, the costs of the supplies that would not be incurred but for the experiment are “trivial in comparison to the supplies that must be placed at risk of loss when conducting this type of research.” The result of the Second Circuit’s decision, the petition continues, “is that the credit is rendered trivial for the type of plant-scale production process research that is so important to manufacturing industries generally, and the chemical industry in particular.” Absent this deference, the petition argues, the regulation is most reasonably construed in accordance with the taxpayer’s broader reading of the term “indirect” expenses.
With respect to the second question, the petition argues that the Second Circuit stretched the concept of “Auer deference” (that is, deference to an agency’s interpretation of its own regulations) too far. The petition asserts that the court mistakenly applied Supreme Court precedent “as requiring a seemingly extraordinary deference to the government’s interpretation of a regulation in a case in which the government itself is a financially interested party, [which] amounts to affording a naked preference to a government litigant over its non-governmental adversaries — permitting the government to place its thumb on the scales of justice.”
As noted in our prior post, the Second Circuit’s opinion did extend the concept of Auer deference beyond the specific situations in which it has thus far been applied by the Supreme Court. In Auer v. Robbins, 519 U.S. 452 (1997), the Court had deferred to an agency’s interpretation when it was set forth in an amicus brief filed by a non-party; here, the court deferred to the IRS’s interpretation presented in a brief in which the IRS was a litigant. Justice Scalia has suggested that he would be open to reconsidering even Auer itself in an appropriate case (even though he authored the Auer opinion). Union Carbide is hoping that other Justices share that view or that they will be troubled by the apparent expansion of the doctrine here, and that enough of them will believe that this is an appropriate case to revisit the question of agency deference to its own regulations. Whether or not that turns out to be the case, the petition’s focus on the broadly applicable deference issue certainly gives the Court something to think about beyond whether it wants to hear the substantive tax issue. Ordinarily, taxpayers have a hard time persuading the Court to hear a technical tax question on which there is no circuit conflict.
The government’s brief in response to the petition is currently due January 3. The government often obtains at least a 30-day extension to file such responses.
December 27, 2012
The Federal Circuit yesterday dismissed the taxpayer’s appeal in Cadrecha. As noted in our prior post, this was a formality after the parties agreed to settle the case.
December 20, 2012
Following up on the Sixth Circuit’s order, the taxpayer has now filed a response to the government’s petition for rehearing en banc in Quality Stores. See our prior reports here. The brief offers a point-by-point response to the government’s petition, arguing in particular that the Sixth Circuit was correct in relying on Coffy v. Republic Steel Corp., 447 U.S. 191 (1980), and disputing the government’s contention that the panel’s decision was inconsistent with earlier Sixth Circuit decisions.
The petition is now back in the lap of the Sixth Circuit, which could rule in the next few weeks on whether it will rehear the case.
December 5, 2012
The Sixth Circuit yesterday directed the taxpayer to file a response to the government’s petition for rehearing en banc in Quality Stores. As we previously noted, the Federal Rules of Appellate Procedure prohibit responding to rehearing petitions unless ordered by the court, but such an order in this case was a strong possibility. Courts of appeals frequently direct responses to rehearing petitions filed by the government, and the government’s petition highlights why this case is a strong candidate for the relatively rare action of rehearing en banc. If the court’s order is surprising at all, it is that it took so long to issue it.
The order signifies that the Sixth Circuit is giving more than usual attention to this rehearing petition, but it does not necessarily mean that the petition will be granted.
The taxpayer’s response is due December 18.
November 21, 2012
The parties have now filed their opening briefs in the Fifth Circuit in Rodriguez, an appeal from the Tax Court’s decision that section 951 inclusion income is not to be taxed at the lower rate applicable to qualified dividends. See our prior report here.
As they argued in the Tax Court, the taxpayers emphasize a policy argument, stating that “Subpart F’s general purpose and mechanics should govern” and “Subpart F treats the amount included in the U.S. shareholder’s gross income essentially like a dividend.” The taxpayer also invokes substance vs. form principles and statements in the legislative history of Subpart F characterizing section 951 inclusions as deemed dividends. The taxpayers also point to GCMs, private letter rulings, and Internal Revenue Manual sections that support deemed dividend treatment.
The government’s response, like the Tax Court, focuses mostly on the text of the Code. It argues that the section 951 inclusion income is not literally a dividend; that the Code decrees that it should be treated as a dividend for other purposes but makes no such provision concerning the qualified dividend tax rate; and that there are some contexts in which section 951 inclusion income is not treated as a dividend, such as the earnings and profits calculation.
With respect to policy, the government asserts that the policy underlying enactment of the favorable tax rate for qualified dividends was to provide “an incentive for corporations to distribute their earnings to shareholders instead of retaining them.” Accordingly, the government argues, it does not advance that policy to provide the preferential tax rate in a situation where the corporation did not distribute the earnings.
Finally, the government urges the court to ignore the taxpayers’ argument that the IRS had previously treated section 951 inclusions as dividends in prior pronouncements. It states that those pronouncements did not specifically address the preferential tax rate question at issue here and that they are not the kind of IRS pronouncements that can be cited as authoritative precedent. In any event, the government states, the Commissioner “may change an erroneous administrative interpretation if he determines that such a position is incorrect.”
November 1, 2012
We have previously reported on the taxpayers’ appeal in Cadrecha from an application of the statute of limitations that the Court of Federal Claims acknowledged as “harsh,” but found to be required by law. The taxpayers’ brief emphasized the unfairness of the result, and it struck a chord with the Department of Justice, whose appellate lawyers concluded that the taxpayers ought to get a break — either because they deserved one or perhaps because DOJ feared that the facts were so sympathetic that they created a risk of an adverse Federal Circuit decision that would cause mischief down the road.
Either way, the government has now filed a motion to suspend the appeal. The motion recites that, after consultation between DOJ and the IRS, the government has accepted a settlement offer from the taxpayers and agreed to refund “a portion of the amount of the income-tax payment that is at issue in this case.” After the refund check is processed and paid, the parties will submit papers to the court dismissing the appeal.
October 29, 2012
The Supreme Court this morning granted PPL’s petition for certiorari and will decide the question of the availability of the foreign tax credit for payments of the U.K. Windfall Tax on which we have reported extensively before. See here and here. The Court took no action on the government’s petition for certiorari in the companion Entergy case from the Fifth Circuit. That is a common practice for the Court when two cases present the same issue. The Court will “hold” (that is, continue to take no action on it) the Entergy petition until it issues a decision in PPL, and then it will dispose of the Entergy petition as appropriate in light of the PPL decision.
PPL’s brief is due December 13. The case likely will be argued in February or March, and a decision can be expected before the end of June.
(In case you are wondering why the Court is issuing orders on a day when the rest of Washington is shut down because of a hurricane, it is something of a Court tradition to stay open when the rest of the government is closed. In 1996, the Court heard oral arguments (as it is also doing today) on a day when the city was hit with a paralyzing blizzard. The Court sent out four-wheel drive vehicles to bring the Justices to the Court.)
October 23, 2012
The Third Circuit yesterday denied the taxpayer’s petition for rehearing en banc in Historic Boardwalk in what seems like record time (the petition was filed on October 10). The taxpayer’s last hope is to seek Supreme Court review, though the case does not look like one that could pique the Court’s interest. A petition for certiorari would be due on January 22.
October 19, 2012
The government yesterday filed a petition for rehearing en banc in the Sixth Circuit in the Quality Stores case, asking the full court to reverse the panel and eliminate the circuit conflict on the treatment for FICA purposes of supplemental unemployment compensation benefits. As noted in our previous post, regardless of whether the petition is granted, the mere filing of the petition has the effect of postponing the deadline for seeking Supreme Court review. The 90-day period for filing a petition for certiorari begins to run anew from the date of the resolution of the rehearing petition. Thus, if this case ultimately goes to the Supreme Court, there is no longer any realistic possibility that it would be heard this Term — that is, a decision could not be expected by June 2013.
The rehearing petition emphasizes that the issue is important, stating that $120 million is at stake in pending refund suits alone, and that a total of over $1 billion is at issue when all claims are taken into account. It also recites that the IRS has suspended action on administrative refund claims totalling over $127 million from approximately 800 taxpayers located in the Sixth Circuit.
The petition argues that the Sixth Circuit panel erred in two key respects. “First, it failed to address the actual FICA question here based on its erroneous belief that Coffy [v. Republic Steel Co., 447 U.S. 191 (1980),] establishes that SUB pay is not wages for FICA purposes.” Coffy was not a tax case, but instead was a case interpreting the Veterans’ Reemployment Rights Act, holding that SUB benefits are a “perquisite of seniority” for which returning veterans must be given service time credit for the time they spent in the military. (That may sound deadly dull, but I note parenthetically that Coffy was also my first Supreme Court argument.) On this point, the petition argues that the panel’s decision is in tension with two prior Sixth Circuit decisions holding that wages for FICA purposes is not limited to compensation for work performed.
The second error asserted in the rehearing petition is that, “in construing I.R.C. § 3402(o), the panel failed to recognize that the section’s applicability is expressly limited to income-tax withholding, which was a key factor in the Federal Circuit’s CSX decision.” That issue was a focus of the original briefing in the case, but the rehearing petition asserts that the panel failed to address it in its decision.
There is no current due date for the taxpayer’s response. Rule 40(a)(3) of the Federal Rules of Appellate Procedure provides that parties are not to respond to petitions for rehearing unless ordered by the court. Given the importance and complexity of this case, there is a strong probability that the court will order a response.
October 11, 2012
The taxpayer has filed a petition for rehearing and rehearing en banc in Historic Boardwalk, asking the Third Circuit to reconsider its decision denying the taxpayer’s claim for historic rehabilitation credits. Among other points, the petition criticizes the panel’s decision for analogizing this case to the Second Circuit’s Castle Harbour decision, TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), which found that the partner there had no downside risk that it would not recover its capital contribution. The taxpayer argues that there was a risk here that the partner would not recover its capital contribution from the partnership, and the court erred in finding that there was no risk by taking the tax credits into account. Specifically, the petition argues, “the Opinion wrongfully treats the allocation of the historic rehabilitation tax credits to [the investor] by operation of law (i.e., under the Code) as a repayment of capital to” the investor by the partnership.
There is no due date for a response by the government. Under Rules 35 and 40 of the Federal Rules of Appellate Procedure, a party is prohibited from responding to a petition for rehearing unless it is directed to do so by the court.
October 4, 2012
In our previous post discussing the pending requests for Supreme Court review of the question of the creditability of the U.K. Windfall Tax, we noted that the Court had scheduled consideration of the PPL cert petition for its October 5 conference. The Court has now postponed that consideration until its October 26 conference. The reason for the change is to allow the Court to consider the PPL petition in tandem with the government’s petition in Entergy.
This postponement allows the Court to consider the issue with the benefit of an adversarial presentation. As you will recall, the government “acquiesced” in PPL’s cert petition on the theory that the Court should resolve the circuit conflict, and therefore there are no briefs in that case arguing that the Court should deny certiorari. The same is not true in Entergy, where the taxpayer vigorously argues that the Court should deny certiorari in both cases because the issue is not sufficiently significant to warrant Supreme Court review. Entergy notes that there are only three taxpayers directly affected by the Windfall Tax issue and asserts that the Third Circuit and Fifth Circuit, though reaching different outcomes on the specific issue, do not disagree “on matters of fundamental principle” regarding the foreign tax credit provisions. Rather, Entergy characterizes the circuit conflict as reflecting “an exceedingly narrow and technical disagreement” limited to how those principles should apply to the U.K. Windfall Tax. In its reply brief, the government acknowledges that there are only three directly affected taxpayers, but argues that there is a difference between the two circuits on the “proper analytical approach” to foreign tax credit issues that could potentially lead to disparate results in cases involving other foreign taxes.
As a result of the schedule change, the Court will likely announce whether it will review the issue on its October 29 order list. It is possible, if certiorari is granted, that the Court would make that announcement on October 26 in order to give the parties a head start on the briefing.
September 10, 2012
More than two years after the appellate briefing was completed, the Sixth Circuit has finally issued its decision in Quality Stores. (See our previous coverage here.) The court ruled that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes. In so holding, the Sixth Circuit expressly declined to follow the Federal Circuit’s contrary decision in CSX Corp. v. United States, 518 F.3d 1328 (2008).
The court agreed with the taxpayer’s argument that the severance payments are not literally “wages” under the Code. Although Code section 3402(o) provides that “supplemental unemployment compensation benefits” (which the court found to include these severance payments) should be “treated . . . as wages” for income tax withholding purposes, there is no analogous directive for FICA. At the same time, relying on Rowan Cos. v. United States, 452 U.S. 247 (1981), the court ruled that the definition of “wages” is the same for income tax withholding and FICA purposes. (As discussed in prior posts, the government argues that intervening legislation has made Rowan no longer good law for that proposition.) Therefore, the court concluded, the Code does not make the severance tax payments subject to FICA taxation.
The government is likely to seek further review in this case. Given the clear circuit conflict, and the importance to the case of the continuing vitality of the Supreme Court’s decision in Rowan, this issue is certainly a candidate for Supreme Court review down the road.
A petition for rehearing is due on October 22. A petition for certiorari is currently due on December 6. That date would be pushed off if the government seeks rehearing.
September 7, 2012
The Second Circuit today affirmed the Tax Court’s decision in Union Carbide denying the research and experimentation credit for the costs of certain supplies used in production process experiments that sought to improve a process that was already in use for producing products. The court concluded that the credit is available only for the costs of supplies that would not have been incurred but for the experiment; hence, it disallowed the credit claim for the costs of other supplies that concededly were necessary for the experiment because they are otherwise necessary for the production process, but would have been incurred anyway if production had proceeded without the experimental process.
As discussed in our prior post, the taxpayer’s argument rested primarily on the plain meaning of the statute, which states that the credit is available for the cost of supplies “used in the conduct of qualified research.” 26 U.S.C. § 41(b)(2)(A)(ii). The Second Circuit held that this language is not sufficiently clear to carry the day without further inquiry. First, the court rejected the general proposition that dictionary definitions are dispositive. Second, the court stated that the taxpayer’s analysis improperly focused on the single word “used,” when it should have looked to the meaning of the more ambiguous complete phrase “used in the conduct of qualified research.”
The court then stated that it agreed with the Tax Court that the taxpayer was seeking a credit for “indirect research costs,” which are excluded from qualified research expenses under Treas. Reg. § 1.41-2(b)(2). The court did not find the regulation itself conclusive, recognizing that the regulation did not clearly explain “how one distinguishes between direct and indirect research expenses.” But the court found that this clarity was supplied by the government’s brief, stating that, on the authority of Auer v. Robbins, 519 U.S. 452, 461-62 (1997), courts “ordinarily give deference to an agency’s interpretation of its own ambiguous regulations, even if that interpretation appears in a legal brief.” (We note that Justice Scalia, the author of Auer, recently remarked that this approach is problematic because it encourages agencies to issue vague regulations and then obtain deference to their own interpretations of those regulations without subjecting the interpretations to notice-and-comment review. No other Justice, however, joined Justice Scalia’s statement that he would be open to reconsidering Auer. See Talk America, Inc. v. Michigan Bell Tel. Co., 131 S. Ct. 2254, 2266 (2011) (Scalia, J., concurring)) The Second Circuit in this respect is taking a step beyond Auer, where the agency’s interpretation was found in an amicus brief filed by a non-party rather than by a party trying to defend a particular result that is in its pecuniary interest.
The Second Circuit added that deference to this interpretation was appropriate because, based on a House Report, the court perceived the purpose of the credit to be “to provide a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur.” According to the court, “[a]ffording a credit for the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting simply creates an unintended windfall.” Judge Pooler did not embrace this part of the opinion, writing separately to note her “view that Congress may well have intended to give a tax credit for those supplies which would have been purchased absent any qualified research.” Because Congress had not expressed that intent clearly enough “so as to preclude either the Commissioner’s regulations or his interpretations,” however, she joined the majority in affirming the Tax Court.
The Union Carbide decision is a blow to manufacturers hoping for a broader reading of the R&E credit. The extent of its impact remains to be seen. R&E credit cases are fact-intensive, and the facts of this case were relatively unsympathetic to the taxpayer in that it sought a credit for costs that unquestionably would have been incurred anyway – even without the experiment – and that produced a product that was sold. Other cases involving less established processes could yield different results. And, as noted in Judge Pooler’s concurring opinion, Congress has the last word on this topic if it determines that the Second Circuit’s approach does not create a sufficient incentive for research and experimentation.
A petition for rehearing would be due on October 22.
September 5, 2012
As previously reported here a few weeks ago, PPL filed a petition for certiorari asking the Supreme Court to review the Third Circuit’s decision denying a foreign tax credit for U.K. Windfall Tax payments. Given that the Fifth Circuit had decided the same issue in the opposite way in the Entergy case, there was a significant possibility that the government would not oppose certiorari, but instead would urge the Court to resolve the circuit conflict.
The government has now decided that its interests in resolving the conflict and potentially securing a reversal in Entergy outweigh its interest in preserving its victory in PPL, and accordingly it has filed an “acquiescence” in PPL urging the Court to hear the case. In that brief, the Solicitor General makes his case for why he believes PPL was correctly decided and also for why the issue is sufficiently important to justify Supreme Court review.
On the first point, the government’s brief rejects the characterization of the U.K. Windfall Tax as an “excess profits” tax. Instead, the government says, it is “a tax on the difference between the price at which each company was sold at flotation and the price at which it should have been sold, based on its ability to generate income.”
On the latter point, the government acknowledges both that the “specific question presented in this case is . . . unlikely to recur or to have significance for a large number of U.S. taxpayers” and that, “[b]y their nature, issues regarding the regulatory tests set forth in 26 C.F.R. 1.901-2(b) will necessarily arise in cases involving specific foreign tax laws that are unlikely to affect a large number of Americans.” But the government concludes that, “[n]evertheless, this Court’s guidance on the correct analytical approach for evaluating foreign taxes under Section 901 and the Treasury regulation may have significant administrative importance beyond the specific foreign tax law at issue here” and that the interest in uniform enforcement of the tax laws further justifies Supreme Court review.
Concurrent with its filing in PPL, the government filed a “protective” petition for certiorari in Entergy. In accordance with the Solicitor General’s common practice in situations where two different cases present the same issue, that document does not ask the Court to take immediate action. Instead, it asks the Court to hold the petition and to dispose of it as appropriate in light of the final disposition of the PPL case. The Court is likely to follow that advice, which means that if the PPL petition is denied, or if the decision is overturned, the Court will just deny the Entergy petition. If the PPL decision is affirmed, the Court would then grant the Entergy petition, vacate the Fifth Circuit’s decision, and remand the case for reconsideration in light of the Court’s intervening decision in PPL.
But that is getting ahead of things. First, the Court must decide whether to hear the issue at all. It has no obligation to do so, even though both parties recommend certiorari. Presumably, the Justices have not been dreaming about the opportunity to wade through the foreign tax credit regulations, and their inherent interest (or lack thereof) in the subject matter could tip the balance if they believe the question of importance of Supreme Court review is a close call.
The PPL petition is scheduled to be considered at the Court’s October 5 conference. An announcement of whether certiorari will be granted will most likely issue either on that date or on October 9.
August 30, 2012
[Note: Miller & Chevalier filed a brief in this case on behalf of National Trust for Historic Preservation]
In a detailed 85-page opinion, the Third Circuit has reversed the Tax Court’s opinion that upheld a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. See our earlier report here. The government had argued both that the transaction lacked economic substance and that the private partner, Pitney Bowes, was not a bona fide partner in the enterprise. The Third Circuit agreed with the government’s second argument and therefore found it unnecessary to decide whether there was economic substance. Given that approach, the court stated that it would “not opine on the parties’ dispute” on whether the Ninth Circuit was correct in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in stating that the policy of providing a rehabilitation credit as a tax incentive is relevant “in evaluating whether a transaction has economic substance.” Slip op. 54 n.50. The court did make some general observations on economic substance, however, noting its agreement with amicus that the government’s position had inappropriately blurred the line between economic substance and the substance-over-form doctrine, which are “distinct” doctrines. Slip op. 52 n.50. Citing Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 484 (5th Cir. 2011), the court added that “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.” Slip op. 53 n.50.
Turning to the issue that it found dispositive, the court concluded that Pitney Bowes was not a bona fide partner because it “lacked a meaningful stake in either the success or failure of [the partnership].” Slip op. 85. In reaching that conclusion, the court relied heavily on two recent court of appeals’ decisions, the Second Circuit’s analysis of bona fide equity partnership participation in TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”) and the Fourth Circuit’s analysis of “disguised sales” in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Although the taxpayer had objected that the latter case was irrelevant because no disguised sale issue was present, the court agreed with the government’s argument in its reply brief that “the disguised-sale analysis in that case ‘touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination.’” Slip op. 67 n.54 (quoting U.S. Reply Br. 9). See our previous report here. The court elaborated on this point as follows: “Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.” Id. at 69 n.54.
The taxpayer had relied heavily on the Tax Court’s findings regarding the essentially factbound question of bona fide partnership, but the Third Circuit found that the deferential standard of review of factual findings was not an obstacle to reversal. The court first stated that “the record belies” the Tax Court’s conclusion that Pitney Bowes faced a risk that the rehabilitation would not be completed. Id. at 73. To deal with the standard of review, the court of appeals drew a hair-splitting distinction between the factual issue of “the existence of a risk” and what the court believed to be a “purely . . . legal question of how the parties agreed to divide that risk,” which “depends on the . . . documents and hence is a question of law.” Id. at 73 n.57. The court of appeals directly rejected other Tax Court findings regarding risk as “clearly erroneous.” Id. at 76.
The court did not dwell on the policy implications of its decision. It stated that it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and had not ignored the concerns expressed by the amici that a ruling for the government could “jeopardize the viability of future historic rehabilitation projects.” Id. at 84. But the court brushed aside those concerns, taking comfort in the response of the government’s reply brief that “[i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the IRS has challenged.” Id. at 85. Be that as it may, decisions like this are likely to diminish the practical effectiveness of the credit as an incentive and thus to frustrate to some extent Congress’s desire to encourage historic rehabilitation projects.
A petition for rehearing would be due on October 11.
August 6, 2012
The taxpayers have appealed to the Fifth Circuit from the Tax Court’s decision in Rodriguez v. Commissioner, No. 13909-08 (Dec. 7, 2011), which rejected qualified dividend treatment for certain amounts included in their income pursuant to Code Section 951. In 2003, Congress established a preferential tax rate for “qualified dividend income,” which includes dividends received from a qualified foreign corporation. Separately, section 951 contains provisions designed to limit tax deferrals by a “controlled foreign corporation” (CFC). Section 951 requires a taxpayer to include in income earnings of a CFC that are derived from investments in U.S real estate. The taxpayers in this case included such earnings in their income but sought to have them taxed at the favorable qualified dividend rate. In a comprehensive opinion, the Tax Court held that they were not “dividends” and hence should be taxed as ordinary income.
The taxpayers’ position was largely policy-based, arguing that the effect of the income inclusion was similar to that of a dividend, but their argument lacked strong direct support in the statutory text. As the Tax Court noted, legislative history and case law had described the section 951 inclusions as substantially equivalent to receiving dividends. See, e.g., Gulf Oil Corp. v. Commissioner, 87 T.C. 548, 571 (1986) (“Subpart F treats the amount of the increased investment much like a constructive dividend to the U.S. shareholders”). But the Tax Court concluded that this similarity did not resolve the case, observing that “to say that section 951 treats a CFC’s investments in U.S. property ‘much like’ a constructive dividend is a far cry from saying that such amounts actually constitute dividends.”
Instead, the Tax Court focused on a textual analysis. First, the court said that the section 951 inclusion did not meet the statutory definition of a dividend (Code section 316(a)) because there was no “distribution” by the corporation; a distribution cannot occur unless there is a “change in ownership of corporate property.” The court noted that the Code expressly provides that section 951 inclusions should be treated as a dividend for certain other purposes, but there is no such express provision for qualified dividend rates. See I.R.C. §§ 851(b), 904(d)(3)(G), 960(a)(1). The court also pointed to several provisions directing that other kinds of non-dividend income, such as redemptions and undistributed foreign personal holding company income, should be treated as dividends. See, e.g., I.R.C. §§ 302(a), 551(b). Given these examples of explicit dividend treatment elsewhere in the Code, the Tax Court concluded that the lack of an explicit textual basis for dividend treatment was a fatal flaw in the taxpayers’ position.
The Tax Court acknowledged that the taxpayers’ position drew support from the original 1962 Senate Report, which explained that, under Subpart F, “earnings brought back to the United States are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them.” S. Rep. No. 1881, 87th Cong., 2d Sess. 794 (1962). But the court found that this sentence was not controlling, pointing to other ways in which treatment of section 951 inclusions differs from dividends (for example, effect on earnings and profits). The court added that affording qualified dividend treatment would not advance the stated legislative purpose for the preferential interest rate.
The impact of this decision is not necessarily confined to the context of qualified dividends. Rather, its reasoning seems applicable to other contexts in which one might argue that section 951 inclusions should be treated as dividends, but where there is no explicit provision to that effect. And the shoe might be on the other foot. For example, the new health care surtax on investment income for taxpayers earning more than $250,000 defines “net investment income” as including “income from interest, dividends, annuities, royalties, and rents.” I.R.C. § 1411(c)(1)(A)(i). If the IRS would like to impose the surtax on section 951 inclusion income, its victory in Rodriguez would appear to pose an obstacle to that position.
August 1, 2012
[Note: Miller & Chevalier filed an amicus brief on behalf of American Electric Power in the PPL case.]
We have fallen behind in updating the progress of the litigation concerning the creditability of the U.K. Windfall Tax that was imposed on British utilities in the 1990s. As we previously reported, the Tax Court held in two companion cases that this tax was equivalent to an income tax in the U.S. sense of the term and hence creditable. The government took two appeals — to the Third Circuit in PPL and to the Fifth Circuit in Entergy. Those courts reached opposite conclusions, and PPL has now asked the Supreme Court to grant certiorari to resolve the conflict. (See here and here for previous posts on the parties’ briefing in these cases.)
The Third Circuit was first to rule, in December 2011, and it rejected the Tax Court’s decision in an opinion that rested in large part on arguments not made in the government’s brief. The Third Circuit focused heavily on the details of the three-part test set forth in the regulations, stating that, in focusing on the “predominant character” language in those regulations, the Tax Court had errroneously suggested that the regulation “appl[y] a ‘predominant character standard’ independent of the three requirements.” In that connection, the Third Circuit dismissed the relevance of case law that predated those regulations, notwithstanding language in the preamble indicating that Treasury did not intend to depart from that prior case law. The Third Circuit also criticized PPL’s position that the “flotation value” component of the calculation was not relevant to the three-part test because it merely defined what part of the company’s profits would be taxed as “excess.” The Third Circuit did not deny that this approach would appear to prevent any “excess profits” tax from meeting the test, but it explained that “this argument merely suggests that the regulation misinterprets the statute,” and it was too late for PPL to argue that the regulation is invalid. Finally, the court surprisingly held that the Tax Court’s decision could not be squared with Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3, an example that illustrates how the gross receipts part of the regulatory test applies in a situation where the tax base is derived indirectly from a quantity that is “deemed” to reflect gross receipts. This example is of dubious relevance to the Windfall Tax, which was based on actual profits, not a “deemed” quantity; the example was not raised in the Tax Court proceedings and was mentioned only tangentially in the government’s brief.
The Fifth Circuit had heard oral argument in Entergy a couple of months before PPL was decided, but did not issue its opinion until June 2012. The Fifth Circuit stated that “the Commissioner’s assertion that we should rely exclusively, or even chiefly, on the text of the Windfall Tax” was contrary to settled case law establishing that the form of the foreign tax is not determinative. “Viewed in practical terms,” the court continued, “the Windfall Tax clearly satisfies the realization and net income requirements.” With respect to the gross receipts part of the test, the Fifth Circuit was “persuaded by the Tax Court’s astute observations as to the Windfall Tax’s predominant character” – namely, to claw back the utilities’ excess profits.
The Fifth Circuit then addressed itself directly to the Third Circuit’s PPL decision, characterizing the latter court’s reasoning as exemplifying “the form-over-substance methodology that the governing regulation and case law eschew.” The example in the regulations relied upon by the Third Circuit is “facially irrelevant,” the Fifth Circuit observed, because “[t]he Windfall Tax relies on no Example 3-type imputed amount, nor indeed on any imputation, for calculating gross receipts.” Thus, although noting that it is “always chary to create a circuit split,” the Fifth Circuit concluded that it had to disagree with the Third Circuit and find the Windfall Tax creditable.
After its petition for rehearing en banc was denied, PPL filed a petition for certiorari on July 9. The petition emphasizes the need to resolve the circuit conflict in order to achieve uniform administration of the tax law and heavily criticizes the Third Circuit for elevating the form of the tax over its substance. For its part, the government has chosen not to seek rehearing in Entergy, bringing the schedules of the cases closer together again. A petition for certiorari in Entergy is now due on September 4. The government’s response to PPL’s cert petition is currently due August 8, but a 30-day extension is likely, which would make the response due on September 7.
The position that the government decides to take in these cases is an important factor in assessing the prospects for a grant of certiorari. Most federal tax cases heard by the Supreme Court involve clear conflicts in the circuits, and it is impossible to deny the existence of such a conflict here. But the Court does not hear every tax case that involves a circuit conflict. Rather, it agrees to hear a case only when it believes that resolution of the conflict is sufficiently important, particularly to the uniform administration of the tax laws. Historically, the Court has afforded considerable deference to the government’s advice on the question of importance. As a repeat litigant at the Court, the government is very selective in asking for Supreme Court review, on the theory that if it does not ask too often, the Court is more likely to grant its requests when it really matters. And the Court does grant a high percentage (in the neighborhood of 70%) of the government’s petitions for certiorari. Thus, in deciding whether to ask the Court to resolve this conflict, the government will weigh its own interests, including estimating its prospects for success if the Court hears the case, and make a judgment about whether it views this issue as important enough to tax administration or to the government’s bottom line to justify using one of its precious “chits.”
Although one might think that the government’s monetary interests could induce it to oppose certiorari in PPL even if were to file a cert petition in Entergy, the Solicitor General’s long-term interest in maintaining credibility with the Supreme Court would trump those short-term monetary interests. Thus, there are two likely courses of action open to the government. Either it will oppose PPL’s petition and not push for Supreme Court review in Entergy or it will file a certiorari petition in Entergy and not oppose PPL’s petition. Unless there are additional extensions, we should know in early September how the government will approach the conflict. The Supreme Court will give its answer several weeks after that.
July 27, 2012
The taxpayers have filed their opening brief (literally! only 18 pages!) in Cadrecha. They focus on two points. First, they argue that the Court of Federal Claims mistakenly relied on an IRS official’s affidavit for conclusions about what transpired in telephone conversations, when the taxpayers were not given an adequate opportunity to dispute those facts. Therefore, the court erred in ruling at the motion to dismiss stage. Second, they argue that their claim should be viewed as timely in any event. The taxpayers reason that, since the IRS’s notice of disallowance referred to a May 2007 claim, the timely March 2007 claim was never actually disallowed and the two-year statute of limitations did not begin to run. More generally, the taxpayers throw themselves on the mercy of the Federal Circuit, relying on the unfairness of having been denied a refund to which they had a substantive entitlement, when the IRS’s processing of their timely claim contributed to the apparently late filing of a refund suit.
The government’s brief is due September 7.
June 14, 2012
[Note: Miller & Chevalier represents amicus National Trust for Historic Preservation in this case.]
The Third Circuit has scheduled oral argument in the Historic Boardwalk case for June 25 in Philadelphia. (The argument previously had been tentatively scheduled for April, but was postponed.) The panel will consist of Judges Sloviter, Chagares, and Jordan.
Federal Circuit Deals Utilities a Major Victory on Interest Capitalization and Invalidates Regulation on APA Grounds
June 8, 2012
Last year’s decision in Mayo Found. for Med. Educ. and Research v. United States, 131 S. Ct. 704 (2011), was generally hailed as a big victory for the government in holding that deference to Treasury Regulations would henceforth be governed by the generally applicable Chevron standards, not by the less deferential National Muffler Dealer standards that had previously applied in tax cases. See our report here. In Dominion Resources v. United States, CAFC No. 2011-5087 (May 31, 2011), however, the Federal Circuit reminded Treasury that being treated like every other agency is not always a bed of roses – for example, you can have your regulations invalidated for the agency’s failure to provide an adequate supporting rationale when the regulations were promulgated. Together with the Supreme Court’s recent decision in Home Concrete, the courts have flashed a yellow caution light in the face of those who thought that the practical effect of Mayo would be to give Treasury almost unfettered authority to legislate by regulation.
Dominion Resources involved a complicated capitalization issue important to the utility industry. Specifically, it addressed the validity of a regulation issued under Code section 263A. In general, the Code requires that costs of improving property must be capitalized, not deducted. Certain indirect costs, like taxes and interest, must be capitalized to the extent those costs are “allocable” to improving property. Under section 263A(f)(2), allocable interest includes not only obvious expenditures like interest on a loan taken out to fund the improvements, but also interest on other indebtedness “to the extent that the taxpayer’s interest costs could have been reduced if production expenditures . . . had not been incurred.” This section implements a notion of “avoided cost” by including “interest costs incurred by reason of borrowings that could have been repaid with funds expended for construction.” S. Rep. No. 99-313, at 144.
The regulation at issue in Dominion Resources defines “production expenditures” for purposes of this avoided-cost calculation, and it includes in that amount the adjusted basis of property that must be temporarily withdrawn from service to complete the improvements. Treas. Reg. § 1.263A-11(e)(2)(ii)(B). In this case, Dominion replaced coal burners in two of its plants and had to shut them down for a few months to do the work. It challenged the validity of the regulation, which had the effect of requiring it to capitalize, rather than deduct, a larger portion of its interest on unrelated indebtedness because of the inclusion of the adjusted basis of those properties as “production expenditures” for allocation purposes.
The Court of Federal Claims ruled for the government, in an opinion that appeared to highlight the difficulty of attacking regulations that are entitled to Chevron deference. The court expressed considerable skepticism about the logic of the regulation, stating that “[i]t is stretching the statute quite far to say that the associated-property rule ‘is a “reasonable interpretation” of the enacted text’” (quoting Mayo). The government’s suggested rationales for including adjusted basis, in the court’s view, were “not very satisfying.” Indeed, one suggested rationale (the idea that the property could be sold at a value equal to its basis in order to pay down the debt) was “removed from reality” because the property was intended to remain in service. The court also suggested that the regulation was bad policy because it created a tax disincentive to improvements. In the end, however, the trial court concluded that it is a “very close case” and that it “cannot say that the Treasury overstepped the latitude granted by the statute to adopt regulations” – in other words, the Chevron Step 2 bar of being a “reasonable” interpretation of the statute is sufficiently low that the regulation should survive despite the court’s criticism.
The Court of Federal Claims also responded to the taxpayer’s argument that the regulations failed to comply with the Administrative Procedure Act. Treasury regulations traditionally have not often been challenged on APA grounds, but Mayo’s holding that such regulations should be given the same deference as regulations issued by other agencies has brought to the fore the idea that other general administrative law principles, including APA rules, should apply equally to Treasury regulations. (Judge Holmes of the Tax Court has been particularly outspoken about the applicability of the APA and general administrative law principles to tax cases – both on the bench (see his concurring opinion in the Intermountain case, 134 T.C. 211, 222-23 (2010), which was recently upheld by the Supreme Court on other grounds in Home Concrete) and off the bench (see Shamik Trivedi, Mayo Increases Taxpayer Chances of Success, Judge Says, Tax Notes, June 27, 2011, p. 1319)).
In Dominion Resources, the taxpayer argued that the regulation ran afoul of the APA’s “arbitrary [and] capricious” standard on the grounds addressed in Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). The Supreme Court there stated that an agency must “articulate a satisfactory explanation for its action,” that is, “cogently explain why it has exercised its discretion in a given manner.” Id. at 43. The trial court in Dominion Resources found that it was “a stretch to conclude” that Treasury had provided this cogent explanation, but observed that Treasury’s “lack of exactitude and the ensuing confusion do not signify that Treasury acted to establish the final rule in an arbitrary and capricious manner.” Instead, the court seized on the Supreme Court’s statement in State Farm that “a decision of less than ideal clarity” can be upheld “if the agency’s path may reasonably be discerned.” Id. The court held that Treasury’s “‘path’ . . . can be ‘discerned,’ albeit somewhat murkily,” and on that basis it rejected the APA challenge.
The Federal Circuit was less forgiving, and it invalidated the regulation. The majority (Judges Rader and Reyna) agreed with both of the taxpayer’s primary arguments. With respect to the Chevron analysis, the majority echoed the trial court’s criticisms of the regulation and concluded that they required a different outcome. The majority stated that the regulation passed Chevron Step 1, “but only because the statute is opaque” and therefore “ambiguous.” But the regulation failed the Step 2 reasonableness test because, in the majority’s view, it “directly contradicts the avoided-cost rule that Congress intended the statute to implement.” Moreover, the court stated, the regulation “leads to absurd results” because it “can require capitalizing vastly different amounts of interest for the same improvements” – if the different properties had different adjusted bases. The court noted that the Court of Federal Claims had correctly described the government’s argument that the property owner could have sold the unit in order to pay the debt as “removed from reality,” but found that the trial court erred in excusing that “fiction [as] a ‘policy choice’ by the agency and thus permissible.” Because the government’s proffered rationale was unreasonable, “the regulation is not a reasonable interpretation of the statute.”
The Federal Circuit also ruled that the trial court had erred in rejecting the taxpayers’ APA argument. The court stated that the notice of rulemaking “provides no explanation for the way that use of an adjusted basis implements the avoided-cost rule” and hence failed to satisfy the State Farm requirement that “the regulation must articulate a satisfactory or cogent explanation.”
Judge Clevenger concurred in the result, agreeing with the majority’s APA analysis but disagreeing with its Chevron analysis. In his view, the majority’s approach swept too broadly because it “creates a binding rule . . . that the government can never re-promulgate its associated-property rule for property temporarily withdrawn from service, no matter how well-formed its reasoning.” Judge Clevenger would have preferred a narrower resolution that deemed the regulation “procedurally unlawful” for the government’s failure to “articulat[e] any rational explanation for many details of the regulation . . . up to the current date.” That approach “would give the government another chance to explain and justify its view that the adjusted basis of property temporarily withdrawn from service can be taken into account in determining production expenses.”
Judge Clevenger then went on to provide a possible rationale for the regulation, describing it as an attempt to approximate “opportunity costs” — that is, “the lost value associated with the withdrawal of property from service” – in a way that does not present overwhelming administrative difficulties. He did not dispute the majority’s criticism of the notion that the taxpayer could have sold the property to service the debt as “fiction.” But he asserted that “the avoided cost rule is in its entire concept a fiction,” and therefore this was not enough of a reason to conclude that the regulation fails Chevron Step 2.
The Dominion Resources opinion is significant on two levels. First, the specific holding concerning whether adjusted basis plays a role in determining how much interest must be capitalized to improvements resolves a recurring issue that is particularly important in the utility industry and can involve significant amounts of tax. Second, the APA holding that Judge Clevenger characterized as “narrower” may in fact have an even broader impact. It is not unusual for Treasury regulations to be accompanied by a less-than-illuminating explanation of how the regulation implements the statutory purpose. In the wake of Dominion Resources, taxpayers can be expected to raise APA challenges to such regulations, and some of those may succeed. As Judge Clevenger stated, the impact of invalidation on State Farm grounds presumably can be limited by repromulgating the regulation with a satisfactory explanation. But unless retroactive application of the repromulgated regulation can be justified, Treasury would stand to lose the benefit of the regulation for a significant period. Thus, one ancillary effect of increased scrutiny of Treasury regulations on State Farm grounds could be increased litigation over Treasury’s power to issue retroactive regulations – an issue that the Supreme Court did not touch in Home Concrete (see our report here).
Given the significance of the decision, it would not be surprising for the government to seek further review. A petition for rehearing en banc would be due on July 16.
May 30, 2012
In Cadrecha v. United States, No. 11-152 (Apr. 2, 2012), the Court of Federal Claims ruled that the taxpayers could not escape the clutches of the statute of limitations, even though the failure to file a timely lawsuit was largely attributable to contradictory and confusing IRS communications. The taxpayers have now appealed, hoping that the Federal Circuit will be more sympathetic.
The Court of Federal Claims acknowledged that the result was “harsh” on these facts. The taxpayers filed a timely amended return in March 2007, styled as a protective claim for refund, on the theory that a recent Court of Federal Claims decision (Fisher) entitled the taxpayers to a refund of gains reported from the sale of stock received as a result of an insurance company demutualization. (That decision was affirmed by the Federal Circuit in October 2009). After the three-year statute of limitations had expired, the IRS responded by asking for more “supporting information” and invited the taxpayers to file another claim identifying the court case on which it relied. The taxpayers replied to this letter in May 2007, identifying the case.
The IRS then sent a couple of letters indicating that it needed more time to respond. Thereafter, in August 2007, it sent a notice disallowing the claim on the ground that it was untimely. This disallowance was patently erroneous, as the IRS apparently overlooked the March 2007 amended return and instead treated the May 2007 supplementary letter as if it were the original refund claim. The letter disallowing the claim invited the taxpayers to appeal the disallowance to the IRS Appeals Office and also stated that the taxpayers had two years to file a refund suit.
The taxpayers immediately responded with a letter pointing out that the IRS had erred in ignoring the March 2007 filing. There ensued a succession of communications from the IRS — at least seven letters plus some oral conversations — in which the IRS reported various transfers to different IRS offices and that it needed more time to research the issue. By the time the taxpayer lost patience with this process and filed suit in the Court of Federal Claims, more than two years had elapsed since the disallowance letter was sent. The court therefore dismissed the suit as untimely – even though there was no question that the IRS’s ground for disallowance (an allegedly untimely refund claim) was erroneous and that the taxpayer’s position was correct on the merits under Federal Circuit precedent. The court acknowledged that this result was “harsh” because the untimeliness was, in large part, attributable to the IRS’s own behavior; the court found that “[a]s a result, to some degree, of the IRS’s actions, plaintiffs may have come to believe that the IRS was continuing to analyze their refund claim and that the IRS was in the process of reconsidering the notice of disallowance.”
The court held, however, that there was no legal basis for excusing the taxpayers’ failure to file suit within the two-year limitations period. The taxpayers relied upon cases that excused apparent statute of limitations problems on the ground that the IRS had orally withdrawn a notice of disallowance. The court found those cases distinguishable, observing that neither the notice of disallowance nor the timeliness issue was mentioned in any of the IRS correspondence — though that correspondence certainly suggested that the taxpayers’ claim was still under active consideration at the IRS. The court then added that the law does not permit equitable tolling of the statute of limitations and therefore, if the notice was not withdrawn, it made no difference “if the actions of the IRS misled or confused the taxpayer.”
May 29, 2012
Long-time readers of the blog may recall our coverage of the Federal Circuit’s stumbles through TEFRA in the Bush litigation, where a panel issued a surprising decision finding that a notice of deficiency was required to make what was previously understood as a mere TEFRA computational adjustment, but that the IRS’s failure to issue the notice was harmless error. Both sides cried foul, and the en banc court overturned the panel’s decision. The Supreme Court this morning today denied the taxpayers’ petition for certiorari, meaning that the case has reached the end of the line, which turns out to be pretty much where the Court of Federal Claims put the case in the first place.
Home Concrete Decision Leaves Administrative Law Questions Unsettled While Excluding Overstatements of Basis from Six-Year Statute of Limitations
May 3, 2012
[A shorter version of this blog post appears on SCOTUSblog.]
The Supreme Court last week ruled 5-4 in favor of the taxpayer in Home Concrete, thus putting an end to the long-running saga of the Intermountain litigation on which we have been reporting for the past 18 months. The opinion was authored by Justice Breyer and joined in full by three other Justices, but Justice Scalia joined only in part. The result is a definitive resolution of the specific tax issue – the six-year statute of limitations does not apply to an overstatement of basis. But the Court’s decision provides a much less definitive resolution of the broader administrative law issues implicated in the case.
As foreshadowed by the oral argument (see our previous report here), the tax issue turned on the continuing vitality of the Court’s decision in The Colony, Inc. v. Commissioner, 357 U.S. 28 (1958). To recap, the Court held in Colony that the “omits from gross income” language in the 1939 Code did not encompass situations where the return understates gross income because of an overstatement of basis, and hence the extended six-year statute of limitations did not apply in those situations. The government argued that Colony did not control the interpretation of the same language in current section 6501(e) of the 1954 Code, because changes elsewhere in that section suggested that Congress might have intended a different result in the 1954 Code.
The administrative law issues came into play because, after two courts of appeals had ruled that Colony controlled the interpretation of the 1954 Code, the government tried an end run around that precedent. Treasury issued regulations interpreting the “omits from gross income” language in the 1954 Code as including overstatements of basis, thus bringing those situations within the six-year statute of limitations. Under National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005), the government argued, an agency is empowered to issue regulations that define a statute differently than an existing court decision, so long as the court decision did not declare the statutory language unambiguous. Because the Colony opinion had indicated that the 1939 Code language standing alone was “not unambiguous,” the government argued that Treasury’s new regulations were entitled to Chevron deference, which would supplant any precedential effect that Colony would otherwise have on the interpretation of the 1954 Code provision.
The Court’s Opinion
Justice Breyer wrote the opinion for the Court, joined in full by Chief Justice Roberts and Justices Alito and Thomas. Justice Scalia joined Justice Breyer’s analysis of the statute, but departed from his analysis of the administrative law issues.
The opinion dealt straightforwardly with the basic tax issue. First, the Court emphasized that the critical “omits from gross income” language in the current statute is identical to the 1939 Code language construed in Colony, and it recounted the Colony Court’s reasoning that led it to conclude that the language does not encompass overstatements of basis. Colony is determinative, the Court held, because it “would be difficult, perhaps impossible, to give the same language here a different interpretation without effectively overruling Colony, a course of action that basic principles of stare decisis wisely counsel us not to take.” With respect to the statutory changes made elsewhere in section 6501(e), the Court concluded that “these points are too fragile to bear the significant argumentative weight the Government seeks to place upon them.” The Court addressed each of these changes and concluded that none called for a different interpretation of the key language (and that one of the government’s arguments was “like hoping that a new batboy will change the outcome of the World Series”).
The Court then turned to the administrative law issues, reciting the government’s position that, under Brand X, the new regulations were owed deference despite the Court’s prior construction of the language in Colony. The opinion first responded to that position with a two-sentence subsection: “We do not accept this argument. In our view, Colony has already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency.”
Standing alone, that was not much of a response to the government’s Brand X argument, because Brand X said that the agency can adopt a construction different from that provided in a prior court decision so long as the statute was ambiguous. These two sentences were enough for Justice Scalia, however, and he ended his agreement with Justice Breyer’s opinion at this point. In a separate concurring opinion, Justice Scalia explained that he is adhering to the view expressed in his dissent in Brand X that an agency cannot issue regulations reinterpreting statutory language that has been definitively construed by a court.
With the other Justices in the majority not feeling free to ignore Brand X, Justice Breyer’s opinion (now a plurality opinion) then proceeded to explain why Brand X did not require a ruling for the government. According to the plurality, Brand X should be given a more nuanced reading than that urged by the government, one that looks to whether a prior judicial decision found a statute to be “unambiguous” in the sense that the court concluded that Congress intended to leave “‘no gap for the agency to fill’ and thus ‘no room for agency discretion.’” Under Chevron jurisprudence, the opinion continued, unambiguous statutory language provides a “clear sign” that Congress did not delegate gap-filling authority to an agency, while ambiguous language provides “a presumptive indication that Congress did delegate that gap-filling authority.” That presumption is not conclusive, however, and thus this reading of Brand X leaves room for a court to conclude that a judicial interpretation of ambiguous statutory language can foreclose an agency from issuing a contrary regulatory interpretation. In support of that proposition, the plurality quoted footnote 9 of Chevron, which states that “[i]f a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law and must be given effect.”
The plurality then ruled that the Court in Colony had concluded that Congress had definitively resolved the legal issue and left no gap to be filled by a regulatory interpretation. Given its analysis of the scope of Brand X, the plurality explained that the Colony Court’s statement (26 years before Chevron) that the statutory language was not “unambiguous” did not necessarily leave room for the agency to act. Rather, the Colony Court’s opinion as a whole – notably, its view that the taxpayer had the better interpretation of the statutory language and had additional support from the legislative history – showed that the Court believed that Congress had not “left a gap to fill.” Therefore, “the Government’s gap-filling regulation cannot change Colony’s interpretation of the statute,” and the Court today is obliged by stare decisis to follow it.
The Concurring and Dissenting Opinions
Justice Kennedy’s dissent, joined by Justices Ginsburg, Sotomayor, and Kagan, reached a different conclusion on the basic tax dispute. The dissent looked at the statutory changes made in the 1954 Code and concluded that they are “meaningful” and “strongly favor” the conclusion that the “omits from gross income” language in the 1954 Code should not be read the way the Colony Court read that same language in the 1939 Code. Given that view, the administrative law issue – and the resolution of the case – became easy. The dissent stated that the Treasury regulations are operating on a blank slate, construing a statute different from the one construed in Colony, and therefore they are owed Chevron deference without the need to rely on Brand X at all.
Justice Scalia’s concurring opinion declared a pox on both houses. He was extremely critical of the plurality’s approach, accusing it of “revising yet again the meaning of Chevron . . . in a direction that will create confusion and uncertainty.” He also criticized the dissent for praising the idea of a “continuing dialogue among the three branches of Government on questions of statutory interpretation,” when the right approach should be to say that “Congress prescribes and we obey.” Justice Scalia concluded: “Rather than making our judicial-review jurisprudence curiouser and curiouser, the Court should abandon the opinion that produces these contortions, Brand X. I join the judgment announced by the Court because it is indisputable that Colony resolved the construction of the statutory language at issue here, and that construction must therefore control.”
What Does It Mean?
The Home Concrete decision provides a clear resolution of the specific tax issue. The six-year statute of limitations does not apply to overstatements of basis. The multitude of cases pending administratively and in the courts that involve this issue will now be dismissed as untimely, leaving the IRS unable to recover what it estimated as close to $1 billion in unpaid taxes.
Indeed, in a series of orders issued on April 30, the Court has already cleared its docket of the other Intermountain-type cases that had been decided in the courts of appeals and kept alive by filing petitions for certiorari. In Burks and the other Fifth Circuit cases in which the taxpayers had prevailed, the Court simply denied certiorari, making the taxpayers’ victory final. For the certiorari petitions filed from courts of appeals that had sided with the government, such as Grapevine (Federal Circuit), Beard (Seventh Circuit), Salman Ranch (Tenth Circuit), and Intermountain and UTAM (D.C. Circuit), the Court granted the petitions and immediately vacated the court of appeals decisions and remanded the cases to the courts of appeals for reconsideration. Now constriained by Home Concrete, those courts will enter judgments in favor of the taxpayers in due course.
Notably, although the retroactive nature of the Treasury regulations was a significant point of contention in the litigation, retroactivity did not play a role in the final resolution. The Court held that Colony is controlling and leaves no room for the agency to construe the “omits from gross income” language differently. Thus, Treasury does not have the ability to use its regulatory authority to extend the six-year statute to overstatements of basis even prospectively. Any such extension will have to come from Congress.
The effect of the decision on administrative law generally is considerably more muddled. First, a couple of observations on what the Court did not do. It did not signal any retreat from Mayo. Treasury regulations addressed to tax issues will continue to be judged under the same Chevron deference principles that apply to regulations issued by other agencies. Furthermore, as noted above, the Court did not rely on the retroactive aspect of the regulations. Thus, the decision does not provide guidance one way or another on the extent to which Treasury is constrained in its ability to apply regulations to earlier tax years.
What the Court did do, however, is to weaken the authority of Brand X. Under the reasoning of Justice Breyer’s plurality opinion, courts are now free to decline to defer to a regulatory interpretation that construes ambiguous statutory language – if the court concludes that a prior court decision, using “traditional tools of statutory construction” that go beyond the text, determined that Congress intended to resolve the issue rather than leave a gap for the agency to fill. Although there were only four votes for that proposition, Justice Scalia’s approach would lead him to agree with such a result just as he did in Home Concrete, so lower courts may treat the plurality opinion as controlling. There is, however, room for debate about the impact of the Home Concrete approach. Justice Breyer’s opinion emphasizes the fact that Colony was decided long before Chevron, and lower courts may disagree regarding its impact when the court decision at issue is post-Chevron and, in particular, post-Brand X. At a minimum, the Home Concrete decision should make agencies less confident in their ability to use regulations to overturn judicial interpretations of statutes and should give taxpayers more ammunition to challenge such regulations if necessary.
Interestingly, Justice Breyer’s approach, and in particular his invocation of Chevron’s footnote 9 reference to “traditional tools of statutory construction,” was previewed in the argument in the Federal Circuit in the Grapevine case. As we reported at the time, that argument involved considerable discussion of whether the determination of “ambiguous” at Chevron step 1 must be based entirely on the statutory text, as Brand X suggests, or can be based on other “traditional tools of statutory construction,” as Chevron footnote 9 declares. In its decision, the Federal Circuit stuck to the statutory text and ruled for the government.
Justice Breyer’s opinion, however, supports the proposition that Chevron step 1 analysis can look beyond the statutory text. If that portion of Justice Breyer’s opinion had commanded a majority, it would be extremely significant because it would justify looking beyond the statutory text not only in assessing the impact of Brand X when there is a court decision on the books, but also in considering a Chevron deference argument in the first instance. A court could decide, under the approach suggested by Justice Breyer, that a statute whose text standing alone is ambiguous nonetheless leaves no room for agency interpretation – if other tools of statutory construction show that Congress intended to resolve the issue rather than leaving a gap for the agency. On this point, however, the plurality opinion cannot be treated as controlling because Justice Scalia would surely look askance at a decision that used legislative history to find a lack of ambiguity at Chevron Step 1. By the same token, the dissenters had no occasion to address this point, so we do not know if any of them would have agreed with Justice Breyer’s approach. For now, it is fair to say that Justice Breyer has heightened the visibility and potential importance of Chevron footnote 9, but that Home Concrete alone probably will not yield a significant change in how courts approach Chevron step 1.
In sum, Home Concrete may be a bit of a disappointment to those observers who thought that the decision would bring great clarity to the administrative law issues presented. In that respect, it joins a long list of administrative law cases that reach the Supreme Court and seem to yield as many questions as answers. But for the taxpayers with millions of dollars riding on the difference between a three-year and six-year statute of limitations, the decision is not disappointing at all. It is a huge victory.
Second Circuit to Resolve Disagreement Between Tax Court and Federal Circuit Over Availability of Interest Netting for Pre-1998 Tax Periods
April 24, 2012
[Note: Miller & Chevalier represents the taxpayer Exxon Mobil Corp. in this case.]
The government has appealed the Tax Court’s decision on interest netting in Exxon Mobil Corp. v. Commissioner, 136 T.C. No. 5 (Feb. 3, 2011). The briefing is now complete, and the Second Circuit (Judges Cabranes, Walker, and Winter) is scheduled to hear oral argument on April 25.
Congress expressly required global interest netting by enacting Code section 6621(d) in 1998. Before then, the IRS had sometimes taken advantage of the differential interest rates established in 1986 to collect net interest when no net tax was due. Specifically, for periods of overlapping indebtedness where the taxpayer owed money to the government for one tax year but the government owed money to the taxpayer for a different tax year, the government would not net the overlapping amounts, but rather would collect interest at the higher underpayment rate while paying interest to the taxpayer at the lower overpayment rate on the same amount. Section 6621(d) ended this practice by providing that “the net rate of interest . . . on such amounts” of overlapping indebtedness “shall be zero.” That net rate of zero can be implemented either by increasing the overpayment rate or decreasing the underpayment rate from what they would otherwise be in the absence of interest netting. Section 6621(d) applies prospectively without restriction, but Congress also enacted a “special rule” that makes the interest netting rule also apply to pre-1998 periods of overlapping indebtedness in certain circumstances. The Exxon Mobil case involves the construction of that special rule.
The special rule provides that section 6621(d) applies to past periods “[s]ubject to any applicable statute of limitation not having expired with respect to either a tax underpayment or a tax overpayment” on the July 22, 1998, effective date of section 6621(d). Taxpayers interpret this provision to mean that interest netting is available for past periods so long as the statute of limitations for either of the overlapping periods of indebtedness was open on the effective date. The IRS, however, has interpreted the special rule to mean that interest netting is available for past periods only if the statute of limitations for both of the overlapping periods of indebtedness was open on the effective date.
The issue was first litigated by Fannie Mae in the Court of Federal Claims, which held that the special rule was best read in accordance with the taxpayer’s position. The Federal Circuit, however, reversed. Federal National Mortgage Ass’n v. United States, 379 F.3d 1303 (Fed. Cir. 2004), rev’g, 56 Fed. Cl. 228 (2003). The Federal Circuit did not take issue with the statutory analysis of the Court of Federal Claims, but instead relied on an argument that was not presented below. The Federal Circuit reasoned that the special rule was a waiver of sovereign immunity that must be strictly construed in favor of the government; since the statutory language was capable of being read to support either position, the court concluded, that strict construction principle required a ruling in the government’s favor.
The Exxon Mobil case raises the same issue, but it arises in a different procedural posture and hence in a different jurisdiction. Exxon petitioned the Tax Court for a redetermination of deficiencies for its 1979-1982 tax years, and the Tax Court’s determination eventually resulted in an overpayment. The IRS paid interest on that overpayment at the regular overpayment rate, unadjusted for the fact that interest netting principles would have called for a higher rate because there was a period of overlapping indebtedness with underpayments that Exxon owed for the 1975-78 tax years. Exxon Mobil then filed a motion for redetermination of interest under Code section 7481 seeking additional overpayment interest through application of the interest netting rule of section 6621(d).
The IRS argued that interest netting did not apply because the statutes of limitations for the 1975-78 tax years were no longer open on July 22, 1998, although it acknowledged that the statutes of limitations for the overpayment leg of the overlap period were open on that date. The Tax Court declined to follow the Federal Circuit’s view and rejected the IRS’s argument. The Tax Court stated that “the special rule is not a waiver of sovereign immunity but an interest rate provision.” It added that, even if it were a waiver of sovereign immunity, that would not require the court to adopt a reading that contravened Congress’s intent to achieve the remedial purpose of relieving taxpayers from paying interest when no net tax was due.
The government’s brief on appeal relies heavily on the Federal Circuit’s decision in Fannie Mae. It argues that the Tax Court erred in rejecting the basic principle of that decision, asserting that “the special rule is a waiver of sovereign immunity because it authorizes recovery of certain retroactive refund claims for overpaid interest and thus ‘discriminates between those claims for overpaid interest Congress has authorized and those it has not’” (quoting Fannie Mae, 379 F.3d at 1310). Exxon Mobil’s brief first addresses the special rule independently, asserting that the natural reading of the text and the evident purpose of the special rule both indicate that Congress intended to allow interest netting for pre-1998 periods so long as one leg of the overpayment period was open. The brief then addresses the government’s sovereign immunity argument, arguing that the special rule is not a waiver of sovereign immunity and, even if it were, the canon of construction would not justify adopting an interpretation that would thwart the evident intent of Congress.
April 3, 2012
As we previously reported, Day 1 of last week’s oral argument in the Supreme Court on the challenges to the health care legislation focused on whether the Anti-Injunction Act bars the lawsuits. The excitement about the argument on that issue was largely gone as soon as it was over, because it was fairly apparent that the Court will not find the Act to be an obstacle to reaching the merits of the health care dispute. Indeed, Robert Long, the lawyer who argued as amicus for that position, has predicted that he will not get a single vote. Certainly the argument was almost completely forgotten by the next day when the Court’s questioning on the constitutionality of the individual mandate led many observers to conclude that the mandate will be invalidated. (For the record, my opinion is that the health care legislation will survive, but that topic is beyond the scope of this blog.) Still, the Court’s decision to reject the applicability of the Anti-Injunction Act could have precedential significance, depending on the rationale that the Justices use. Therefore, we briefly recount the argument here with that issue in mind.
There were two basic arguments made for holding that the health care lawsuits could proceed despite the Anti-Injunction Act. The primary argument was that the Act by its terms did not apply – that is, that for a variety of reasons the “penalty” for failing to obtain health insurance is not a “tax” within the meaning of the Anti-Injunction Act. Both the challengers to the health care legislation and the United States took this position. Preliminary to this statutory interpretation question, however, was the argument that the Anti-Injunction Act should not apply in this case — even if the health care penalty would ordinarily come within the ambit of the Anti-Injunction Act — because the government had waived the defense and urged that the lawsuits should proceed. The validity of that waiver argument turns on whether the Anti-Injunction Act is “jurisdictional,” meaning that it addresses a court’s jurisdiction or power to hear a case, as opposed to being a “claim processing rule.”
A court does not have the authority to create its own jurisdiction, even if both parties want it to hear the case. Thus, if a statute is “jurisdictional,” a court is obliged to examine jurisdiction on its own and to dismiss the case if it finds that the statutory conditions are not met. Conversely, if a statutory condition is not jurisdictional, then a party can waive satisfaction of that condition and the court can proceed to hear the case. (For example, many exhaustion requirements or statutes of limitations are not jurisdictional, see Reed Elsevier, Inc. v. Muchnick, 130 S. Ct. 1237 (2010); Day v. McDonough, 547 U.S. 198, 205-06 (2006)). In the health care litigation, although the United States wanted the lawsuits to proceed, it took the position that the Anti-Injunction Act is “jurisdictional” and therefore (in contrast to the challengers to the law) argued that the Court could proceed to hear the case only if it concluded that the Anti-Injunction Act by its terms did not apply to the “penalty” for failing to obtain insurance.
If the Court were to resolve the case on waiver grounds, concluding that the Anti-Injunction Act is not jurisdictional, that could create opportunities for taxpayers in future cases if a government attorney overlooks an Anti-Injunction Act defense. It also would give the government flexibility to assert the defense when it wants, but to allow cases like the health care challenge to go forward if the government determines that it wants a prompt answer. The government, however, is concerned about a holding that the Anti-Injunction Act is not jurisdictional, because courts are freer to adopt equitable exceptions to non-jurisdictional statutes.
At the oral argument, the Justices explored both possible grounds for resolving the issue. Chief Justice Roberts and Justice Alito seemed the most interested in concluding that the Act is not jurisdictional and thus giving effect to the government’s waiver. Roberts described as the “biggest hurdle” to the Anti-Injunction Act argument a 1938 case in which the Court had gone ahead and decided an issue apparently barred by the Act after the government had waived its defense. When counsel responded that the case was no longer good law and pointed out that the Court had since repeatedly referred to the Act as “jurisdictional,” Alito forced him to concede that the Court had never actually held that the statute was “jurisdictional” in a case where that characterization would make a difference. Justices Ginsburg, Kagan, and Sotomayor all joined in that line of questioning, pointing to similarly worded statutes or precedents that in Justice Sotomayor’s words indicated that “Congress has accepted that in the extraordinary case we will hear the case.”
As the argument progressed, however, it appeared less likely that a majority would coalesce around this position. Justice Breyer volunteered that he was inclined to agree that the Anti-Injunction Act is jurisdictional, but that he doubted it applied to the health care legislation. Sotomayor indicated that she thought this position, which is what was being espoused by the government, was the least problematic. Justice Ginsburg suggested that she sided with the position that the Act did not apply, observing that this conclusion would make it unnecessary to resolve the thornier “jurisdictional” question.
Although it is always hazardous to predict outcomes based on questions asked at oral argument, the most likely outcome appears to be that the majority of Justices will address the merits of the Anti-Injunction Act issue, rather than relying on the government’s waiver of the defense. If so, the decision will not foreclose courts in the future from applying the Anti-Injunction Act when the government has failed to raise the defense or deliberately chosen not to raise it.
A decision is expected in the last week of June, perhaps June 28, and will surely be overshadowed by the Court’s contemporaneous decision on the constitutionality of the health care legislation.
April 2, 2012
We present here a guest post by our colleague Patricia Sweeney:
On March 29, 2012, the Second Circuit heard oral arguments in Union Carbide Corp. & Subsidiaries v. Commissioner, No. 11-2552 (Judges Straub, Pooler & (visiting district court Judge) Korman on the panel ). The case involves Union Carbide Corp’s (“UCC’s”) claim for research and experimentation credits with respect to 106 research projects. In order to resolve the issues expeditiously, the parties agreed that the Tax Court would limit trial to the five largest projects. All five projects involved process experimentation after products were placed in commercial operation. For two of the five projects, the Tax Court held that the projects involved qualified research, but it determined that the costs of materials incurred to produce the commercial product necessary for UCC to conduct the process research were not eligible for the credit. UCC has appealed this holding, as well as the Tax Court’s separate conclusion that one of the other projects did not involve a process of experimentation because UCC did not conduct additional post-test analysis after it determined that the test was successful. The Second Circuit’s decision with respect to the costs of materials issue could have widespread implications for taxpayers claiming the research credit.
Background Regarding the R&E Credit. To be eligible for the research credit under section 41(a)(1) of the Code, a taxpayer must show that it has performed “qualified research.” To be qualified research: (1) the research must be eligible as research under section 174 of the Code; (2) the research must be undertaken for the purpose of discovering technological information; (3) the taxpayer must intend for the discovered information to be useful in the development of a new or improved business component; and (4) substantially all of the research activities must constitute elements of a process of experimentation. These tests are applied separately to each “business component.” Section 41(d)(2)(C) provides that the development of an improved process is a separate business component from the product being produced. At the same time, the Code generally provides in section 41(d)(4)(A) that research conducted after the beginning of commercial production of the business component is not eligible for the research credit. Because the products in issue were all in commercial production, the “improved process” rule is critical to UCC’s position to avoid the expenses from being declared ineligible for the research credit under section 41(d)(4)(A).
The research credit is computed by reference to qualified research expenses (“QREs”), including “any amount paid or incurred for supplies used in the conduct of qualified research . . .” other than land, improvements to land, and depreciable property. I.R.C. § 41(b)(2)(A). In a post-Union Carbide decision, TG Missouri v. Commissioner, 133 T.C. 278 (2009), the IRS did not challenge, and the Tax Court allowed without discussion, the inclusion in the QREs of material costs for production molds sold to clients. In Trinity Industries v. United States, 691 F.Supp. 2d 688, 697 (2010), the U.S. District Court for the Northern District of Texas expressly allowed the material costs incurred to construct ships because it concluded that the costs “are properly considered research expenditures in that the business component – the ship – could not have been developed without them.”
The Parties’ Briefs with Respect to the Supplies Argument. As previously noted, although the Tax Court agreed that 2 of the 5 projects in issue were qualified research and that the experiments could not have occurred without the supplies claimed by UCC (a process cannot be tested unless it is applied to the production of the product), it concluded that the supplies were not “used in the conduct of” the process of experimentation with respect to process development. Instead, the court allocated the supply costs to the product business component and disallowed all the supplies claimed. In essence, the court established a primary purpose test, and concluded that the primary purpose of the expenditures was to produce the commercial product, not to conduct research. In this context, the Tax Court noted that the supply costs in issue were “at best, indirect research expenditures excluded from the definition of QREs.”
In its briefs, UCC argues that the Tax Court has created an inappropriate distinction between product and process experimentation. It maintains that the Tax Court erred when it created two new requirements, i.e., that in addition to being used in the conduct of research, the costs must have been “primarily” incurred as a result of the process experimentation, and that supplies incurred both to produce a product and to be used in process experimentation are not primarily incurred in process experimentation. There is nothing in the Code, regulations or legislative history to indicate that the qualification of supplies as QREs turns on whether they are incurred with respect to process or product experimentation. Moreover, there is nothing in the Code, regulations or legislative history that either creates a hierarchy that would allocate the costs solely to the production of the product or disallows such costs as “indirect costs.” UCC argues that the Second Circuit should apply the plain meaning of the statute, which provides that costs “used in the conduct of qualified research” qualify for the credit. There is no dispute that UCC could conduct its process experimentation only if it produced the product in issue. As a result, UCC maintains that the material costs were necessary for the process experimentation, were at risk in that experimentation, and therefore, must be included in the QREs.
As noted by UCC, the government in its brief did not attempt to reconcile the Tax Court’s decisions in UCC and TG Missouri, or the Trinity decision. It distinguished these other two decisions as involving product rather than process experimentation, stating “in each of these cases . . . the supply costs found to be eligible for the credit were the direct, incremental cost of performing the qualified research.” The focus of the government’s argument in its brief is that the costs of supplies to produce goods for sale are “indirect research expenses,” which are excluded from the definition of QREs under Treas. Reg. § 1.41-2(b)(2) because they are expenses that would have been incurred regardless of any research activities. The government argues that Congress intended that only the incremental costs arising from the research are sufficiently “direct” to qualify as QREs. For support, it cites other limitations restricting the availability of the credit – such as the limitations on qualified research to a discrete business component or to pre-commercial production. It further asserts that it is unreasonable to claim supply costs that otherwise would have been incurred in commercial production.
The Potential Impact. As noted in an amicus brief filed by the National Association of Manufacturers, the American Chemistry Council, and the Chamber of Commerce of the United States, the Second Circuit decision could have a wide impact on U.S. manufacturers. If the Tax Court’s decision is sustained, the incentive that Congress intended by allowing the research credit could be significantly curtailed. Moreover, as pointed out by both the amicus brief and UCC, such a decision would ignore the significant risks associated with process research and create an inappropriate distinction between product and process research. However, there could be an even worse result for taxpayers than an affirmance of the Tax Court decision. As noted by UCC in its briefs, the government’s argument that production costs are not QREs could be extended to product research. If the Second Circuit accepted that extension, it could conclude that only incremental production costs qualify as QREs, a decision that would have much broader ramifications and that would be at odds with the decisions in both TG Missouri and Trinity. Time will tell.
We will return soon with a report on the oral argument.
March 16, 2012
The Supreme Court is preparing to hold oral arguments on its long-awaited consideration of the constitutionality of the health care legislation. The arguments will cover four distinct issues in three different cases and occur over three days, March 26-28. The most prominent issue, of course, is whether the “individual mandate” requiring almost everyone to have health insurance is constitutional. Additional issues are “severability” (whether the entire law must be struck down if the individual mandate provision is unconstitutional or whether other portions of the law can survive) and whether the Medicaid expansion provisions of the law are impermissibly “coercive.”
But leading all of this off on March 26 in HHS v. Florida, No. 11-398, is a tax issue – whether the challenges to the law are barred by Code section 7421, the Tax Anti-Injunction Act. Former Solicitor General Paul Clement is slated to argue the other three issues for the challengers to the law, but has left the tax issue for someone else. He remarked (tongue-in-cheek, I believe) that the Court was playing a “practical joke” on the public in its scheduling and that the folks who wait in line all night to attend the first day of arguments on March 26 are going to end up sitting through “the most boring jurisdictional stuff one can imagine.” Tax lawyers might disagree (or they might not). Either way, the section 7421 issue could hijack the case and have the effect of prolonging the uncertainty over the constitutionality of the law for several more years.
The issue is simple on its face. Section 7421 forbids federal courts from maintaining any suit “for the purpose of restraining the assessment or collection of any tax.” Rather, one generally must wait until the tax is imposed and then contest the liability through a refund claim or in defending against an enforcement proceeding. The individual mandate in the statute is enforced by imposing a “penalty” on individuals who are required to purchase insurance but fail to do so. The relevant provision is section 5000A of the Internal Revenue Code, which requires individuals to report on their tax return information about their compliance with the mandate and pay a penalty if necessary. That Code section also generally provides that the amounts owed are to be assessed and collected in the same manner as other penalties under the Code.
If the health insurance penalty is a “tax” subject to section 7421, then the current challenges to the mandate (which in essence are challenging the imposition of a penalty for failure to purchase insurance) are premature. Rather, the legality of the penalty would have to be contested after it is imposed, like other taxes. The individual mandate does not kick in until 2014, so an income tax return that self-reports penalty liability, thereby potentially triggering an assessment, would not be filed until 2015. The Fourth Circuit adopted this view and dismissed a suit challenging the health care statute, telling the plaintiffs to come back in a few years. Other circuits have disagreed, finding that, despite its presence in the Code and linkage to the assessment procedures for more conventional tax penalties (which are generally treated as “taxes”), the health care penalty has nothing to do with income tax and ought not to be governed by section 7421. Of course, the issue is not that simple. A concise and more nuanced summary of the respective arguments can be found in this article (see page eight) by our colleague George Hani.
One interesting sidelight to the Court’s consideration of this issue is that the Court had to appoint counsel to argue that section 7421 bars the suit. The challengers, of course, have argued all along that section 7421 is no bar. The government initially raised section 7421 as a defense, but later reversed course and abandoned that position because it did not want uncertainty over the legislation’s legality to linger. Thus, in the Supreme Court, both sides are arguing that section 7421 does not bar the lawsuit. The Court appointed Robert Long, an experienced Supreme Court practitioner, as an amicus curiae to brief and argue the position that section 7421 does bar the suit.
The oral argument on the morning of March 26 will proceed as follows: Robert Long, arguing as amicus for 40 minutes that the challenges are barred; Solicitor General Donald Verrilli, arguing for the government for 30 minutes that section 7421 does not bar the challenges, and Gregory Katsas, arguing for the challengers for 20 minutes also that section 7421 does not bar the challenges.
The Court has annouced that a transcript and audio of the argument will be posted on its website by 2:00 that afternoon. We will be back sometime after that with some observations on the argument.
The Supreme Court briefs filed on this issue can be found here. The Court is likely to issue its decision during the last week of June.
February 27, 2012
The Supreme Court (opinion attached below) has affirmed the Ninth Circuit’s decision in Kawashima, ruling that resident aliens who pled guilty to making (or assisting in making) a false tax return in violation of Code section 7206 had committed “aggravated felonies” that made them deportable. The vote was 6-3, with Justice Thomas writing the opinion and Justices Ginsburg, Breyer, and Kagan dissenting.
As we have previously reported, the Kawashima case involves the interplay between two subsections of the deportation statute’s definition of aggravated felonies, 8 U.S.C. § 1101(a)(43). Subsection (M)(i) broadly includes offenses “involv[ing] fraud or deceit”; subsection (M)(ii) adds violations of Code section 7201 (tax evasion). The Kawashimas argued that subsection (ii) is addressed to tax offenses and therefore the statute does not include the less serious tax offenses covered by section 7206. The government argued that section 7206 offenses involve “fraud or deceit,” and therefore they are covered by subsection (ii). (See here for a more detailed analysis of the Supreme Court briefing).
The majority agreed with the government, applying a literal and technical approach to the statutory language that did not afford much weight to the historical understanding of the criminal tax provisions. The Court first found that the conduct of willfully submitting a false tax return inherently involves ‘deceit” and therefore is encompassed within subsection (i). The Court then rejected the Kawashimas’ primary argument that this conclusion was untenable because it would make subsection (ii) entirely superfluous (since tax evasion also involves deceit). To support that conclusion, the Court accepted the government’s technical argument that subsection (ii) was not superfluous because there was theoretically a situation where tax evasion does not involve “deceit” – namely, when a taxpayer files a truthful tax return but evades payment by moving his assets beyond the reach of the IRS. Thus, the Court ruled that, “[a]lthough the Government concedes that evasion-of-payment cases will almost invariably involve some affirmative acts of fraud or deceit, it is still true that the elements of tax evasion pursuant to §7201 do not necessarily involve fraud or deceit.”
The dissenters characterized the majority’s construction of the statute as “dubious,” criticizing in particular its contortions to avoid the conclusion that its construction “effectively renders Clause (ii) superfluous.” According to the dissent, the government’s proposed instances of tax evasion not involving “deceit” are not just “rare,” they are “imaginary.” Given that the Court has previously “declined to interpret legislation in a way that ‘would in practical effect render [a provision] entirely superfluous in all but the most unusual circumstances,” the dissent argued that the majority’s reading is unsustainable. Pointing to an amicus brief filed by former IRS Commissioner Johnnie Walters, the dissent also stated that the Court’s decision would have adverse consequences for the efficient handling of tax prosecutions. In particular, it will discourage aliens from pleading guilty to the lesser section 7206 offense instead of going to trial on a tax evasion charge, because of the risk of deportation.
February 2, 2012
[Note: Miller and Chevalier represents amicus National Trust for Historic Preservation in this case]
The government has filed its reply brief in the Historic Boardwalk case in the Third Circuit. (See our prior report and the other briefs here.) The brief mostly goes over the same ground as the opening brief in seeking to deny section 47 historic rehabilitation credits to the private investor partner in the partnership that rehabilitated East Hall on the Atlantic City boardwalk. It attempts to side-step the Ninth Circuit’s economic substance analysis in Sacks by arguing that the Third Circuit did not explicitly endorse Sacks when it distinguished that case in other decisions. The brief urges the court instead to follow the Fourth Circuit’s Virginia Historic decision (see our coverage here), even though that case involved the disguised sale provisions, arguing that the case “touches on the same risk-reward analysis that lies at the heart of the bona-fide partner determination.” The government also argues that Congress’s intent in passing section 47 would not be thwarted because the private investor allegedly “made no investment in the Hall.”
Indeed, the reply brief includes a special “postscript” “in response to the amicus brief” filed for the National Trust for Historic Preservation that seeks to deflect the charge that the government’s position would undermine Congress’s purpose to facilitate historic rehabilitation. Not so, says the government. It is only “the prohibited sale of federal tax credits — not the rehabilitation tax credit provision itself — that is under attack here.”
Oral argument in the case has been tentatively scheduled for April 20.
January 22, 2012
The Supreme Court heard oral argument in the Home Concrete case on January 17, with the Justices vigourously questioning both sides on both the statutory and administrative deference issues. The Court will issue its decision by the end of June. The following is a recap of the argument that is also published at SCOTUSblog. A full transcript of the oral argument can be found here.
Home Concrete involves the scope of the extended six-year statute of limitations applicable when a taxpayer “omits from gross income an amount properly includible therein.” The case presents two main issues: (1) whether that statutory language covers overstatements of tax basis, even though the Supreme Court construed the same phrase in a predecessor statute not to do so; and, (2) if the Court does not accept the government’s statutory argument, whether it must defer to a recent Treasury regulation that adopts the government’s proffered interpretation. The argument was lively, with all Justices save Justice Thomas asking questions at some point. It was also somewhat disjointed, as the discussion jumped from topic to topic without any obvious agreement among the Justices concerning which issue would be the ground for resolving the case.
Arguing on behalf of the United States, Deputy Solicitor General Malcolm Stewart began by making a determined effort to persuade the Court that it should prevail on a standard statutory analysis without the need to resort to Chevron deference. In response to questions from the Chief Justice and Justice Scalia suggesting that the Court’s decision in The Colony, Inc. v. Commissioner derails that argument from the start, Stewart argued that Colony did not purport to give a definitive definition of the “omits from gross income” language wherever it appears in the Code. Rather, it just interpreted the language for the 1939 Code, and the 1954 Code should be read differently because of the additional subsections that were added.
Several Justices (the Chief Justice, Justice Scalia, and Justice Sotomayor) expressed skepticism that Congress would have used such an obscure mechanism to change the interpretation of the “omits from gross income” phrase. Stewart responded that he would agree if Colony had been on the books when the 1954 Code was enacted. But in fact Colony was not decided until 1958, and Congress was acting against the backdrop of the existing circuit conflict on the meaning of the 1939 Code. Justices Kennedy and Scalia immediately questioned that response, stating that it is “very strange” to say that the same language would have a different meaning depending upon when Colony was decided. Justice Scalia then elaborated on his skepticism over the government’s attempts to prevail on the statute alone, stating that “we’re not writing on a blank slate here.” “I think Colony may well have been wrong, but there it is. It’s the law. And it said that that language meant a certain thing.”
At that point, Justice Kagan sought to rescue Stewart by interjecting that the government has two arguments and the second one – that Treasury had the power to reinterpret the statute in regulations – was independent of Colony’s interpretation of the statutory language. Although Stewart first tried to steer the Court back to the statute, Justice Kagan persisted, and the Chief Justice then entered the fray to question the linchpin of the government’s deference argument – namely, that Colony had found the statute to be “ambiguous.” The Chief Justice pointed out that Justice Harlan, in using that word in 1958, “was writing very much in a pre-Chevron world” and likely was using the word not as “a term of art,” but rather in an attempt to be gracious to the lawyers and courts that had taken the opposite position. Justice Ginsburg, however, pointed out that the Court had characterized the new subsection in the 1954 Code as “unambiguous” and therefore should be taken at its word that the 1939 Code was ambiguous.
Another line of questioning explored the extent to which there was ever a well-entrenched view that Colony controlled the meaning of the 1954 Code. Stewart rejected the taxpayer’s position that everyone understood Colony as controlling prior to the Son-of-BOSS litigation, stating that there was a “surprising dearth of law” on the point, but the only arguably relevant case was a 1968 Fifth Circuit decision that suggested that Colony was not controlling. The taxpayer and the Fifth Circuit dispute that reading of the case. (No one observed that the likely reason there was no case law on this issue was because the IRS accepted Colony as controlling and therefore never attempted to invoke the six-year statute for overstatements of basis.) Justice Breyer asked about a 2000 IRS guidance document that appeared to adopt the taxpayer’s view of Colony, but government counsel dismissed it as merely the view of a single District Counsel. That prompted the Chief Justice to ask acerbically “at what level of the IRS bureaucracy can you feel comfortable that the advice you are getting is correct?”
When Gregory Garre took the podium on behalf of the taxpayer, Justice Kagan asked why Congress had added the new subsection addressing a trade or business. Garre argued that it was designed to resolve the Colony issue favorably to the taxpayer, noting that there was nothing problematic about the fact that the new subsection addressed the specific problem of cost of goods sold instead of explicitly sweeping more broadly. That answer triggered a more extensive discussion of why Congress acted as it did and whether it was drawing a distinction between sales of goods and services (addressed in the new subsection) and sales of real estate (at issue in Colony).
The key administrative law precedent at issue on the deference argument is National Cable & Telecommunications. Ass’n v. Brand X Internet Services, in which the Court accorded deference to a regulation that overturned existing court of appeals precedent. The Court did not show any interest in backing away from Brand X, but it did suggest that it might read the case somewhat more narrowly than the government would like. In Brand X, Justice Stevens wrote a short concurring opinion stating that the holding would not apply to a Supreme Court opinion because at that point no ambiguity would be left. At the beginning of the argument, Justice Scalia echoed that view when he objected to Stewart’s reliance on the statement in Colony that the statute was “not unambiguous” by observing: “Yes, but once we resolve an ambiguity in the statute, that’s the law and the agency cannot issue a regulation that changes the law just because going in the language was ambiguous.” The Chief Justice returned to this point at the argument’s close. He asked the only questions during the government’s rebuttal argument, seeking to confirm that the Court has never applied Brand X to one of its own decisions – that is, that “we’ve never said an agency can change what we’ve said the law means.”
The more open-ended issue concerning the scope of Brand X is what exactly was meant in that case by the statement that the judicial construction can trump a later regulation “only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.” The Court’s exploration of this point began with a lighthearted comment by Justice Scalia that the question in the case boils down to whether indeed Colony meant “ambiguous” when it used that term. Justice Alito followed up, however, pointing out that every statutory interpretation question in the Supreme Court “involve[s] some degree of ambiguity . . ., [s]o what degree of ambiguity is Brand X referring to?”
Garre’s response to this question was to go back to the original Chevron decision, which “looks to whether Congress has addressed the specific question presented.” Under that approach, Colony should be regarded as having found the degree of clarity necessary to insulate it from being overturned by regulation, because the Court concluded that Congress had addressed this specific question. Justice Kagan, later seconded by Justice Ginsburg, questioned that approach, commenting that the relevant question is “how clearly did Congress speak to that specific situation?” Because the Colony Court stated that the text was ambiguous and had to do a lot of “tap dancing” through the legislative history to resolve the case, she stated that Colony must be read as indicating “a lot of ambiguity.” Justice Breyer then jumped in to express agreement with the taxpayer’s argument that the Colony Court’s resort to legislative history was just a standard mode of statutory construction that did not require treating that case as finding an ambiguity under Brand X. Instead, Justice Breyer stated, “[t]here are many different kinds of ambiguity and the question is, is this of the kind where the agency later would come and use its expertise”?
The argument devoted relatively little attention to the retroactivity question. The Chief Justice observed that, in light of Brand X, a taxpayer could never feel confident about a tax precedent because the IRS can change the rule and apply it retroactively. This observation, however, did not obviously elicit much concern from the other Justices, with the notable exception of Justice Breyer who had stated early on that it was “unfair” for the IRS to promulgate “a regulation which tries to reach back and capture people who filed their return nine years before.” Later, Justice Breyer acknowledged that merely tagging the retroactivity as unfair “is not enough” and asked Garre an incredibly long question designed to explore possible justifications for avoiding the retroactive application of the regulations even if the Court were to defer to them on a prospective basis. These ideas, however, did not appear to gain any traction with the other Justices.
Predicting the outcome on the basis of this oral argument is dicey. Justice Kagan appeared sympathetic to the government’s position, while Justice Breyer was very troubled by the unfairness of it. Justices Ginsburg and Sotomayor seemed to tilt towards the government. But most of the Justices expressed enough difficulty with both sides that their votes cannot reasonably be forecast. Overall, however, it did appear that the Court is more likely heading towards a relatively narrow decision than towards one that would break new ground in administrative law. The Court’s approach to Colony will likely be critical. If the Court treats Colony as precedential with respect to the 1954 Code, as it was generally regarded for fifty years, then it would not be difficult to rule for the taxpayer. Brand X might be distinguished because Colony is a Supreme Court decision, or perhaps on the ground that the case should not be treated as finding an “ambiguity” in Chevron terms. Conversely, if the Court views Colony as inapplicable to the 1954 Code, then, notwithstanding Justice Scalia’s observation to the contrary, the Court will essentially be writing on a blank slate. If so, Brand X would likely lead to a ruling for the government.
January 15, 2012
The long journey of the Intermountain cases toward a definitive resolution enters its final phase on Tuesday morning when the Supreme Court hears oral argument in the Home Concrete case. (The final brief, the government’s reply brief, was filed last week.) Each side will have 30 minutes for its argument, with the government going first and having the opportunity for rebuttal (using whatever portion of the 30 minutes that remains after its opening argument). Deputy Solicitor General Malcolm Stewart (the Deputy SG in charge of tax cases) will argue for the government. Gregory Garre, who served as Solicitor General during the last few months of the Bush administration in 2008-09, will argue for the taxpayer. Both counsel have many Supreme Court arguments under their belts.
Regular readers of the blog know that we have covered these issues extensively since the Tax Court issued its decision in Intermountain. The following is a preview of the argument that summarizes the issues for those who have not been following it so closely (or perhaps have gotten tired reading about it and want a refresher course). A shorter version of this argument preview appears at SCOTUSblog.
We will return later in the week with a report on the argument.
Depending on how the Court resolves a threshold statutory construction issue, Home Concrete could yield a decision of broad importance or one of interest only to tax lawyers. The ultimate issue concerns the scope of an extended statute of limitations applicable only to tax cases. The first possible ground for decision is purely a matter of interpreting the language of the tax statutes. But the government faces significant hurdles on that ground, notably the Court’s 1958 decision in The Colony, Inc. v. Commissioner, which interpreted the same words in a predecessor statute in the 1939 Code in accordance with the taxpayer’s position. If the Court rejects the government’s position that the statutory language alone is dispositive, the case will move to the second issue presented – whether the Court must adopt the government’s statutory construction because Chevron requires it to defer to recently promulgated Treasury regulations. A decision on that issue could be a significant administrative-deference precedent that would have broad ramifications outside the tax context as well.
Generally, the IRS has three years from the date a tax return is filed to assess additional tax on the ground that a taxpayer underreported its tax liability. Under 26 U.S.C. § 6501(e)(1)(A), however, there is an extended six-year statute of limitations if the taxpayer “omits from gross income” a significant amount that it should have included. A similar provision governing partnership tax returns is found at 26 U.S.C. § 6229(c)(2). The question presented in Home Concrete is whether that “omits from gross income” language includes a situation where a taxpayer overstates its basis.
The textual question at the heart of this case goes back almost 70 years. The 1939 Internal Revenue Code, which was later superseded by the 1954 Code, contained a provision with language identical to that of current section 6501(e)(1)(A). Taxpayers argued that the extended statute of limitations applied only when there was a literal omission of gross income – that is, a failure to list an item of gross income on the return. The government argued that the extended statute also applied when there was an overstatement of basis, because that leads to an understatement of gross income. The issue generated a circuit conflict and eventually made it to the Supreme Court in the Colony case.
In the meantime, Congress enacted the 1954 Code, which largely carried forward the previous statute. Congress did not change the “omits from gross income” language and did not directly address the then-existing dispute about its scope. Congress did add a new subsection that specifically defined “gross income” in the case of a trade or business, and it defined that term so that an overstatement of basis could not possibly be an omission of “gross income.”
Thereafter, the Colony case arrived in the Supreme Court. Construing the 1939 Code, the Court ruled for the taxpayer, holding that “the statute is limited to situations in which specific receipts or accruals of income are left out of the computation of gross income” and therefore it did not apply to overstatements of basis. Little did the Court know that 50 years later litigants would be parsing its reasoning to see how the case fits into the framework of Chevron – specifically, whether the Colony Court should be understood to have found the statutory language before it unambiguous. Two statements by the Colony Court are particularly relevant. First, the Court stated that, although the statutory text “lends itself more plausibly to the taxpayer’s interpretation, it cannot be said that the language is unambiguous.” The Court then looked to the legislative history, where it found persuasive support for the taxpayer, and also concluded that the government’s interpretation would apply the statute more broadly than necessary to achieve Congress’s purpose. Second, having been urged by the parties to consider whether the new legislation shed any light on the meaning of the 1939 Code, the Court stated that its conclusion was “in harmony with the unambiguous language” of the 1954 Code.
Fast forward 50 years. The issue has lain dormant, as everyone assumed that Colony controlled the interpretation of the identical language in the 1954 Code. The IRS learned that many taxpayers had engaged in a series of securities transactions that came to be known as a Son-of-BOSS transaction. The IRS views this transaction as a tax avoidance scheme that manipulates certain tax rules to produce an artificially inflated basis for an asset that is then sold, producing either a noneconomic paper loss or a smaller gain than it should. The IRS has successfully challenged these transactions, with the courts generally concluding that they lack “economic substance” and therefore the taxpayers cannot take advantage of the apparent tax benefits. But in many cases, the IRS discovered that more than three years had elapsed before it could challenge the tax treatment, and therefore the standard statute of limitations had expired.
Seeking to recover what it estimated as almost $1 billion in unpaid taxes, the IRS began to argue that the extended six-year statute of limitations applied to these transactions because they involved an overstatement of basis. It contended that Colony was not controlling because the Court’s decision should be limited to the 1939 Code and that a different result should obtain in the Son-of-BOSS cases (which arise outside the “trade or business” context and hence are not encompassed within the new subsection added in 1954). This argument initially fell flat in the courts, as the Tax Court and the Ninth and Federal Circuits held that Colony controls the interpretation of the “omits from gross income” language of the 1954 Code.
The government then moved on to Plan B. The Treasury Department issued temporary regulations interpreting the “omits from gross income” language to include overstatements of basis. (These regulations have since been issued without material change as final regulations after a notice-and-comment period.) The government then filed a motion for reconsideration in the Intermountain case, arguing that the Tax Court should reverse its decision because of an “intervening change in the law” requiring it to accord Chevron deference to the new regulatory interpretation. The Tax Court was unimpressed, voting 13-0 (in three different opinions giving three different grounds) against the government.
Unfazed, the government filed appeals in several cases heading to different circuits, and the tide began to turn. First, the Seventh Circuit became the only court thus far to agree with the government’s statutory argument. The Fourth and Fifth Circuits quickly rejected that view and also rejected the government’s Chevron argument, holding that after Colony there was no ambiguity for the Treasury Department to interpret. Three other court of appeals decisions followed in short order, however, and all three circuits ruled for the government on Chevron deference grounds. Of particular note on that point is the Federal Circuit’s decision, since the Federal Circuit had already rejected the government’s pre-regulation statutory interpretation. The Federal Circuit explained that it still believed that the taxpayer had the best reading of the statute, but that it was required to defer to the regulation because it could not say that the regulation’s interpretation was unreasonable. The Court granted certiorari in Home Concrete, the Fourth Circuit case, to resolve the conflict.
With respect to the meaning of the statute, the taxpayer rests primarily on Colony, characterizing the IRS as having “overruled” that decision. The taxpayer argues that its reliance on stare decisis is buttressed by the fact that Congress reenacted the same statutory language in later years against the background of Colony, thereby putting a legislative stamp on the Court’s determination that the words “omits from gross income” should be interpreted not to include overstatements of basis.
The government in turn argues that Colony is irrelevant because it involved a different statute, which was materially changed in 1954 when Congress added a subsection making clear that there is no extended statute of limitations for overstatements of basis by a trade or business. Implicit in Congress’s decision to make that addition was its understanding that overstatements of basis would be covered outside of the trade or business context; otherwise, the new provision would be superfluous. The taxpayer responds that the new subsection is not superfluous and that it is absurd to conclude that the 1954 Code cut back on taxpayers’ statute of limitations protections when the only changes made to the statute favored taxpayers.
In addition to the Colony-related arguments, both sides argue that their position reflects the best reading of the statutory text and purpose. The taxpayer argues that “omits” means leaving something out, while the government emphasizes that overstatements of basis inevitably cause an understatement (that is, an “omission” of a portion) of gross income.
The taxpayer makes a couple of other narrow arguments that could theoretically divert the Court from reaching the deference issue: (1) that the regulations were procedurally defective; and (2) that by their terms, the regulations do not apply to cases like this one, where the three-year statute had already expired before the regulations were promulgated. These arguments did not prevail in any court of appeals, and the Court is unlikely to adopt them. That will lead the Court to a deference issue of potentially broad doctrinal significance.
Back in 1971, the Second Circuit thought it obvious that the Treasury Department did not have the power to affect pending litigation that the government claims here, stating that “the Commissioner may not take advantage of his power to promulgate retroactive regulations during the course of litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations.” But the D.C. Circuit, in reversing the Tax Court’s reviewed Intermountain decision, said that the Second Circuit’s statement has been “superseded” by Supreme Court precedent. The Home Concrete case is well positioned to determine who is right.
Basically, the government argues that the Court’s Chevron jurisprudence has already crossed all the lines that are necessary to get to its desired end result here. In Smiley v. Citibank, N.A., the Court afforded deference to a regulation in a case that was already pending when the regulation was issued, stating that it was irrelevant whether the regulation was prompted by litigation. In National Cable & Telecomms. Ass’n v. Brand X Internet Servs., the Court afforded deference to a regulation that overturned existing court of appeals precedent, holding that a “court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.” Put those two together, the government argues, and there is no justification for failing to defer to Treasury’s interpretation because Colony had described the 1939 statute as not “unambiguous.”
Not so fast, says the taxpayer, arguing that, after Colony, the law was settled and there was no ambiguity that could permissibly be “clarified” by regulation. Smiley is different, because the regulation there did not overturn a previously settled interpretation. Brand X is not applicable because Colony is properly read as having held that Congress did unambiguously express its intent not to include overstatements of basis. More generally, the taxpayer contends that the retroactive effect of the government’s position is a bridge too far that is not authorized by these precedents. Among the several amicus briefs filed in support of the taxpayer, one filed by the American College of Tax Counsel focuses exclusively on the retroactivity question, asserting that “retroactive fighting regulations” designed to change the outcome of pending litigation “are inconsistent with the highest traditions of the rule of law” and should not be afforded Chevron deference.
At the end of the day, the deference issue may turn on the Court’s comfort level with the amount of authority the government is asking courts to concede to agencies – particularly an agency frequently in a position to advance its fiscal interest through regulations that will affect its own litigation. That general topic has been flagged in the court of appeals opinions. In the Federal Circuit decision holding that the new regulation trumped that court’s precedent, the court observed that the case “highlights the extent of the Treasury Department’s authority over the Tax Code” because “Congress has the power to give regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.” Conversely, Judge Wilkinson cautioned in his concurring opinion in Home Concrete that “agencies are not a law unto themselves,” but must “operate in a system in which the last words in law belong to Congress and the Supreme Court.” In his view, the government’s invocation of Chevron deference in this case wrongly “pass[es] the point where the beneficial application of agency expertise gives way to a lack of accountability and risk of arbitrariness.”
In recent years, the Court has not evinced much concern over the amount of power that its Chevron jurisprudence has given to agencies. But this case could induce it to look more closely at the big picture. Justice Scalia’s position will be of particular interest. Justice Scalia was an early force in the development of Chevron deference, dating back to his time on the D.C. Circuit shortly after Chevron was decided. But recently, he has expressed some uneasiness that the way in which the doctrine has developed had given agencies too much power. He dissented in Brand X, commenting that the decision was creating a “breathtaking novelty: judicial decisions subject to reversal by executive officers.” And just last June, he noted in a concurring opinion in Talk America, Inc. v. Michigan Bell Telephone Co., that he would be open to reconsidering Auer v. Robbins (a decision that he authored in 1997) because its rule of extreme deference to an agency’s interpretations of its own regulations “encourages the agency to enact vague rules which give it the power, in future adjudications, to do what it pleases.” Justice Scalia’s questions at oral argument, and the reaction of other Justices to them, will be worth watching.
January 12, 2012
[Note: Miller and Chevalier represents amicus National Trust for Historic Preservation in this case]
We present here a guest post by our colleague David Blair who has considerable experience in this area and authored the amicus brief in this case on behalf of the National Trust for Historic Preservation.
The government has appealed to the Third Circuit its loss before the Tax Court in Historic Boardwalk Hall, LLC v. Comm’r, which involves a public/private partnership that earned historic rehabilitation tax credits under Code section 47. The partnership rehabilitated East Hall, which is located on the boardwalk in Atlantic City. East Hall was completed in 1929, hosted the Miss America Pageant for many years, and is listed on the National Register of Historic Places. The IRS sought to prevent the private partner, Pitney Bowes, from claiming the historic rehabilitation tax credits, but the Tax Court upheld the taxpayer’s position after a four-day trial.
In its opening brief, the government advances the same three arguments in support of its disallowance that it made in the Tax Court. First, it asserts that Pitney Bowes was not in substance a partner because it did not have a meaningful stake in the partnership under the Culbertson-Tower line of cases. Second, it argues that the partnership was a sham for tax purposes under sham partnership and economic substance cases. Third, it argues that the partnership did not own the historic building for tax purposes and thus was not eligible for the section 47 credits for rehabilitating the building. In making the first two arguments, the government relies heavily on its recent victory in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, where the Fourth Circuit overturned the Tax Court and found a disguised sale of state tax credits. (See our previous reports on that case here.) Similarly, the government’s brief places heavy reliance on its first-round victory before the Second Circuit in TIFD III-E, Inc. v. Comm’r (Castle Harbor), which is now back up on appeal. (See our previous reports on that case here.) In support of its sham partnership theory, the government cites provisions in the partnership agreement that protect investors from unnecessary risks, including environmental risks. On the third argument, the government asserts that the partnership never owned the building for tax purposes because the benefits and burdens of ownership never transferred.
Having won at trial, the taxpayer’s brief emphasizes the Tax Court’s factual findings in its favor. It also emphasizes the historic character of the building and the Congressional policy of using the tax laws to encourage private investment to preserve this type of historic structure. The taxpayer argues that the partnership was bona fide because the partners joined together with a business purpose of rehabilitating East Hall and earning profits going forward. The taxpayer also argues that the partnership has economic substance. In this regard, the taxpayer argues that the Ninth Circuit’s decision in Sacks v. Comm’r, 69 F.3d 982 (9th Cir. 1995), requires a modification of the normal economic substance analysis where Congress has offered tax credits to change taxpayers’ incentives. The taxpayer also argues that the partnership owned East Hall for tax purposes and therefore was eligible for the section 47 credits.
The National Trust for Historic Preservation filed an amicus brief in support of the taxpayer. That brief sets out the longstanding Congressional policy of offering the section 47 credit to encourage taxpayers to invest in historic rehabilitation projects that would not otherwise make economic sense. It further explains that historic rehabilitation projects typically involve partnerships between developers and investors that are motivated in part by the availability of the credit. It also is typical for these partnership agreements to protect the investors from unnecessarily taking on business risks. The amicus brief argues that, in applying the economic substance doctrine, courts should not override the narrowly focused Congressional policy of encouraging rehabilitation projects through the section 47 credit. Thus, courts should not simply review the non-tax business purpose and pre-tax profitability of investments in historic rehabilitation projects, but should acknowledge that the taxpayer can properly take into account the credits that Congress provides for historic rehabilitation projects. To do otherwise, as the Ninth Circuit observed in Sacks, “takes away with the executive hand what [the government] gives with the legislative.” The amicus argues that, at any rate, the transaction met the economic substance doctrine under Third Circuit precedent and that the partnership and Pitney Bowes interests were bona fide. It also points out that the Virginia Historic case is inapplicable because it involved a disguised sale, which the government has not alleged in this case. Similarly, the Castle Harbor case is distinguished on its facts due to the differences in the partnership agreements in the two cases.
The Real Estate Roundtable also filed an amicus brief, which highlights to the court that the recent codification of the economic substance doctrine in Code section 7701(o) places significant pressure on the distinction between, on the one hand, the economic substance doctrine, and on the other hand, substance-over-form and other “soft doctrine” attacks on transactions. This is due to the strict liability penalty that can apply to transactions that violate the economic substance doctrine. As the IRS has recognized in recent guidance under section 7701(o), it is necessary for the IRS and courts to carefully distinguish between cases where the economic substance doctrine is “relevant” and those where other judicial doctrines apply. The Real Estate Round Table then argues that the transaction at issue had economic substance.
The government’s reply brief is due January 31.
December 28, 2011
The taxpayer has filed its brief in Home Concrete. The brief argues forcefully that the case is controlled by Colony, characterizing the underlying statutory issue as “settled by stare decisis.” The brief disputes the government’s arguments that the changes made by Congress in the 1954 Code had the effect of extending the six-year statute to overstatements of basis outside the trade or business context, observing that the 1954 Code changes were all designed to favor taxpayers.
With respect to the regulations, the taxpayer first argues that Colony should be understood as having held that the statutory language was unambiguous, thus foreclosing Treasury from issuing regulations that would require a different statutory interpretation. (As we previously reported, this particular point was the focus of oral argument before the Federal Circuit in Grapevine, with the court ultimately resolving that point in favor of the government and deferring to the regulation.) Second, the brief argues that the regulation would in any event be invalid because of its retroactive effect on pending litigation. In addition, the brief makes some narrower arguments about this particular regulation, maintaining that by its terms the regulation does not cover cases like Home Concrete and that the regulation is procedurally defective.
At least eight amicus briefs were filed in support of the taxpayer. A brief filed by the American College of Tax Counsel focuses on the retroactive application of the regulations, elaborating on the taxpayer’s arguments in asserting that “retroactive fighting regulations” that are designed to change the outcome of pending litigation “are inconsistent with the highest traditions of the rule of law” and should not be afforded Chevron deference. The brief invokes general principles against retroactive legislation and also argues that Code section 7805(b)’s prohibition on retroactive regulations applies. The government argues that section 7805(b) does not apply to regulations interpreting statutes enacted before 1996, a position that was not heavily disputed by taxpayers in the court of appeals litigation of these cases.
Four other amicus briefs were filed by taxpayers who litigated the Home Concrete issues in other circuits and whose cases will be controlled by the outcome — one filed by Grapevine Imports (Federal Circuit), one filed by UTAM, Ltd. (D.C. Circuit), one filed jointly by Daniel Burks (5th Circuit) and Reynolds Properties (case pending in the 9th Circuit), and one filed by Bausch & Lomb (cases pending in the Second Circuit). The latter brief emphasizes that Bausch & Lomb’s case does not involve a son-of-BOSS tax shelter, but rather a more standard business transaction, and also that it involves only section 6229, which does not contain the statutory changes from the 1939 Code found in section 6501 and on which the government heavily relies to distinguish Colony. Amicus briefs were also filed by the Government of the U.S. Virgin Islands, the National Association of Home Builders, and the National Federation of Independent Business, Small Business Legal Center. Copies of the taxpayer’s brief and some of the amicus briefs are attached.
The oral argument in Home Concrete is scheduled for January 17. The government’s reply brief is due on January 10.
December 27, 2011
As we have previously reported (see here, here, and here), in Anschutz the Tax Court collapsed two transactions and held that they amounted to a taxable sale of stock. The Tenth Circuit was unmoved by the taxpayer’s appeal and has now affirmed, barely five weeks after hearing oral argument. In its decision, the court of appeals analyzes the transaction through the lens of the eight factors for determining a sale listed in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981). With respect to the factor that assesses whether an equity interest was acquired in the property, the court quotes at length from the IRS’s Feb. 6, 2008, Coordinated Issues Paper on the topic, finding its analysis “compelling and applicable to the case before us.”
The court also rejects the taxpayer’s efforts to analogize its transactions to other approved transactions. The court explains that the transaction addressed in Rev. Rul. 2003-7 is distinguishable, in part because there was no borrowing of pledged shares. And the court holds that the taxpayers’ transactions in this case did not fall within the “safe harbor” of Code section 1058 because they “effectively eliminated [the] risk of loss and substantially reduced [the] opportunity for gain.”
December 13, 2011
In our earlier discussion of the disguised sale cases, we noted that the federal district court in New Jersey had issued an unpublished opinion in the GI Holdings case that applied the disguised sale rule of 26 U.S.C. § 707(a)(2)(B) to undo a transaction. We noted that there was not yet an appealable order in that case, but at some point an appeal to the Third Circuit was possible. It now appears that the case has been settled and will be formally dismissed in the coming weeks. Thus, there will be no appeal to the Third Circuit, and the Fourth Circuit’s recent decision in Virginia Historic (see our report here) remains as the sole appellate ruling on disguised sales.
November 23, 2011
The Supreme Court has set January 17 as the date for the oral argument in Home Concrete, the case in which it will decide the “Intermountain” issues concerning the applicability of the six-year statute of limitations to overstatements of basis, on which we have reported extensively many times before. (See here and here for a sample.) In the meantime, the briefing has commenced with the filing of the government’s opening brief (linked below).
The brief covers what is mostly familiar ground at this point, but it does further develop some of the arguments that have emerged in the course of the court of appeals litigation, with particular reliance on the D.C. Circuit’s decision in Intermountain. The government divides its argument into three sections. The first analyzes the statutory text, structure, and purpose, emphasizing a broad definition of the word “omission” and arguing that its position is supported by other subsections within section 6501(e). Second, the government argues for deference to the final regulations. Finally, the third section argues that the Supreme Court’s Colony decision is not controlling.
With respect to the administrative deference point that is of the broadest significance in this case, the government not surprisingly offers up arguments that will enable the Court to rule in its favor without exploring the outer limits of the power that the Court’s recent precedents arguably confer on the Treasury Department. But the government does not shirk from pushing those limits in case its other arguments are unpersuasive.
For example, although the government argues that the Colony decision is inapplicable because it involved a 1939 Code provision that has since changed in some ways, the government maintains that it should still prevail even if no changes had been made to the statute in the 1954 Code. “Under Brand X,” the government states, “the new Treasury Department regulation would be entitled to Chevron deference even if that rule construed precisely the same statutory provision that was before the Court in Colony.” Thus, the government is not bashful about claiming an extraordinary amount of power for the Treasury Department. Congress can pass a law establishing a particular rule, and the Supreme Court can construe that law, but the Treasury Department can turn it all upside down as long as the Court did not declare the statutory language unambiguous.
The government’s brief also addresses the additional objection that the regulations operate retroactively. The government argues that they are not truly retroactive, because they supposedly “clarified rather than changed existing law” (notwithstanding Colony and two court of appeals decisions that were unquestionably on point) and addressed “procedures,” rather than the legality of the conduct. In the end, however, the government maintains that “the rule would be valid even if it had retroactive effect.” Thus, the government fully embraces an expansion of the Treasury Department’s power beyond that recognized in Mayo — arguing that an agency not only has the power to promulgate rules that overturn settled judicial precedents, but also has the power to apply those new rules to prior years. Given that even Congress is usually constrained in adopting retroactive legislation, it will be interesting to see if the Court balks at conferring this kind of power on unelected officials.
The taxpayer’s brief is due December 15.
November 17, 2011
On November 16, the Tenth Circuit heard oral argument in the Anschutz case, involving the taxpayers’ appeal from the Tax Court’s decision to collapse two transactions involving the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”), and treat them as a taxable sale of stock. A fuller description of the case and the parties’ briefs can be found in our prior reports here and here.
The panel hearing oral argument was Chief Judge Briscoe (a Clinton appointee and former Kansas state court judge and Assistant U.S. Attorney), Senior Judge McKay (a Carter appointee who was previously in private practice), and Judge O’Brien (a Bush II appointee who served for many years as a Wyoming state judge).
There is no specific date by which the court must decide the case, but a decision is most likely in the spring of 2012.
October 10, 2011
In our report on the oral argument in Sunoco, which took place back in January, we remarked that the Third Circuit panel seemed skeptical of the Tax Court’s decision, even if the panel had not yet mastered the complexities of the case. It took more than eight months, but the Third Circuit has now issued a comprehensive opinion reversing the Tax Court and holding that it lacked jurisdiction to consider Sunoco’s claims for additional overpayment interest. The court’s opinion tracks the government’s position fairly closely, and it accepts the government’s view that Estate of Baumgardner v. Commissioner, 85 T.C. 445 (1995), is correctly decided but applies only to claims for deficiency (i.e., underpayment) interest. That case cannot help Sunoco with its efforts to receive additional overpayment interest, which it could have obtained only by bringing suit in the Court of Federal Claims.
The Third Circuit explains that the Code gives the Tax Court jurisdiction over claims for overpayment interest only “in two very narrow circumstances,” under sections 6512(b)(2) and 7481(c), and neither of those sections come into play in Sunoco’s situation. The court summarized its view of the critical defect in Sunoco’s position as follows: “The overpayment interest at issue here is not attributable to any decision of the Tax Court . . . . Rather, the interest at issue here arises from overpayments that were refunded or credited before this case began. We can find no statutory authorization for the Tax Court to determine this kind of claim.”
If Sunoco decides to seek further review, a petition for rehearing would be due on November 21, and a petition for certiorari would be due on January 5, 2012.
September 27, 2011
The Court this morning granted certiorari in the Home Concrete case from the Fourth Circuit, thus paving the way for a definitive, nationwide resolution of the issues presented in the Intermountain cases. We had previously indicated that it was more likely that the Court would hear the Beard case, since the petition in that case was filed first. It is ironic that the Court chose to hear the Home Concrete case, since that is the one case that neither party urged the Court to take. (The government asked the Court to grant Beard and hold the Home Concrete case, and the taxpayer asked the Court to deny certiorari. See our previous report here.) Perhaps the Court thought that Home Concrete was the preferable vehicle because the court of appeals had addressed the applicability of the regulations; perhaps the Court was just being ornery and wanted to resist the government’s efforts to manipulate the docket by contriving to have the Beard case jump ahead of the earlier-decided Home Concrete case. See our previous report here.
In the long term, it does not appear to make much difference which case the Court agreed to review. The Court can be expected to resolve the six-year statute question in this case, likely addressing the effect of the regulation. In the short term, the Court’s choice does affect the briefing schedule. Since the government is the petitioner in Home Concrete, its brief will be due first, and it will have the opportunity to file a reply brief. This schedule gives taxpayers interested in filing an amicus brief a bit more time to prepare one than they would have had if Beard were the lead case, as such a brief would be due seven days after the taxpayer’s brief, which will now not be due until mid-December.
The Court took no action on the petitions in Beard and Grapevine. The petitions in these cases will likely be held and acted upon only after the Home Concrete case is decided.
The government’s opening brief in Home Concrete is due November 14. The case will likely be argued in January, or possibly February, and the Court will issue its decision before the end of June 2012.
September 15, 2011
Although our blog coverage might reasonably be accused of hibernating over the summer, court calendars inexorably marched on, and there were several developments in the various Intermountain cases. If the Supreme Court grants cert in Beard on September 26, as we have predicted, these developments will not be of much moment, since all of the cases will likely be governed by the Supreme Court’s decision in Beard. The one possible exception is the Federal Circuit’s decision in Grapevine, where the taxpayer’s cert petition has been fully briefed and is ready for consideration by the Supreme Court on September 26 together with Beard. In any event, for those keeping score, here is an update, along with a selection of the filings, which are somewhat duplicative.
Federal Circuit: The Federal Circuit denied rehearing in Grapevine on June 6. The taxpayer petitioned for certiorari, docketed as No. 11-163, and the government responded by asking the Court to hold the petition and dispose of it as appropriate in light of its decision in Beard. The government filed its response early, thus allowing the Court to consider the petition in tandem with Beard on September 26. Thus, the Court could conceivably agree to hear both cases, or agree to hear Grapevine alone (because the regulatory deference issue is fleshed out in the court of appeals opinion in that case). The government, however, does not urge either of those approaches. Instead, it asks the Court to grant cert in Beard alone, following its usual practice of hearing the earliest-filed case when two petitions raise the same issue.
D.C. Circuit: The taxpayers in both Intermountain and UTAM filed petitions for rehearing. The court denied the petition in Intermountain on August 18 and denied the petition in UTAM earlier today on September 15. In both cases, the court slightly amended its opinion to provide what it believed to be a better response to certain relatively narrow arguments made by the taxpayers.
Fourth Circuit: The government filed a petition for certiorari in Home Concrete, asking the Court to hold the case for Beard. The taxpayer filed a brief in opposition asking the Court to deny certiorari on the grounds that the Fourth Circuit got it right and that Congress has closed the son-of-BOSS loophole for future years. Good luck with that. The Home Concrete petition will also be considered at the Court’s September 26 conference. If the Court grants cert in Beard or Grapevine, it will surely hold the Home Concrete petition pending consideration of those cases.
Fifth Circuit: The government filed a cert petition in Burks, docketed as No. 11-178, and asking that that case also be held pending the disposition of Beard. The taxpayer did not file an early response, and that case will not be ready for consideration at the Court’s September 26 conference.
Ninth Circuit: The Ninth Circuit’s Reynolds Properties case lagged behind those in the other circuits because the briefing schedule was delayed for some time by the mediation process. Undeterred for now by the prospect that the Supreme Court will resolve the issue, the Ninth Circuit is marching ahead. The case is now fully briefed and is scheduled for oral argument on October 13, 2011.
Tenth Circuit: The court denied rehearing in Salman Ranch on August 9. The taxpayer obtained a stay of the mandate so that it can file a petition for certiorari, which will surely be held if the Court grants cert in one of the other cases.
We will be back soon with a report on what, if anything, the Court does at its September 26 conference.
August 4, 2011
At long last, the Sixth Circuit has scheduled oral argument in the Quality Stores case for October 6, 2011. This will be more than a year since the briefing in the case was completed. The identity of the three-judge panel is expected to be announced on September 19.
July 29, 2011
The government has now filed its response to the taxpayer’s petition for certiorari in Beard, the first of the Intermountain cases to reach the Supreme Court. As expected, the government filed an “acquiescence,” meaning that it told the Court that the Seventh Circuit had correctly ruled against the taxpayer, but the government agreed that it is appropriate for the Supreme Court to hear the case in order to resolve the conflict in the circuits. In the words of the response, “[a]lthough the decision below is correct, . . . [i]n light of the square circuit conflict, and the importance of the uniform administration of federal tax law, the petition for a writ of certiorari should be granted.”
It is very likely that the Supreme Court will agree to hear the case in light of the government’s acquiescence. The Court does not issue orders on certiorari petitions over its summer recess, but will sometimes issue them during the week before the Court’s formal return on the first Monday in October. Look for an order granting certiorari to issue on September 26 or soon thereafter.
July 22, 2011
While we wait to see what the government will say to the Supreme Court on the Intermountain issue, litigation continues in the courts of appeals. (The government’s response to the certiorari petition in Beard is currently due on July 27.) The taxpayer has filed a petition for rehearing en banc in Salman Ranch. It is hard to imagine that the Tenth Circuit will head down that road when it appears that the Supreme Court will address the issue. Salman Ranch, however, does present one wrinkle not present in the other cases — namely, whether the government was precluded by collateral estoppel from relitigating the issue against this taxpayer because Salman Ranch had prevailed in the Federal Circuit on the same issue in another tax year. The Tenth Circuit panel ruled that collateral estoppel did not apply because, in light of the issuance of the regulations, it was not true that the “applicable legal rules remain unchanged.”
The petition for rehearing, as well as the other briefs in this case, are linked below.
July 7, 2011
[Note: Miller & Chevalier represents amicus curiae American Electric Power Co. in this case.]
The PPL case is now fully briefed in the Third Circuit and ready for oral argument, which has been tentatively scheduled for September 22. PPL’s response brief addresses in detail the considerable evidence presented to the Tax Court regarding the operation and effect of the U.K. windfall tax, arguing that the evidence conclusively shows that the tax operated like a typical U.S. excess profits tax and therefore should qualify for a foreign tax credit. Amerian Electric Power Co. filed an amicus curiae brief in support of PPL that focuses primarily on discussing the precedents that call for courts to consider the kind of extrinsic evidence introduced by PPL. The government’s reply brief, like the one it filed in the companion Entergy case (see here), backs away from its previous argument that the court cannot ever consider extrinsic evidence. The government maintains, however, that PPL’s evidence was not probative and that the Tax Court should have denied creditability because the UK windfall tax describes the tax as being on “value.”
June 30, 2011
We have been noting for the past few months that the Intermountain issue would be heading to the Supreme Court soon, with the government’s petition in the Home Concrete case due on July 5. The taxpayers in Beard have jumped the line, however, by seeking certiorari ahead of the deadline, and that case is now docketed in the Supreme Court as No. 10-1553. Meanwhile, the government has obtained a 30-day extension until August 3 to file its certiorari petition in Home Concrete. Thus, unless the taxpayer in either Salman Ranch, Grapevine, or one of the D.C. Circuit cases sprints to the Court with its own cert petition well before the deadline, it looks like Beard will be at the head of the line by a good margin.
The petition does not add much to the arguments on the merits of the dispute. The goal of a certiorari petition is to explain to the Court why it is important for it to hear the case. If cert is granted, there is plenty of opportunity for the litigant to address the merits. One of the best ways to convince the Court that it has to step in to a dispute is to demonstrate a conflict among the various courts of appeals, which will lead to different outcomes in similar cases unless the Court steps in. Making that showing on the Intermountain issues is like shooting fish in a barrel. The Beard petition sensibly focuses on discussing the circuit conflicts, both on the statutory interpretation issue (where the Seventh Circuit in Beard is the only court to have ruled that, even without the regulations, the statute should be construed as providing for a six-year statute of limitations (see here)), and on the question whether Chevron deference is owed to the regulations.
There are two items worth noting in the petition that relate to the merits. The petition signals that the taxpayer will argue that Chevron is getting completely out of hand if deference is paid in the context of this case. Specifically, the petition states that the government’s position that “the Treasury is empowered to reject and overrule longstanding precedent of this Court and other courts that it disfavors, simply through the issuance of temporary regulations without notice and public comment threatens obvious, far-reaching consequences.” Second, the petition briefly responds to the argument that Colony should be read as applying only to cases involving a trade or business by pointing out that, although Colony itself did involve a trade or business, the Court was seeking there to establish a rule that would resolve a circuit conflict, and some of the conflicting cases did not involve a trade or business.
The next step is a response by the government, currently due on July 27. In most cases, of course, the government’s response to a cert petition is to oppose the petition and argue that the Court should leave standing the court of appeals decision in favor of the government. Sometimes, however, when there is a circuit conflict on an important issue, the government will “acquiesce” in the petition — meaning that it will tell the Court that the court of appeals decision was correct but that it agrees with the petition that the Supreme Court should hear the case so that it can pronounce a rule that will apply uniformly throughout the country.
The government is virtually certain to agree that the Court should resolve the Intermountain dispute. The only question would seem to be a tactical one: will the government acquiesce in the Beard petition and have the dispute resolved in that case, where the government prevailed below? Or will the government instead try to steer the Court towards a different case where perhaps it believes the facts are more favorable or where the taxpayer prevailed below. The request for an extension in Home Concrete is a pretty good indication that the government is content to let the issue be resolved in Beard.
As far as timing, the government routinely secures extensions of time to respond to certiorari petitions. (You may recall that the government got four extensions to respond to the Kawashima petition. See here). But if the government decides to acquiesce in Beard, that would be a very simple filing, and the government has had plenty of time already to decide what it wants to do in these cases. Thus, it is possible that the government’s response will be filed on July 27.
The Beard petition is linked below.
June 22, 2011
The D.C. Circuit yesterday reversed the Tax Court in Intermountain, handing the government more ammunition to use if, as appears increasingly likely, the Supreme Court considers the question of the applicability to overstatements of basis of the six-year statute of limitations found in Code sections 6229(c)(2) and 6501(e)(1)(A). This now makes the score 4-2 for the government and represents the third straight court of appeals to adopt the government’s primary argument that courts owe Chevron deference to the relatively recent Treasury regulations interpreting the six-year statutes to apply to overstatements of basis.
The D.C. Circuit’s opinion is comprehensive, tracing the same ground as the Federal Circuit’s Grapevine decision, but also supplementing that court’s analysis. In particular, the D.C. Circuit explores in detail the background of Colony and the legislative history of the 1954 Code in order to justify the conclusion that section 6501 does not unambiguously provide that overstatements of basis do not trigger the six-year statute — even though the same statutory term “omission from gross income” in the 1939 Code was construed in Colony not to include overstatements of basis. Having reached that conclusion, the D.C. Circuit found that the Chevron step two analysis was “easy,” and there was no justification for suggesting that the Treasury regulation was an unreasonable interpretation of the statute.
One item of interest is the court’s refusal to address a couple of arguments made by Intermountain’s counsel because they were not raised in a timely fashion. The court’s analysis distinguishing current law from the 1939 Code provision addressed in Colony relies heavily on the 1954 addition of section 6501(e)(1)(A)(i), which specifically addresses “gross income” in the case of a trade or business. Intermountain contended at oral argument that this analysis ought to be irrelevant in a case that involved only section 6229, not section 6501. The court, however, refused to consider that argument, stating that Intermountain had never before argued “that the two sections have different meanings outside the trade or business context.” The court also refused to consider, as raised too late, Intermountain’s reliance on positions taken by the Commissioner on the meaning of Colony before the son-of-BOSS cases arose. One might see these arguments raised and addressed in the Supreme Court down the road.
The Intermountain opinion also governs the companion UTAM case that was argued in tandem. The D.C. Circuit did issue a separate opinion in UTAM addressing an issue unique to that case — whether a final partnership administrative adjustment (FPAA) tolls an individual partner’s limitations period under section 6501 in the same way section 6229(d) tolls the section 6229(a) “minimum period.” The court ruled for the government on that issue as well, and we plan to address that opinion in another post.
Intermountain is likely the last that will be heard from the courts of appeals on the six-year statute issue before it moves to the Supreme Court. (The Federal Circuit, as expected, denied rehearing in Grapevine on June 6. Reynolds Properties v. Commissioner, No. 10-72406, has been fully briefed in the Ninth Circuit, but oral argument is not yet scheduled.) The government’s recent successes in the courts of appeals give it a lot of momentum heading to the Court. Of course, it is often said that momentum is only as good as the next day’s starting pitcher, and in the end the Supreme Court will make up its own mind without regard to the score in the courts of appeals. The government’s anticipated petition for certiorari in Home Concrete is due July 5.
June 14, 2011
The government has filed its reply brief in the Fifth Circuit in Entergy. (See our initial report on the case here.) The reply brief puts forth a somewhat less disapproving attitude towards the examination of extrinsic evidence in foreign tax credit cases than previously advanced, stating as follows: “The Commissioner does not contend (as he did below) that extrinsic evidence has no relevance in determining creditability under Treas. Reg. § 1.901-2(b). Rather, our argument is that it was improper for the Tax Court to supplant an analysis of the windfall-tax statute with an analysis of extrinsic evidence.”
The bottom line, however, is the same. The government maintains that the text of the U.K. Windfall Tax statute, by describing the tax using the term “value,” conclusively establishes that the tax is not an “income” tax in the U.S. sense and therefore is not creditable.
The case will now await an order from the Fifth Circuit setting a date for the oral argument, which is likely a few months away.
June 2, 2011
As we previously reported, the Ninth Circuit in Washington Mutual reversed the district court and ruled that the taxpayer did have basis in regulatory rights that it received in connection with a transaction in which it took over failed thrifts during the savings-and-loan crisis of the 1980s. The government has now allowed the periods for seeking rehearing and certiorari to expire without taking action. The Ninth Circuit’s decision is therefore final, and the case will move on to further proceedings on remand in the district court to determine the amount of basis.
May 31, 2011
The Tenth Circuit, after a long period of deliberation, has reversed the Tax Court in Salman Ranch. (Opinion linked here.) This now makes the score 3-2 in favor of the government in the series of appeals that have spread to most circuits. See our original report here.
The Tenth Circuit’s opinion closely tracks the reasoning of the Federal Circuit in Grapevine. The court first looked at the Supreme Court’s decision in Colony and concluded that it should not be read as holding that the statute unambiguously supports the taxpayer’s position. (The Tenth Circuit did note its disagreement with the Seventh Circuit’s conclusion in Beard that the statute unambiguously resolves the issue in the government’s favor.) Having found that Colony was not an obstacle to the issuance of valid Treasury regulations, the court proceeded to apply the Chevron test to the regulations and, like the Federal Circuit, ruled that the regulations surmounted the relatively low bar of being a reasonable interpretation of the statute. The Tenth Circuit stated: “Although we are not convinced the IRS’s interpretation is the only permissible one or even the one we would have adopted if addressing this question afresh, we are satisfied that it is a ‘permissible construction’ within the mandate of Chevron.”
The Salman Ranch case presented one interesting wrinkle not found in the other Intermountain cases. The Salman Ranch partnership had already prevailed on the identical issue in the Federal Circuit for a different tax year. See Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009). Ordinarily, that decision would have collateral estoppel effect in other litigation on the same issue between the same parties, and therefore it would have controlled the outcome in the Tenth Circuit. The Tenth Circuit ruled, however, that there was no collateral estoppel effect because the “rules” had changed in the interim — because of the issuance of the new regulations. The Federal Circuit had observed in Grapevine that the Chevron doctrine gives “regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.” The Tenth Circuit’s decision goes that statement one better with respect to the power of agencies to make law, at least in this particular context. It potentially gives regulatory agencies more power than even Congress to change the law, as Congress usually does not act retroactively when it enacts new legislation to overturn a court decision. Without retroactive effect, new legislation would not destroy the collateral estoppel effect of a court decision.
If the taxpayer wishes to seek rehearing, the petition would be due on July 18. By that time, the issues could be on their way to the Supreme Court because the government’s deadline for seeking certiorari in Home Concrete, the most advanced of these cases, is July 5.
May 23, 2011
The Supreme Court this morning granted certiorari in one case, Kawashima v. Holder, on which we have been reporting for some time. See our original post here. As we observed in our report on the cert petition, the Court always has the option of limiting its grant of certiorari to a subset of the questions presented in the petition, and it has exercised that option here. The Court will resolve only the first question presented — namely, whether violations of 26 U.S.C. 7206 (subscribing to a false statement on a tax return) are “aggravated felonies” that can justify deportation of a resident alien. The Kawashimas argue that only tax evasion convictions under section 7201 are aggravated felonies, and the courts of appeals have divided on the issue. Now the Supreme Court will resolve the dispute.
The case will now be briefed over the summer and argued in the fall of 2011, with a decision likely in the spring of 2012. The Kawashimas’ opening brief is due July 7.
May 23, 2011
The government has filed its brief in the Third Circuit in PPL. The brief is virtually identical to the brief filed a few weeks ago in the Fifth Circuit in Entergy that addresses the same issue of the creditability of the U.K. Windfall Tax under Code section 901. See our initial report here. The only significant differences are addressing PPL’s facts instead of Entergy’s and placing more weight on Third Circuit precedent instead of Fifth Circuit precedent. The essence of the government’s argument is that the section 901 determination should be based entirely on the text of the foreign statute, and therefore the Tax Court erred in considering extrinsic evidence of how the tax operates. Because the U.K. statute uses the term “profit-making value,” the government says that it is a tax on “value,” not an “income” tax, and therefore it should not be creditable.
PPL’s brief is due June 9.
May 16, 2011
The Supreme Court was expected to announce this morning whether it would grant certiorari in the Kawashima case, but today’s order list contained no order in the case. Instead, the Court has “relisted” the petition for consideration at this week’s conference. That means that the case has caught the Court’s attention and distinguished itself from the mass of cert petitions that are routinely denied, with some of the Justices determining that the petition warrants more careful study. Although the odds that the petition will be granted have increased, it remains true that most cert petitions are denied, even the ones that are relisted. (That is what happened last month with the State of Virginia’s cert petition seeking immediate review of its challenge to the constitutionality of the new health care legislation.) If the Court is ready to decide on the Kawashima petition this week with the benefit of another week to consider it, the order denying or granting certiorari would be announced next Monday, May 23.
May 13, 2011
The taxpayer has filed its answering brief in Entergy defending the Tax Court’s decision that the U.K. windfall tax is a creditable tax for purposes of the foreign tax credit under Code section 901. See our original report here. According to the taxpayer, the essence of the government’s argument is that “the creditability of a foreign tax can be determined only by the literal text of the foreign tax statute, and that the consideration of any other evidence is legal error.” This position, the taxpayer argues, is rebutted by “overwhelming authority establishing that the predominant character of a foreign tax is measured by its intent and effect,” which requires resort to evidence beyond the text of the foreign statute.
The taxpayer also argues that the government has mischaracterized the Tax Court’s decision in stating that the court ignored the three-part regulatory test for creditability. Instead, the Tax Court correctly heard evidence of the intent and effect of the U.K. tax to determine its predominant character — namely, a tax on excess profits — and then applied the three-part test to that predominant character.
The government’s reply brief is due May 31.
May 9, 2011
After four extensions, the government finally filed its response to the petition for certiorari in Kawashima. As we previously reported (see here and here), that petition raises a question on which the courts of appeals are in conflict — whether a tax offense other than tax evasion can be an “aggravated felony” for purposes of the immigration laws, which would justify deportation of a resident alien. Maybe the government was spending all that extra time considering whether to “acquiesce” in the petition and invite the Supreme Court to resolve the conflict, or maybe it was just taking its sweet old time. In any event, the government has filed a brief urging the Court to deny certiorari.
The brief in opposition acknowledges that there is a conflict in the circuits, terming it “a narrow disagreement.” But the government argues that there is no need for the Court to resolve that disagreement. In particular, the government argues that the Court’s recent decision in Nijhawan v. Holder, 129 S. Ct. 2294 (2009), supports the government’s position and, since the Third Circuit’s contrary decision was issued before Nijhawan, “the narrow disagreement in the courts of appeals may be resolved without further intervention of this Court.” On the merits, the government resists the petition’s statutory construction analysis by arguing that “fraud or deceit” is not necessarily an element of tax evasion under 26 U.S.C. § 7201. If it is not, then theoretically 8 U.S.C. §1101(a)(43)(M)(ii) is not superfluous, as the petition argues.
In their reply brief, petitioners vigorously contest the government’s premise that “fraud or deceit” is not necessarily an element of tax evasion under 26 U.S.C. § 7201 by analyzing the structure of the Code’s criminal tax provisions. Among other things, petitioners state that the government’s “reasoning defies logic: the greater offense [section 7201] does not necessarily involve ‘fraud or deceit,’ but the lesser offense [section 7206] necessarily does.” With respect to the government’s assertion that this circuit conflict does not warrant the Supreme Court’s attention, petitioners maintain that the need to stop unlawful deportations presents a compelling reason for Supreme Court review.
The Court is likely to act on the petition on May 16.
May 3, 2011
The Fifth Circuit yesterday issued a short, unpublished opinion affirming the Tax Court’s decision in Container. As discussed in more detail in our earlier post, the issue is the sourcing of guarantee fees charged by a Mexican parent to guarantee notes issued by its U.S. subsidiary. The Fifth Circuit ruled that the issue turned to a considerable extent on the Tax Court’s factual findings concluding that the fees were payments for services, which it found were not clearly erroneous. The Fifth Circuit concluded that the Tax Court’s ultimate characterization of the fees as foreign-source income was correct because they were payments for a service that was performed in Mexico — namely, the parent’s provision of the guarantee. The government had argued that the guarantee fees were more in the nature of interest that should be sourced to the United States.
This decision is of limited significance going forward. As we previously noted, Congress has already acted to reverse the result of this case for future years by enacting legislation specifically providing that a guarantee fee paid by a U.S. company is U.S.- sourced income. And the opinion resists making broad pronouncements about sourcing analysis, largely confining the discussion to the facts of the case. Indeed, by declining to publish the opinion, the Fifth Circuit has deliberately sought to minimize its precedential value. Under Fifth Circuit Rule 47.5.4, unpublished decisions may be cited, but they “are not precedent, except under the doctrine of res judicata, collateral estoppel or law of the case.”
A petition for rehearing, should the government choose to file one, would be due on June 16.
April 21, 2011
On April 15, the Fifth Circuit denied the government’s rehearing petition in Burks. Not surprisingly, the courts of appeals are showing little interest in sitting en banc to address the Intermountain issue when they cannot eliminate the circuit conflict. To recap, a rehearing petition is pending in the Federal Circuit, but the other three circuits to rule (the Fourth, Fifth, and Seventh) have denied rehearing, and the time is running to file petitions for certiorari in those cases. The first deadline on the horizon is in the Home Concrete case from the Fourth Circuit, where the certiorari petition is due July 5.
April 15, 2011
The taxpayer has filed a petition for rehearing en banc in the Federal Circuit in Grapevine. Because Grapevine is the first appellate decision to rely on the new regulations (see here), the petition focuses part of its argument on criticizing the Federal Circuit’s decision to defer to those regulations, especially after the same court in Salman Ranch had rejected the statutory interpretation embodied in the regulations. The petition also argues that applying the regulations to Grapevine is unlawful, even if the regulations could be controlling in future cases, because Grapevine had already obtained a favorable judgment from the Court of Federal Claims before the regulations were promulgated.
With the courts of appeals hopelessly conflicted already on the Intermountain six-year statute of limitations issue, it is a longshot to expect the Federal Circuit to want to wade into these issues en banc. At this point, that court most likely will be inclined to sit back and see what the Supreme Court has to say.
April 14, 2011
The government has filed its opening brief in the Fifth Circuit in Entergy, seeking reversal of the Tax Court’s holding that the U.K. windfall tax is a “creditable” tax for purposes of the U.S. foreign tax credit. See our previous report here. The government argues that the Tax Court misapplied a three-part test set forth in the regulations for determining whether a foreign tax is creditable. That test assesses whether the foreign tax has the “predominant character” of an income tax by examining whether it satisfies each of three requirements – relating to “realization,” “gross receipts,” and “net income.” According to the government, the U.K. windfall tax did not meet any of the three requirements because the tax was imposed on “value,” not realized “income,” and because gross receipts and expenses were not “components of the tax base.” The brief goes on to criticize the Tax Court for investigating the legislative purpose of the tax, rather than restricting its inquiry to the text of the statute.
The taxpayer’s brief is due May 16.
The Ninth Circuit Rejects the Government’s Effort to Disregard “Economic Realities” in Washington Mutual
April 8, 2011
[Note: Miller & Chevalier is counsel to Washington Mutual in this case.]
In the past decade, the government has often defeated taxpayer claims that tax benefits flowed from certain transactions on the grounds that the economic substance of the transactions did not justify the tax benefits and that the taxpayer’s contrary arguments reflect a hypertechnical reading of the rules. In Washington Mutual Inc. v. United States (9th Cir. No. 09-36109), the proverbial shoe was on the other foot. A key element of the taxpayer’s business transaction was the receipt of regulatory rights in exchange for incurring the cost of relieving the government of impending liabilities. The government argued, however, that, with respect to determining basis in those intangible assets, technical requirements in the reorganization rules trumped the economic reality that the taxpayer had purchased those rights. The Ninth Circuit rejected that argument and ruled for the taxpayer.
The controversy stemmed from an acquisition by Washington Mutual’s predecessor, Home Savings, of three failed thrifts during the savings and loan crisis of the early 1980s. In part due to skyrocketing interest rates, many thrifts at that time had deposit liabilities that exceeded the value of their assets. The policy of the Federal Savings and Loan Insurance Corporation (FSLIC) was to encourage healthy thrifts to acquire such failed thrifts in what were called “supervisory mergers,” which would spare FSLIC the liability it would otherwise incur if it had to liquidate the thrifts and pay off its insurance obligation to depositors. In this case, the primary inducement offered to Home to convince it to enter into what would otherwise have been a losing proposition was a pair of regulatory rights (the right to open branches in other states and the right to the accounting treatment for regulatory purposes that was involved in United States v. Winstar Corp., 518 U.S. 839 (1996)).
Home indisputably incurred a cost in getting FSLIC off the hook in this way because Home inherited the failed thrifts’ net liabilities. Arguing that the transaction was in substance a purchase of regulatory rights, Washington Mutual contended that basic tax principles dictated that Home took a cost basis in the acquired assets – that is, the two regulatory rights. Alternatively, Washington Mutual argued that the assets could have a fair market value basis, through the operation of Code section 597, if they were viewed as FSLIC assistance rather than as the object of a purchase. The government objected to both theories on technical grounds. It argued that the assignment of a carryover basis to the thrift assets under the “G” reorganization rules precluded assigning a cost basis to the regulatory rights. And it raised a variety of hypertechnical textual objections to application of section 597. The district court agreed with the government, holding that the regulatory rights had no basis at all.
The Ninth Circuit reversed in an opinion authored by Judge Betty Fletcher and joined by Judge Bybee, holding that Home took a cost basis in the regulatory rights. The opinion began by emphasizing the “overarching principle” that, “absent specific provisions, the tax consequences of any particular transaction must reflect the economic reality.” In this case, “the economic realities of the transaction” were that Home engaged in one “all-encompassing transaction” in which it acquired the failed thrifts and received the regulatory rights as “part of the consideration.” The majority explained that the government’s argument based on the “G” reorganization rules did not respect the economic reality of this “all-encompassing transaction,” and the majority concluded that those rules were “not incompatible” with the conclusion that Home took a cost basis in the regulatory rights. In sum, the majority ruled that the tax treatment should follow the economic reality that Home did not acquire the regulatory rights in the “G” reorganization but rather purchased the rights from FSLIC and paid for them by allowing the thrifts, which had negative value, to merge into Home.
Given its ruling on cost basis, the majority did not address the alternative theory that Home took a fair market value basis through the operation of Code section 597. Judge Fernandez, however, found that theory more persuasive, and he concurred in the reversal of the district court on that ground (remarking that he therefore had “no need to wrestle with” the cost basis question). Like the majority, he concluded that the government’s technical theories were unsound and could not justify disregarding the economics of the transaction. “Home Savings greatly benefitted the government at a time of great need,” and “it was given the [regulatory] Rights as part of the inducement to do so. . . . Whether one accepts the analysis of the majority or mine, the result is that Home Savings did have a basis in them.”
The Ninth Circuit’s decision is a welcome reminder that what’s good for the goose is good for the gander. In the words of the majority opinion, when a taxpayer enters into a transaction that “has economic substance and is economically realistic,” the taxpayer should benefit from the accompanying tax treatment provided under the law.
The briefs and opinions in the case are linked below.
If the government decides to seek rehearing of the Ninth Circuit’s decision, its petition would be due on April 18.
April 8, 2011
The Seventh Circuit today denied the taxpayer’s rehearing petition in Beard. Coupled with the Fourth Circuit’s denial of rehearing in Home Concrete a few days ago, this action removes the faint theoretical possibility of resolving the circuit conflict in the Intermountain cases short of the Supreme Court. A petition for certiorari in Beard would be due on July 7.
April 6, 2011
On April 5, the Fourth Circuit denied rehearing in Home Concrete, one of the Intermountain-type cases that went for the taxpayer. This now becomes the first of the cases for which there is no recourse left other than seeking Supreme Court review. The government is very likely to pursue that course of action. A petition for certiorari would be due on July 5.
April 5, 2011
On April 5, the D.C. Circuit (Judges Sentelle, Randolph, and Tatel) heard oral argument in Intermountain and its companion case, UTAM. The court’s questions generally indicated that the most likely outcome is a reversal of the Tax Court and another point for the government in the circuit court competition that is currently tied at 2-2. (See our recent report on the Federal Circuit’s decision in Grapevine.)
Judge Randolph in particular was an advocate for the government’s position. He dismissed the argument that Congress could be regarded as having adopted the Colony result under the doctrine of reenactment, and he expressed the view that Colony could not be controlling for an issue arising under the 1954 Code. He also indicated his belief that an overstatement of basis is logically encompassed within the phrase “omission from gross income.”
Judges Sentelle’s questions were more evenhanded. Both he and Judge Tatel indicated some skepticism about the government’s textual argument that a basis overstatement is an “omission” from gross income. Judge Sentelle also pressed government counsel on the Supreme Court’s statement in Colony that the 1954 Code was unambiguous. But he seemed satisfied with government counsel’s response that the Court’s statement must be read in light of the additions made to the 1954 Code that the Seventh Circuit relied upon in Beard.
Judge Tatel followed up on this issue, pressing taxpayer’s counsel to explain why those additions did not defeat the taxpayer’s reliance on Colony. Taxpayer’s counsel argued that these additions did not exist in the partnership statute, section 6229, and also directed the court to the Federal Circuit’s decision in Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009), for an explanation of why these additions were fully consistent with applying Colony to an individual under the 1954 Code. But it was not apparent that these arguments were making headway. Judge Tatel also jumped in to squash taxpayer counsel’s attempt to get mileage from the fact that the controversy was well underway before the temporary Treasury Regulations issued.
Overall, most of the argument was devoted to Colony and to parsing the statutory text and the differences between the 1939 and 1954 Code provisions. All three judges appeared comfortable with the notion that, if they found Colony not to be controlling, then Brand X and the principle of Chevron deference to Treasury regulations would lead inexorably to a ruling for the government. That is probably the most likely outcome, though, as we have noted previously, it is likely that the Supreme Court will have the last word.
One glimmer of light for the taxpayers was Judge Tatel’s exploration at the end of the argument of the question whether the taxpayers had made an adequate disclosure that would defeat the six-year statute of limitations. Government counsel conceded that this issue remained open and that it should be addressed by the Tax Court on remand if the decision is reversed.
March 29, 2011
As promised, the government filed a petition for rehearing en banc in the Fifth Circuit in the Burks case. The filing has one wrinkle that differs from the numerous other recent filings on this issue. The petition claims an intracircuit conflict as a basis for rehearing en banc, arguing that the panel’s decision conflicts with Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), a case that the panel had found distinguishable. See our previous report on the Burks decision here.
New Government Filings Try to Unify Courts of Appeals Behind the Six-Year Statute for Overstatements of Basis
March 24, 2011
As we have reported extensively (e.g. here and here), the courts of appeals appear to be hopelessly split on the “Intermountain” issue of whether a six-year statute of limitations applies to overstatements of basis. Nevertheless, the government has not given up on the possibility of winning this issue in all courts of appeals and thus eliminating the need for it to go to the Supreme Court. To that end, it filed in two cases at the rehearing stage yesterday.
In the Beard case in the Seventh Circuit, the government filed a response opposing the taxpayer’s petition for rehearing en banc. It argued that the Seventh Circuit’s pro-government decision was correct and pointed out that the Seventh Circuit “cannot by itself resolve this conflict” in the circuits even if it grants rehearing, because there are multiple circuits that have ruled on both sides of the issue.
In the Home Concrete case in the Fourth Circuit, the government filed its own petition for rehearing en banc. It argued that the Fourth Circuit erred and should instead adopt the reasoning of either the Seventh Circuit in Beard or the Federal Circuit in Grapevine. Lawyers being what they are, the government’s own petition managed to avoid pointing out to the Fourth Circuit that it “cannot by itself resolve this conflict.” The petition did state that the government also plans to seek rehearing in the next few days in the Burks case in Fifth Circuit — the other court of appeals that has rejected the government’s position even after the new regulations issued.
For now, these filings seem to put the Beard case back in the lead as the first case likely to be ready for Supreme Court review. But that can change depending on the respective speed with which the different courts of appeals rule on the rehearing petitions.
March 18, 2011
As we have previously reported, the Third Circuit is considering a tricky issue relating to the Tax Court’s jurisdiction to resolve disputes concerning overpayment interest. At the oral argument, the court explored different facets of the issue, even while joking about its complexity. At one point, one of the judges appeared to question whether the Tax Court’s Estate of Baumgardner case was correctly decided, even though the IRS had acqueisced in it. Government counsel declined that offer, instead adhering to the view that Baumgardner is different because it involved deficiency interest rather than overpayment interest. Taxpayer’s counsel invoked Code section 7481(c) as a possible alternative jurisdictional basis for the Tax Court, but the government responded that section 7481(c) could not apply to Sunoco’s situation. In response to a question, government counsel acknowledged that the dispute in Sunoco would not affect many taxpayers, as they usually bring overpayment interest claims to the Court of Federal Claims.
Although no precise consensus emerged from the court’s questions and answers, the panel seemed to exhibit sufficient skepticism about the Tax Court’s reasoning that practitioners should be cautious in placing much weight on the Tax Court’s decision. There is certainly a substantial risk that it will be reversed.
March 18, 2011
The Second Circuit has announced a May 16 oral argument date in TIFD III-E, Inc. v. United States, which is the second go-round for the case better known as Castle Harbour after the district court ruled again for the taxpayer on remand from the Second Circuit’s previous reversal. (See our prior reports and the briefs here, here, and here.) The identity of the three-judge panel will not be revealed until a later date.
March 11, 2011
On March 7, the taxpayer filed a petition for rehearing en banc (attached below) with the Seventh Circuit in Beard, emphasizing that both the Fifth and Fourth Circuits had explicitly disagreed with that decision and reached the opposite result on the Intermountain issue. Although courts of appeals often deny such petitions without a response, the Seventh Circuit almost immediately directed the government to file a response, which is due March 23. Today’s pro-government decision by the Federal Circuit in Grapevine perhaps takes a little steam out of the possibility of rehearing since a circuit conflict will likely persist even if the Seventh Circuit rehears the case and reverses itself, but the full Seventh Circuit still may want to consider whether the panel had a sound basis for disagreeing with so many other courts. The Grapevine decision, of course, rests on a different ground from Beard — namely, deference to the new regulations. With respect to the statutory issue addressed by the Beard panel, the Federal Circuit also is in disagreement with the Seventh Circuit.
Federal Circuit Adds to Intermountain Conflict by Deferring to New Regulations That Apply Six-Year Statute to Overstatements of Basis
March 11, 2011
The Federal Circuit has ruled for the government in Grapevine, throwing the circuits into further disarray by adopting an approach that differs from all three of the courts of appeals that have previously addressed the Intermountain issue subsequent to the issuance of the new regulations. Becuase the Federal Circuit had already rejected the government’s construction of the statute in Salman Ranch, the Grapevine case starkly posed the question whether the new regulations had the effect of requiring the court to disregard its prior decision and reach the opposite result. As we previously reported, at oral argument the day after the decision in Mayo Foundation, the government told the Federal Circuit that Mayo compelled that result. The court has now agreed.
A key section of the court’s opinion considers whether the Supreme Court’s decision in Colony defeats the government’s deference argument. The court says it does not because Colony itself stated that it did not regard the statutory text as unambiguous and, even considering the Colony court’s review of the legislative history, the court did not believe that “Congress’s intent was so clear that no reasonable interpretation could differ.” Therefore, Colony did not resolve the case under Chevron Step 1 and, under Brand X, Treasury was free to issue a regulation that contradicts Colony. (In its analysis, the Federal Circuit appears to have sided with the view, based on footnote 9 of Chevron, that legislative history can be considered at Chevron Step 1 (see our previous post)). The court then applies the Chevron analysis to the new regulations and concludes that they are reasonable based on exactly the same government arguments that the court rejected in Salman Ranch when it was construing the statute in the absence of a regulation. Finally, the court rules that Treasury did not abuse its discretion in applying the new regulations retroactively to years that were still open under the six-year statute.
The Grapevine decision is significant in the specific context of the Intermountain cases, as it virtually ensures that a circuit conflict on the issue will persist even if the Seventh Circuit reconsiders its decision in Beard. And it is the first appellate decision to address in detail the merits of the government’s primary argument that it can overturn the prior adverse decisions in this area by regulation. More generally, the case is a great illustration of Treasury’s power under the combination of Mayo and Brand X. The Federal Circuit was keenly aware of the implications of its decision, summarizing it as follows: “This case highlights the extent of the Treasury Department’s authority over the Tax Code. As Chevron and Brand X illustrate, Congress has the power to give regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.” Presumably, Treasury will continue to test the limits of how far it can go in exercising that “primary responsibility.”
March 3, 2011
The Third Circuit has now issued a briefing schedule in the PPL case that makes the government’s opening brief due on April 5. This schedule should have the case marching along in fairly close parallel with Entergy, the companion case presenting the same UK tax creditability issue to the Fifth Circuit. (See our previous post here.) In Entergy, the government recently requested an extension to file its opening brief. The court granted an extension, but for less time than requested. The brief is now due April 13, after a 30-day extension. That date will likely hold, since the court has already cut back an unopposed extension request. In PPL, by contrast, it is quite possible that the government will get some additional time.
February 23, 2011
I will be participating in what promises to be an interesting panel discussion on the Mayo Foundation decision on Monday February 28 at 1:00 EST. The other two distinguished members of the panel are: Gil Rothenberg, Chief of the Appellate Section of the United States Department of Justice’s Tax Division, who is also currently serving as Acting Deputy Assistant Attorney General for Review and Appellate; and Emily Parker, partner at Thompson & Knight LLP, and former Acting Chief Counsel and Deputy Chief Counsel for the IRS.
Information on how to register for the program can be found here.
We will be discussing the Mayo decision and its ramifications for future litigation and the regulatory process from both the government and taxpayer perspectives.
February 9, 2011
The Fifth Circuit announced today its ruling in favor of the taxpayer in the two consolidated cases pending before it on the Intermountain issue, Burks v. United States, and Commissioner v. MITA. As we previously noted, the Fifth Circuit had decided what the government regarded as the most favorable precedent on this issue before the Son-of-BOSS cases, Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), but the court at oral argument appeared to be leaning towards finding that case distinguishable. And so it did, creating the anomaly that the Seventh Circuit in Beard has given Phinney a much broader reading than the Fifth (see here). In any event, the Fifth Circuit rejected the reasoning of Beard and concluded that Colony is controlling with respect to the meaning of the phrase “omits from gross income” in the 1954 Code. The court addressed this argument in some detail, relying heavily on the “comprehensive analysis” of the Ninth Circuit in favor of the taxpayer’s position in Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009).
The court devoted comparatively little attention to the government’s reliance on the new regulations. It concluded that the statute was unambiguous and therefore there was no basis for affording deference to the regulations. In addition, the court stated that the new regulations by their terms were inapplicable because they should be read as reaching back no more than three years — an argument accepted by the Tax Court majority but that does not appear to be among the taxpayers’ strongest, especially after the final regulations were issued.
The most provocative discussion in the opinion is a long footnote 9 near the end, which points out some possible limitations on the impact of the Supreme Court’s recent Mayo Foundation decision (discussed here). Although its conclusion that the statute is unambiguous made the regulations irrelevant, the court went on to state that it would not have deferred to the regulations under Chevron even if the statute were ambiguous. On this point, the court emphasized an important difference between Mayo and the Intermountain cases — namely, the retroactive nature of the regulations at issue in the latter cases. Noting that the Supreme Court has said that it is inappropriate to defer “to what appears to be nothing more than the agency’s convenient litigating position” (quoting Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 213 (1988)), the Fifth Circuit stated that the “Commissioner ‘may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations’” (quoting Chock Full O’Nuts Corp. v. United States, 453 F.2d 300, 303 (2d Cir. 1971)). In addition, the court questioned the efficacy of the government’s request for deference to final regulations that were largely indistinguishable from the temporary regulations: “That the government allowed for notice and comment after the final [perhaps should read "temporary"] Regulations were enacted is not an acceptable substitute for pre-promulgation notice and comment. See U.S. Steel Corp. v. U.S. EPA, 595 F.2d 207, 214-15 (5th Cir. 1979).”
Thus, we have perfect symmetry between the conflicting decisions of the Fifth and Seventh Circuits. The Seventh Circuit says that the statutory language supports the government, so there is no need to consider the regulations. But if it did consider the regulations, it would defer. The Fifth Circuit says that statutory language unambiguously supports the taxpayer, so there is no justification for considering the regulations. But if it did consider the regulations, it would not defer. The Supreme Court awaits, and it may well have something to say about the Fifth Circuit’s observations in footnote 9.
February 8, 2011
We present here a guest post from our colleague Kevin Kenworthy, who has considerable experience representing taxpayers on the issue of creditable foreign taxes.
The Tax Court’s two companion decisions in PPL Corp. v. Commissioner, 135 T.C. No. 8 (Sept. 9, 2010) and Entergy v. Commissioner, T.C. Memo 2010-166 (Sept. 9, 2010), raise an important question concerning whether a 1997 Windfall Tax imposed by the U.K. government on previously privatized industries is a creditable income tax under U.S. rules. The cases were tried separately before Judge Halpern and addressed in companion opinions issued simultaneously that ruled for the taxpayer (with the analysis contained in the PPL opinion). The opinions are linked below. The government has now appealed these cases to the Third and Fifth Circuits respectively. (The Tax Court cases, in opinions issued a few weeks earlier, also addressed an issue concerning the appropriate recovery period for depreciation of an electric utility’s lighting assets, but it appears at this point that the government does not plan to contest that issue on appeal.)
Under section 901 of the Code and related provisions, a U.S. taxpayer can elect to credit, rather than deduct, qualifying income taxes paid to a foreign country. Only income taxes are eligible for this credit; non-income taxes can only be deducted in computing taxable income. In determining whether a foreign tax is creditable, the ultimate inquiry is whether the levy is an income tax in the U.S. sense of the term. The governing regulations provide a specific framework for assessing whether a foreign tax meets this test, including requirements that the foreign tax meet a three-part test aimed at determining whether the tax will reach net gain in the ordinary circumstances in which it applies. Treas. Reg. § 1.901-2.
The U.K. Windfall Tax is an unconventional levy in some respects, resulting in part from its unique origins in British politics. In the early 1990s, Conservative governments continued a policy of privatizing what had previously been government-owned monopolies, including regional electricity companies, through a series of public stock offerings. The privatizations were anathema to traditional Labour Party tenets. Moreover, the newly privatized entities, although they continued to be subject to price regulation, proved to be quite profitable in the years following privatization. In 1997, the new Labour government announced a tax aimed at “windfall profits” previously realized by the formerly government-owned enterprises. The tax was justified by assertions that windfall profits resulted from the prior government’s decision to sell off the companies at too low a price, compounded by its failure to subject the privatized companies to adequate regulation.
The Windfall Tax was designed as a one-time, retrospective tax imposed on the privatized utilities. The new tax was imposed on the basis of a unique formula that started with the average book profits of these enterprises over the first four years following privatization multiplied by nine, an amount characterized by the statute as the “value in profit-making terms.” Tax at a rate of 23% was then imposed on the excess of this artificial earnings multiple over the initial market capitalization (the “flotation value”) of the shares. The tax was imposed on the companies directly, rather than on the initial private shareholders, many of whom had long ago sold their shares.
The taxpayers argued that the creditability of the Windfall Tax could be established by examining the actual operation and effect of the tax. The taxpayers showed that the statutory formula could be restated algebraically to reveal that the Windfall Tax operated in almost all cases equivalently to a tax imposed at a rate of roughly 50% on profits realized over a four-year period. Based in large part on this equivalence, the taxpayers argued that the Windfall Tax was essentially an income tax and satisfied the regulatory test for creditability. The IRS countered that the creditability of the Windfall Tax could be evaluated only by reference to the statutory language and that resort to extrinsic evidence of the type offered by the taxpayers was inappropriate. Further, the IRS argued that the statute’s apparent reference to valuation principles, rather than to conventional measures of net income, leads to the conclusion that the Windfall Tax is not creditable. Drawing ample support from the regulations themselves and from prior court decisions, the Tax Court refused to limit the creditability inquiry in this manner and found the Windfall Tax to be creditable.
The government’s opening brief in Entergy is due March 14, 2011. No briefing schedule has yet been established in PPL.
February 8, 2011
The Fourth Circuit, in an opinion authored by Judge Wynn and joined by Judges Wilkinson and Gregory, has solidified the circuit conflict on the Intermountain issue by ruling for the taxpayer in the Home Concrete case. (See our original post on these cases here.) First, the court held that the statutory issue was resolved by the Supreme Court’s decision in Colony, rejecting the argument recently accepted by the Seventh Circuit in Beard (see here) that Colony addressed the 1939 Code and should be understood as applying to identical language in the 1954 Code only to the extent that the taxpayer is in a trade or business. The court concluded that “we join the Ninth and Federal Circuits and conclude that Colony forecloses the argument that Home Concrete’s overstated basis in its reporting of the short sale proceeds resulted in an omission from its reported gross income.”
Second, the court held that the outcome was not changed by the new Treasury regulations. The court held that the regulations by their terms could not apply to the 1999 tax year at issue, because “the period for assessing tax” for that year expired in September 2006. See Treas. Reg. § 301.6501(e)-1(e). The government argued that the new regulations apply to all taxable years that are the subject of pending cases, but the court held that this position could not be squared with the statutory text of Code section 6501. In any event, the court continued, no deference would be owed to the regulations under the principles of Brand X because the Supreme Court had already conclusively construed the term “omission from gross income” in Colony and therefore there was no longer any room for the agency to resolve an ambiguity by regulation.
Judge Wilkinson wrote a separate concurring opinion to elaborate on this last point. He observed that Brand X allows a regulation to override a prior court decision only if that decision was not based on a Chevron “step one” analysis — that is, on a conclusion that the statute is unambiguous. This can be a difficult inquiry when examining pre-Chevron decisions in which the court had no reason to analyze the case through the lens of the two-step Chevron framework. Judge Wilkinson explains why he “believe[s] that Colony was decided under Chevron step one,” concluding that the Supreme Court’s statement that it could not conclude that the 1939 Code language is unambiguous was “secondary in importance to the thrust of the opinion” and the Court’s assessment of the statutory purpose. (As previously discussed here, this question of whether Colony should be viewed as a “step one” decision, and the related question of how relevant legislative history is at “step one,” was the focus of the Federal Circuit’s attention in the oral argument in Grapevine.)
Judge Wilkinson then goes on to make some more general observations about the limits of Chevron deference in the wake of the Mayo Foundation case. He states that Mayo “makes perfect sense” in affording “agencies considerable discretion in their areas of expertise.” He cautions, however, that “it remains the case that agencies are not a law unto themselves. No less than any other organ of government, they operate in a system in which the last words in law belong to Congress and the Supreme Court.” In Judge Wilkinson’s view, the government’s attempt to reverse Colony by regulation “pass[es] the point where the beneficial application of agency expertise gives way to a lack of accountability and a risk of arbitrariness.” He concludes that “Chevron, Brand X, and more recently, Mayo Foundation rightly leave agencies with a large and beneficial role, but they do not leave courts with no role where the very language of the law is palpably at stake.”
The Fourth Circuit’s decision seems to eliminate the slim possibility that the Intermountain issue could be definitively resolved short of the Supreme Court. There are now two circuits (the Fourth and the Seventh) that have come down on opposite sides, though both had the opportunity to consider the recent developments of the final regulations and the Mayo decision. At this point, the government is likely to seek Supreme Court review, either by acquiescing in a taxpayer certiorari petition (possibly in Beard) or by filing its own petition in Home Concrete. Unless petitions for rehearing are filed, the parties have 90 days from the date of final judgment to file a petition for certiorari in these cases.
February 2, 2011
The government has filed its reply brief in the D.C. Circuit in Intermountain. Although there are no surprises, the brief is a useful resource because it contains in one place the government’s arguments concerning three recent developments favorable to its case, which it has been calling to the attention of other courts piecemeal in supplemental filings. Those developments are the Seventh Circuit’s Beard decision (see here); the Supreme Court’s decision in Mayo Foundation (see here), and the issuance of final regulations (see here). Despite its recent victory in Beard on purely statutory grounds, the government still seems to believe that Chevron deference to the new regulations is its best bet. The reply brief devotes 3 pages to the statutory argument and 23 pages to the regulatory deference argument.
Oral argument is scheduled for April 5.
January 26, 2011
It took less than a day for the government to try out its new Mayo Foundation toy – that is, the Supreme Court’s ruling that deference to Treasury regulations is governed by the same Chevron principles that apply to regulations issued by other agencies. (See our report on the Mayo decision here.) The Intermountain-type litigation posed the perfect opportunity to examine the impact of Mayo, as the regulations at issue in those cases clearly are more vulnerable under the National Muffler approach of looking to factors like whether the regulation is contemporaneous or designed to reverse judicial decisions. Accordingly, the government promptly filed notices of supplemental authority in those cases calling the various courts’ attention to Mayo.
The Federal Circuit did not have much time to ruminate on the supplemental filing, as oral argument in Grapevine was set for the next day. Even so, the government was not bashful about embracing Mayo. Acting Deputy Assistant Attorney General Gil Rothenberg began his argument by telling the court that Mayo “foreshadows” how the case should be decided because of the “striking . . . parallels” between Mayo and Grapevine. That opening triggered immediate pushback from an active panel (Judges Bryson and Prost, with Judge Lourie remaining mostly silent during the argument). The judges pointed to the obvious difference between the cases, the existence of a Supreme Court decision (The Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958)) that has already construed the statutory language at issue in Grapevine. What ensued was a lively oral argument that focused almost entirely on the rules for Chevron analysis and very little on any topics that would be standard fare for a tax practitioner.
The Chevron jurisprudence issue that dominated the argument is the scope of the Supreme Court’s decision in Nat’l Cable and Telecommunications Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005). As noted in our first post on these cases, Brand X says that Chevron deference is owed even to a regulation that conflicts with judicial precedent – as long as that judicial precedent did not hold that the statute was unambiguous (a so-called Chevron Step 1 conclusion that would leave no room for interpretation by the agency). That limiting principle arguably defeats the deference argument in the Intermountain cases because the Supreme Court in Colony had construed the “omission from gross income” language as not covering cases of overstated basis. On the other hand, in reaching that conclusion, the Court had remarked that the statutory text was not “unambiguous” and had looked to legislative history as well. 357 U.S. at 33. Thus, the government argues that the Brand X limiting principle does not apply because the Supreme Court did not declare the statutory text unambiguous.
The case thus raises a fundamental question of Chevron jurisprudence: to what extent, if any, can a court look beyond the statutory text at Chevron Step 1? Chevron itself clearly answered this question. In defining Step 1 in which no deference is owed if the regulation conflicts with the “unambiguously expressed intent of Congress,” the Court explained in a footnote that a court is to determine Congress’s intent “employing traditional tools of statutory construction,” which presumably allows reference to legislative history. Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843 n.9 (1984). Brand X stated that “[t]he Chevron framework governs our review.” 545 U.S. at 980. So did Brand X reaffirm the statement in Chevron that the Step 1 analysis goes beyond the text and includes analysis of the legislative history? Not so fast. The Brand X opinion was authored by Justice Thomas, no fan of legislative history, and that opinion’s formulation of Chevron Step 1 in Brand X was notably more restrictive; deference is owed unless the “prior court decision holds that its construction follows from the unambiguous terms of the statute.” 545 U.S. at 982 (emphasis added).
The judges at the Grapevine argument focused on this question – in particular pressing government counsel on the contours of the government’s position. Counsel tried to walk a fine line, hoping to significantly marginalize the role of legislative history at Step 1 without blatantly disregarding the language of Chevron. He stated that legislative history is relevant at Step 1 only for the very limited purpose of determining the meaning of a “term” in the statute, but not for determining the general purpose of the statute and using that as an aid to statutory construction. (This approach is more nuanced that the position advanced in the government’s brief, which appeared to argue that legislative history can never be examined at Chevron Step 1.) The court questioned both whether this line could truly be drawn and whether in any event it would aid the government’s position in this case where the Colony Court had used legislative history to construe the statutory phrase “omission from gross income.” Judge Prost specifically asked government counsel whether he was arguing that Brand X had overruled Chevron. In response, he characterized Brand X as “narrowing” the broad language of Chevron and later acknowledged that he believed that Brand X is “not completely consistent” with footnote 9 of Chevron. With respect to the question whether his argument failed in any event because Colony had construed a statutory term, government counsel argued that Colony had construed the 1939 Code and therefore was not authoritative on the meaning of the same language in the 1954 Code.
Taxpayer’s counsel got a similar grilling from the panel when he took the podium and tried to argue that the court should simply follow Chevron footnote 9 and not worry about any possible retrenchment from that position found in Brand X. Judge Bryson observed that there is only a “tiny sliver” left of Chevron deference if one applies footnote 9 aggressively – that is, by allowing a determination of general congressional intent through legislative history to play a significant role at Step 1. Taxpayer’s counsel looked to Mayo for help, observing that Mayo had cited approvingly to pp. 842-43 of Chevron, the very pages that included footnote 9. Judge Bryson, however, quickly retorted that the Mayo citation did not mention footnote 9.
Taxpayer’s counsel spent some of his argument time seeking affirmance on narrower grounds, such as that the new regulations could not apply to Grapevine’s case either because they were promulgated after the trial court issued its final judgment or because, as the Tax Court majority held, the new regulations by their terms did not apply to cases outside the three-year statute of limitations. But the Federal Circuit showed little sympathy for these arguments. Instead, it appears likely that the Federal Circuit’s decision will wade into the question of how Chevron and Brand X apply to the new regulations. The court did not tip its hand, although to this observer it appeared more likely to conclude that the taxpayer should prevail – because Colony was a sufficiently definitive interpretation of the statutory text under Chevron Step 1 that Brand X does not leave room for it to be overruled by regulation.
One interesting aspect of the argument was the failure of anyone to discuss the point made by Justice Stevens in his one-paragraph concurring opinion in Brand X. Justice Stevens noted that he fully joined the majority opinion, “which correctly explains why a court of appeals’ interpretation of an ambiguous provision in a regulatory statute does not foreclose a contrary reading by the agency.” 545 U.S. at 1003 (emphasis added). Justice Stevens added, however, that “[t]hat explanation would not necessarily be applicable to a decision by this Court that would presumably remove any pre-existing ambiguity.” Id. Justice Stevens’ suggested distinction between court of appeals decisions and Supreme Court decisions makes Grapevine an easy case. If Colony is understood to remove any ambiguity in the statutory text, then there is no room for Chevron deference to the new regulations and no need to get into the morass of determining whether Brand X modified Chevron. Taxpayer’s counsel did not raise this point, however, and none of the judges asked about it. (We note that the Tenth Circuit has addressed and rejected Justice Stevens’ suggested distinction between courts of appeals and the Supreme Court in applying Brand X. Hernandez-Carrera v. Carlson, 547 F.3d 1237, 1246-48 (10th Cir. 2008).).
A decision from the Federal Circuit would ordinarily be expected sometime in the spring. Judge Prost did ask government counsel about the status of the other Intermountain cases, and he responded that Grapevine marked the fifth case to be argued, with argument scheduled in the D.C. Circuit in April. But the Federal Circuit did not give the impression that it planned to sit tight and let other circuits sort out these issues. As we report elsewhere, the Seventh Circuit got the ball rolling today by deciding the Beard case – ruling for the government on statutory grounds without relying on the regulations. That decision should not have much impact on the Federal Circuit, which has already rejected the Seventh Circuit’s reasoning in Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009). If the Federal Circuit determines to rule for the government, it will have to rely on the regulations.
January 26, 2011
The Seventh Circuit today became the first court of appeals to weigh in on the Intermountain issue subsequent to the issuance of the temporary regulations, and it handed the government a big victory. Interestingly, the court did not rely on the regulations, instead ruling that the term “omission from gross income” is best read to include overstatements of basis – at least in “non-trade or business situations.” The Court ruled that Colony did not control this issue because that case involved a construction of the 1939 Code, not the 1954 Code. Describing it as a “close call,” the Seventh Circuit ruled that “a close reading of Colony” (which includes explaining away the Colony Court’s observation that the language in the 1954 Code is unambiguous) justifies the conclusion that “an overstatement of basis can be treated as an omission from gross income under the 1954 Code.”
The Seventh Circuit acknowledged that its decision directly conflicts with the two court of appeals decisions that prompted the Treasury Department to attack this issue by issuing temporary regulations, Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007). The court explained that it disagreed with the reasoning in those decisions, and cited approvingly to Judge Newman’s dissenting opinion in Salman Ranch. Thus, there is a clear conflict in the circuits, and the only way that conflict could disappear would be if the government prevails in every single circuit (including the Federal and Ninth Circuits) on its post-regulation appeals. Such a clean sweep is unlikely. With the government anxious to have this issue heard by the Supreme Court, and claiming that $1 billion is at stake, it appears almost inevitable that the Court will ultimately decide the Intermountain issue sometime in 2012.
As we noted in our original post on these cases, the Seventh Circuit panel was the most sympathetic to the government at oral argument and seemed particularly troubled by the bottom line outcome of allowing the taxpayers to retain massive tax benefits from what the court regarded as a tax shelter. That attitude is reflected in the opinion as well, which goes out of its way to commend the government’s description of the transaction as an “abusive . . . tax shelter.” Thus, the court’s reliance on a somewhat strained statutory interpretation might be understood as the least disruptive way to reach what it believed to be the “right result,” while avoiding having to make broad pronouncements on difficult issues of deference owed to temporary regulations. The court indeed stated explicitly that, “[b]ecause we find that Colony is not controlling, we need not reach” the issue of deference to the regulations.
Curiously, though, the court then added two sentences stating in conclusory fashion that it “would have been inclined to grant the temporary regulation Chevron deference,” simply citing some cases in which the court had previously accorded deference to Treasury regulations. Whatever the court’s motivation for adding this dictum, it does not address the difficult issues involved in deferring to these particular regulations. Accordingly, the dictum is unlikely to carry much weight with other courts of appeals that do not agree that Colony is irrelevant to construing the statutory text and therefore are struggling with the question of the degree of deference owed to the regulations.
January 20, 2011
The Fifth Circuit has scheduled the oral argument in Container for Thursday March 3, 2011, in New Orleans. The identity of the three-judge panel will be announced at a future time.
January 12, 2011
The Third Circuit has revised its January oral argument calendar and rescheduled the oral argument in Sunoco for the morning of Tuesday, January 25. The case had been scheduled for argument on the previous day. The panel that will hear the case is Chief Judge Theodore McKee, Judge D. Brooks Smith, and Judge Richard Stearns, a district judge from the District of Massachusetts who is sitting by designation.
Supreme Court Opts for Chevron Analysis of Treasury Regulations, Discarding the Traditional National Muffler Dealers Analysis
January 11, 2011
The Supreme Court this morning issued its opinion in the Mayo Foundation case, ruling unanimously that medical residents are not “students” exempt from FICA taxation. As previously discussed several times on this blog (see here, here, and here), the Mayo case carried the potential for broad ramifications beyond its specific context because the parties had framed the question of whether deference to Treasury regulations is governed solely by general Chevron principles that supersede the deference analysis previously developed in tax cases like National Muffler Dealers. The Court in fact addressed that question and has now endorsed use of the Chevron standard in tax cases, thereby providing the IRS with a big victory that will make it more difficult for taxpayers to prevail in court in the face of contrary regulations, even if they are “bootstrap” regulations designed primarily to influence the outcome of litigation. And for good measure, the Court obliterated the long-held view by many in the tax world that “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under Code section 7805(a) are entitled to less deference than “legislative” regulations promulgated pursuant to more specific rulemaking authority.
The Court’s opinion was authored by the Chief Justice, who was the Justice who spoke out most forcefully during the oral argument in favor of the position that Chevron had superseded earlier decisions in tax cases, as noted in our previous post. Thus, the opinion sought to be very clear on this point and to identify some of the familiar approaches to regulatory deference in tax cases that the Court was now consigning to the trash heap. First, the Court pinpointed some of the key factors that had been identified as important under the National Muffler Dealers analysis, stating that under that analysis “a court might view an agency’s interpretation of a statute with heightened skepticism when it has not been consistent over time, when it was promulgated years after the relevant statute was enacted, or because of the way in which the regulation evolved.” Slip op., at 8-9 (citing Muffler Dealers, 440 U.S. at 477). The Court continued: “Under Chevron, in contrast, deference to an agency’s interpretation of an ambiguous statute does not turn on such considerations.” Id. at 9.
The Court amplified its rejection of the Muffler Dealers analysis by citing a series of non-tax decisions under Chevron that decline to attribute significance to these considerations. Thus, the Court remarked that it had “repeatedly held that ‘[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the Chevron framework’” (quoting National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967, 981 (2005)); “that ‘neither antiquity nor contemporaneity with [a] statute is a condition of [a regulation’s] validity’” (quoting Smiley v. Citibank, N.A., 517 U.S. 735, 740 (1996)); and that it is “immaterial to our analysis that a ‘regulation was prompted by litigation’” (quoting Smiley, 517 U.S. at 741). Trying to link these decisions to its tax law jurisprudence, the Court then observed that in United Dominion Industries, Inc. v. United States, 532 U.S. 822, 838 (2001) (which involved the calculation of product liability losses for affiliated entities under Code section 172(j)), it had “expressly invited the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of the case.” Mayo slip op., at 9. The Court emphasized that it saw no good reason “to carve out an approach to administrative review good for tax law only.” Id. Thus, the Court concluded: “We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.” Id. at 10.
Second, the Court moved to squash another area where it discerned a difference between Chevron principles and those developed in tax cases – even though the parties had not focused on that point. Pointing to an amicus brief filed by Professor Carlton Smith arguing for reduced deference because the regulations in Mayo were “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under 26 U.S.C. § 7805(a), the Court acknowledged that there is pre-Chevron authority for the proposition that courts “‘owe the [Treasury Department’s] interpretation less deference’ when it is contained in a rule adopted under that ‘general authority’ than when it is ‘issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision’” (slip op., at 10-11 (quoting Rowan Cos. v. United States, 452 U.S. 247, 253 (1981)). The Court tossed that precedent aside as well, ruling that the Rowan statement was not compatible with the current approach to administrative deference, which is unaffected by “whether Congress’s delegation of authority was general or specific.” Slip op., at 11.
With the Chevron analytical framework in place, the Court made short work of the FICA issue before it. It reasonably concluded that the statutory text did not unambiguously resolve whether medical residents qualify for the FICA student objection. Hence, the Court moved to “Chevron stage two” – namely, whether the regulation was a “reasonable interpretation” of the statute. Observing that “[r]egulation, like legislation, often requires drawing lines” (slip op., at 13), the Court held that it was reasonable for Treasury to establish a rule that anyone who works a 40-hour week, even a medical resident, is not a “student” for purposes of the FICA student exception.
In sum, the Court’s decision in Mayo resolves the deference issues that have recently divided the lower courts in a way that is extremely favorable to the government. Treasury likely will be emboldened to issue regulations that seek directly to overturn cases that the government loses in court on statutory interpretation issues, or to issue regulations even earlier to sway the outcome of pending litigation before the courts interpret the statute in the first place. Of course, we have seen that phenomenon already in the Mayo case itself, with respect to the statute of limitations issue litigated in Intermountain and a host of other cases (see here and here), and in other settings. The Mayo decision will further encourage the Treasury Department to issue such regulations and will make it tougher for taxpayers to prevail in court in the face of those regulations.
January 7, 2011
The taxpayer has filed its response brief in the D.C. Circuit in Intermountain. The brief does not add much new to the debate, which is hardly surprising at this point. It relies in the alternative on all of the different rationales advanced by the various Tax Court opinions for rejecting the IRS’s position (and adds an additional argument that the basis was adequately disclosed on the return). The taxpayer does not jump into the National Muffler Dealers vs. Chevron debate, content to argue that there is no Chevron deference owed in these circumstances under the established rules for Chevron analysis. The taxpayer does not directly address whether the issuance of final regulations changes that analysis, instead arguing that it is too late for the government to rely on the issuance of the final regs because it did not refer to them in its opening brief.
In the companion UTAM case, the briefing lags the Intermountain schedule by a month. The government has just opened the briefing in that case, and the taxpayer’s response brief is due February 7, 2011. Again not surprisingly, the government’s brief looks a lot like the brief it filed in Intermountain a month ago, though it does refer to the final regulations. The new briefs in the two cases are attached below.
The cases are both scheduled for oral argument on April 5, 2011.
December 21, 2010
As we have previously discussed, the IRS sought to buttress its reliance on the six-year statute of limitations in Son-of-BOSS cases by issuing temporary regulations that interpret the term “omission” of gross income in Code sections 6229 and 6501 to include understatements of gross income attributable to overstatements of basis. Because that interpretation strains the language of the statute and flies in the face of the Supreme Court’s decision in Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958), the government has argued for application of Chevron deference to the temporary regulations. The Tax Court has rejected that argument, and it is now pending in several courts of appeals. Last week, the IRS issued final regulations that supplant the temporary regulations. The final regulations have the same effective date as the temporary regulations (Sept. 14, 2009), and they are essentially the same, although they do clarify what the Tax Court majority in Intermountain found to be an ambiguity — making clear that the regulations are intended to apply to all cases for which the six-year statute of limitations remained open on the effective date.
The government is now submitting the final regulations as supplemental authority to the appellate courts considering the Intermountain issue. (This is an example of the government’s supplemental submission, taken from the Fifth Circuit cases, with the final regulations attached.) In the government’s view, the issuance of the final regulations strenghtens the argument for Chevron deference. Taxpayers have objected that such deference was not owed to the temporary regulations because, among other reasons, they were temporary and issued without notice-and-comment. Indeed, more than a quarter of the pages of argument in the government’s opening brief in Intermountain (here) were devoted to arguing that the temporary regulations were valid and entitled to deference notwithstanding the absence of notice-and-comment. The final regulations arguably eliminate those objections, since the final regulations provided notice and opportunity for comment (even if the comments were disregarded). Notice-and-comment aside, however, the government’s deference argument still faces the formidable obstacle of the contrary Supreme Court decision in Colony.
December 13, 2010
We recently surveyed the nationwide litigation addressing the government’s efforts to apply a six-year statute of limitations to Son-of-BOSS cases, including its efforts to have the courts defer to a late-issued temporary regulation. The government has now filed its opening brief in the D.C. Circuit in Intermountain, the case in which the Tax Court addressed the issue. Of note, the brief contains an extensive argument for applying Chevron deference to the temporary regulation, rather than “the differing standards of pre-Chevron jurisprudence” (an apparent reference to National Muffler Dealers, though the brief declines to acknowledge that case by name), and notwithstanding the lack of opportunity for notice and comment. As we have discussed before here and here, the Supreme Court may shed some light in the next few months on the extent to which Chevron deference applies to Treasury regulations.
The taxpayer’s response brief is due January 5, 2011.
November 30, 2010
The government has successfully challenged understatements of income attributable to stepped-up basis in so-called Son-of-BOSS tax shelters. See, e.g., American Boat Co., LLC v. United States, 583 F.3d 471, 473 (7th Cir. 2009). But it has been stymied in some cases by the three-year statute of limitations for issuing notices of deficiency. Code section 6501(e)(1)(A) provides for a six-year statute “[i]f the taxpayer omits from gross income an amount” that exceeds the stated gross income by 25 percent. Section 6229(c)(2) provides a similar six-year statute for cases governed by the TEFRA partnership rules. The IRS has argued, unsuccessfully so far, that this section applies when there is a substantial understatement of income that is attributable not to a direct omission of income but rather to an overstatement of basis of sold assets.
The major obstacle to the government’s argument is that the Supreme Court long ago rejected essentially the same argument with respect to the predecessor of section 6501(e)(1)(A) (§ 275(c) of the 1939 Code). The Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958). The IRS argued there that the six-year statute applies “where a cost item is overstated” and thus causes an understatement of gross income. Id. at 32. The Court agreed with the taxpayer, however, that the six-year statute “is limited to situations in which specific receipts or accruals of income items are left out of the computation of gross income.” Id. at 33. The Court added that, although this was the best reading, it did not find the statutory language “unambiguous.” Id. Accordingly, the Court noted that its interpretation derived additional support from the legislative history and that it was “in harmony with the unambiguous language of [the newly enacted] section 6501(e)(1)(A).” Id. at 37. Based largely on the precedent of Colony, the Tax Court and two courts of appeals have already rejected the government’s attempts to invoke the six-year statute of limitations in Son-of-BOSS cases. See Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007).
Seeking to rescue numerous other cases that were still pending in the courts or administratively, the government responded by issuing temporary regulations on September 24, 2009, that purported to provide a regulatory interpretation of the statutory language to which the courts would afford Chevron deference. The temporary regulations provide that “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of [sections 6229(c)(2) and 6501(e)(1)(A)].” Temp Regs. §§ 301.6229(c)(2) – 1T, 301.6501(e)-1T.
The Tax Court was the first tribunal to consider the efficacy of this aggressive (one might say, desperate) effort to use the regulatory process to trump settled precedent, as the IRS moved the Tax Court to reconsider its adverse decision in Intermountain Ins. Service v. Commissioner, T.C. Memo. 2009-195, in the wake of the temporary regulations. The reception was underwhelming. The Tax Court denied the motion for reconsideration by a 13-0 vote, generating three different opinions. The majority opinion, joined by seven judges, was the only one to base its ruling on rejecting the substance of the government’s argument that courts should defer to the regulations notwithstanding the Supreme Court’s Colony decision. (Four judges stated simply that the new contention about the temporary regulations should not be entertained on a motion for reconsideration; two judges stated that the temporary regulations are procedurally invalid for failure to submit them for notice and comment.)
The government’s deference argument rests on Nat’l Cable and Telecommunications Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), which ruled that a “court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.” (In a concurring opinion, Justice Stevens stated his view that this rule would not apply to a Supreme Court decision, since that would automatically render the statute unambiguous, but that remains an open question.). The Tax Court majority ruled that the Supreme Court’s statement in Colony that the statute was ambiguous “was only a preliminary conclusion,” but “[a]fter thoroughly reviewing the legislative history, the Supreme Court concluded that Congress’ intent was clear and that the statutory provision was unambiguous.” Accordingly, the majority concluded that Brand X did not apply, and “the temporary regulations are invalid and are not entitled to deferential treatment.” (The two judges who found the regulations procedurally invalid questioned the majority’s reasoning and suggested that the Court should not have reached the substantive issue).
The Tax Court’s decision in Intermountain is just the first skirmish in what will be an extended battle over the temporary regulations. The Justice Department has asserted that there are currently 35-50 cases pending in the federal courts that raise the same issue, with approximately $1 billion at stake. Accordingly, the government is pursuing an appeal to the D.C. Circuit in Intermountain, and it is arguing for deference to the temporary regulations in other cases pending on appeal in other circuits, even where those regulations were not considered by the trial court. The government seems determined to litigate the issue in every possible court of appeals, presumably hoping that it can win somewhere and then persuade the Supreme Court to grant certiorari and reconsider Colony. The current map looks like this:
D.C. Circuit: Briefing schedules have been issued in Intermountain, No. 10-1204, and in an appeal from another Tax Court case, UTAM Ltd. v. Commissioner, No. 10-1262. The government’s opening brief is due in Intermountain on December 6, 2010, and in UTAM on January 6, 2011. The panel assigned to both cases is Judges Sentelle, Tatel, and Randolph.
Federal Circuit: Grapevine Imports, Ltd. v. United States, No. 2008-5090, is fully briefed and scheduled for oral argument on January 12, 2011. The Federal Circuit has already rejected the government’s invocation of the six-year statute in Salman Ranch, but the government is arguing in Grapevine that the Federal Circuit should reverse its position in light of the temporary regulations, which were not previously before the court.
Fourth Circuit: Home Concrete & Supply, LLC v. United States, No. 09-2353, is fully briefed and was argued on October 27, 2010, before Judges Wilkinson, Gregory, and Wynn. In that case, the district court had ruled for the government, distinguishing Colony as limited to situations in which the taxpayer is in a trade or business engaged in the sale of goods or services. That was the rationale of the Court of Federal Claims in the Salman Ranch case, but that decision was reversed by the Federal Circuit.
Fifth Circuit: Burks v. United States, No. 09-11061 (consolidated with Commissioner v. MITA, No. 09-60827) is fully briefed and was argued on November 1, 2010, before Judges DeMoss, Benavides, and Elrod. In its briefs on this issue in various courts, the government has often invoked the Fifth Circuit’s decision in Phinney v. Chambers, 392 F.2d 680 (1968), the only court of appeals decision that has applied the six-year statute in the absence of a complete omission of gross income. In Phinney, the taxpayer on her return had mislabeled proceeds from payment of an installment note as proceeds from a sale of stock with basis equivalent to the proceeds, reporting no income from that sale. The Fifth Circuit accepted the government’s contention that the six-year statute applied, finding that it applies not only in the Colony situation where there is “a complete omission of an item of income of the requisite amount,” but also where there is a “misstating of the nature of an item of income which places the Commissioner . . . at a special disadvantage in detecting errors.” 392 F.2d at 685. The government has argued that Phinney essentially involved an overstatement of basis, and therefore strongly supports its position in the Son-of-BOSS cases. Indeed, the district court in Burks ruled for the government based on Phinney. The government therefore likely viewed the Fifth Circuit as the most favorable appellate forum for the current dispute.
At oral argument, however, the panel appeared sympathetic to the taxpayer’s position that Phinney involved a situation where the taxpayer had taken steps akin to a direct omission that would make it difficult for the IRS to discover the potential tax liability. Therefore, the taxpayer maintains, Phinney is fully consistent with the position that the six-year statute does not generally apply to overstatements of basis.
In addition, the discussion of the temporary regulation at oral argument specifically addressed the debate over whether deference to Treasury regulations is governed by Chevron principles or by the less deferential National Muffler Dealers standard. As we have discussed elsewhere, the Supreme Court may resolve that question in the next few months in the Mayo Foundation case.
Seventh Circuit: Beard v. Commissioner, No. 09-3741 is fully briefed and was argued on September 27, 2010, before Judges Rovner, Evans, and Williams. Although the panel, particularly Judge Rovner, expressed skepticism about some of the IRS’s legal arguments, Judges Williams and Evans appeared troubled by the prospect of allowing the taxpayer to escape scrutiny on statute of limitations grounds. Judge Williams suggested that the taxpayer still ought to have the relevant records and that there was no apparent reason why a misstatement should be treated different from an omission. Judge Evans emphasized that the taxpayer’s position with respect to tax liability was very weak and suggested that Colony might be distinguishable because it involved a return that was much easier for the IRS to decipher than the complex return involved in Beard. Thus, to some extent, the government seemed to have found a sympathetic ear in the Seventh Circuit, though that will not necessarily translate into a reversal of the Tax Court.
Ninth Circuit: Reynolds Properties, L.P. v. Commissioner, No. 10-72406. The court of appeals vacated the briefing schedule to allow the parties to participate in the court’s appellate mediation program. The government, however, has indicated that the case is not suitable for mediation, and therefore a new briefing schedule is likely to be issued soon. The Ninth Circuit has already ruled in Bakersfield that the six-year statute does not apply to overstatements of basis. Presumably, the government will ask the court to reverse itself in light of the temporary regulations, which were not previously before the court.
Tenth Circuit: Salman Ranch Ltd. v. United States, No. 09-9015, is fully briefed and was argued on September 22, 2010, before Judges Tacha, Seymour, and Lucero. This case comes from the Tax Court, but involves the same partnership that prevailed in front of the Federal Circuit.
Attached below as a sampling are the briefs filed in the Fourth and Seventh Circuit cases.
November 22, 2010
The government has filed its reply brief in Container, and the parties will now await an order assigning a date for oral argument. The parties’ respective arguments were well delineated in the opening briefs, and the reply brief does not shed much additional light on the issue. The government emphasizes that it has never argued that guarantee fees are interest; instead it argues that they are more analogous to interest than to a payment for services. And, disputing the taxpayer’s argument, the government reiterates that this analogy is supported by the two most relevant cases, Bank of America and Centel.
The reply brief notes that Congress addressed this issue for future years in the Small Business Jobs Act of 2010. (This legislation is briefly discussed in our first post on the Container case.) Quoting the Blue Book, the reply brief asserts that the new legislation “‘effect[s] a legislative override’ of the Tax Court’s opinion in this case,” providing that a guarantee fee paid by a domestic corporation “is now expressly considered to be income from a United States source.”
We note that the practical implications of the new statute and the Container decision can differ from country to country depending on treaty provisions. The November 8 edition of Tax Analysts’ Tax Notes Today reported on a speech given by Robert Driscoll, a technical adviser at the IRS Large Business and International Division. It quoted Mr. Driscoll as saying that withholding and taxation of guarantee fees could depend on treaty provisions if the guarantor is a qualified resident of a treaty country. Specifically, if the guarantee fee can be categorized as “other income” under the treaty, Mr. Driscoll is quoted as saying, the payment “from a U.S. [subsidiary] to its foreign parent guarantor would not be U.S.-source income and thus would not be subject to withholding.” That statement is imprecise since “other income” provisions of treaties typically do not directly address sourcing. What Mr. Driscoll appears to be indicating is the IRS’s view that the “other income” provisions of treaties could preclude the U.S. from taxing guarantee fee income, even if that income is technically characterized as U.S.-source income under the new law (or, presumably, under prior law if the government prevails in Container). That would lead to the same tax result as a practical matter as a determination that the fees are not U.S.-source income.
Mayo Foundation Oral Argument Tilts Towards the Government and Raises Doubts About the Continuing Vitality of National Muffler Dealers
November 10, 2010
At oral argument on November 8, several Supreme Court Justices expressed skepticism regarding the claim that medical residents fall within the “student exemption” from FICA taxation. Although it is always hazardous to predict the outcome of a case from the questions asked at oral argument, it is difficult to envision the taxpayer getting the five votes needed to overturn the court of appeals’ rejection of the exemption.
The Justices’ objections to the taxpayer’s position came from a variety of angles. Justice Sotomayor focused on the essence of what a medical resident does, suggesting that a person working unsupervised for more than 40 hours per week, and for signficant remuneration, is “really not a student.” Justice Ginsburg focused more on Congress’s intent, suggesting that the exemption seemed directed at “the typical work/study program in a college.” Chief Justice Roberts observed that the line between student and worker is a difficult one to draw and suggested that it was therefore appropriate to let the IRS draw the line in a categorical way and then defer to the IRS’s interpretation. Justice Breyer took a different tack, arguing that the IRS’s position was a valid interpretation of a requirement that had been in the regulations for a long time – namely, that the employment has to be “incident” to the study. Full-time employment, he suggested, would not be “incident” to the study because it is “so big in comparison to the study.”
Justice Alito seemed the most sympathetic to the taxpayer. He rose to the taxpayer’s defense by offering an alternative reading of word “incident.” Later, he challenged the government’s counsel to explain why medical residents should not be eligible for the exemption when law students who write briefs are eligible, arguing that the medical residents should be treated as students if their primary motivation is to complete a course of study rather than to earn money. Justice Ginsburg and the Chief Justice also questioned government counsel, though not as sharply as they had questioned the taxpayer’s counsel. Justices Scalia and Kennedy were uncharacteristically silent during the argument. In accordance with his usual practice, Justice Thomas did not speak. Justice Kagan is recused in the case because of her prior involvement when she was Solicitor General.
In our prior posts on this case (see here, here, and here), we discussed the possibility that this case could be a vehicle for the Supreme Court to address the correct standard for deference to Treasury regulations – that is, whether the more generic Chevron analysis has superseded the more specific, and in some respects less deferential, approach set forth in National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979). The Justices did not exhibit any independent interest in this issue, as their questions focused on the meaning of the statute, not on deference to the regulation. At one point in his opening argument, taxpayer’s counsel noted that the new regulation was issued only after the government had repeatedly lost in court (a fact that would argue for less deference under the National Muffler Dealers approach), but that point did not elicit any reaction from the Justices.
Thus, the oral argument did not touch on the Chevron/National Muffler Dealers issue until the very end when taxpayer’s counsel affirmatively raised it during his few minutes of rebuttal time. Counsel sought again to persuade the Court that the government’s position is suspect because it is a recent invention that seeks to overturn a series of adverse court decisions, and this time phrased the argument explicitly in terms of the standard for deferring to a regulation. Taxpayer’s counsel argued that deference to the new Treasury Regulation is inappropriate under “[t]he National Muffler standards, which we understand still to be appropriate to evaluate deference given to an IRS regulation,” because the regulation “is not a contemporaneous regulation.” Justice Sotomayor quickly objected, asserting that the Court has “said that agencies can clarify situations that have been litigated and positions that they have lost on.” (She was referring here not to tax cases, but to decisions that apply the Chevron analysis.). Shortly thereafter, Chief Justice Roberts zeroed in on the issue, asking:
Why are we talking about National Muffler? I thought the whole point of Chevron was to get away from that kind of multifactor ad hoc balancing?
Taxpayer’s counsel tried to respond by arguing that the National Muffler Dealers factors were “sensible factors” that the Court should continue to apply in the case of a “regulation that pops up 65 years of the enactment of the statute, after the government has lost five cases.” But the Chief Justice was dismissive, stating simply: “If Chevron applies, those considerations are irrelevant, right?”
The outlook for the case therefore is that the Court will likely affirm the Eighth Circuit’s ruling that medical residents do not come within the student exemption from FICA. Such a decision would not necessarily require a discussion of deference to Treasury regulations, but if there is such a discussion, the Court may well be ready to conduct the analysis explicitly in the Chevron framework and consign National Muffler Dealers to the dustbin of history. As noted in our previous post, that would in some respects be an unfortunate outcome – giving too much deference to regulations that may well be unduly influenced by the IRS’s narrow interest in maximizing tax revenues rather than a neutral effort to implement the will of Congress.
Attached below are links to the taxpayer’s reply brief and to the transcript of the oral argument. A decision is expected in the next few months.
November 3, 2010
The Third Circuit has scheduled the oral argument in Sunoco for January 24, 2011. The briefing was completed back in March, and the briefs can be found at the bottom of our previous post.
October 28, 2010
The taxpayer has filed its answering brief in Container (attached below), arguing that guarantee fees paid to its Mexican parent were properly analogized to a payment for services and therefore sourced to Mexico. The taxpayer reasons that the government’s analogy to interest on a loan is misdirected because the guarantor does not advance any funds. All it does is “stand[ ] by to pay,” which is in the nature of a service, and it is the Mexican parent’s assets – located in Mexico – that give it the ability to serve as a guarantor. The taxpayer also maintains that the government’s position conflicts with the Tax Court’s factual findings to the extent that the government argues that the parent was a lender in substance because it expected the U.S. subsidiary to default.
The taxpayer disputes the government’s assertion that the relevant precedents support the interest analogy. With respect to the commissions paid for letters of credit in the Bank of America case, the taxpayer argues that “Bank of America was not being paid for substituting its credit for that of the foreign bank, but for substituting its money.” Accordingly, the taxpayer reasons, the commissions in Bank of America were logically analogized to interest, but a different result is called for in Container where the guarantor did not furnish any money. The taxpayer also distinguishes the Centel decision involving stock warrants as resting on factual findings specific to that case. It further contends that the Fifth Circuit should disregard the observation in Centel that Bank of America rejects analogizing guaranties to services, because that observation is “both dicta and incorrect.”
October 20, 2010
In our initial post on the Mayo Foundation case pending in the Supreme Court, which concerns whether medical residents are exempt from FICA taxation, we noted that the case potentially raised a broad question that has surfaced in the courts of appeals and the Tax Court in recent years – namely, whether Chevron deference principles have supplanted the traditional Muffler Dealers approach to analyzing the deference owed to Treasury regulations. Although that issue was not flagged by the parties at the certiorari stage, we later observed that the taxpayers’ opening merits brief served that ball into the government’s court by relying heavily on some of the Muffler Dealers factors that are not ordinarily part of the Chevron analysis. The government has now responded by directly challenging the continuing vitality of Muffler Dealers. (The government’s brief is attached below.) As a result, there is a good chance that the Supreme Court will address the question and resolve the disagreement between the Tax Court and some courts of appeals on the proper analysis of deference to Treasury regulations.
The government’s brief does not mince words. It states that Muffler Dealers “has been superseded by Chevron” and therefore “the considerations on which [taxpayers] rely are largely irrelevant.” In particular, the government identifies three Muffler Dealers factors relied upon by the taxpayers that are allegedly irrelevant under Chevron: (1) “the recency of [the] adoption” of the regulation; (2) that the new regulation “was enacted ‘to overturn judicial decisions’ interpreting the student exemption”; and (3) that “Treasury’s interpretation of the student exemption has purportedly been inconsistent.”
It is by no means a foregone conclusion that the Supreme Court will resolve the question of the proper deference standard, as there are many ways to resolve the ultimate question of the applicability of the FICA exemption without having to decide on a deference standard. Nor is it as clear as the government would like that Chevron did or should supersede Muffler Dealers. (If it were, the question probably would not still be open 26 years after Chevron was decided). The IRS is often in an adversarial relationship with taxpayers; it has an inherent fiscal interest in interpreting the Internal Revenue Code in a way that maximizes tax revenues. Therefore, there are good reasons for the courts to afford less deference to Treasury regulations that would determine the outcome of tax disputes than to regulations of more neutral agencies that are merely administering a federal statute. Can the government really respond to an IRS defeat in court by promulgating a regulation to overturn the decision and then expect the courts to defer to that regulation without taking any account of how it came to pass? Or can it reverse a regulatory interpretation simply because it determines that the reversal will benefit the public fisc, without paying some price in terms of judicial deference? Perhaps the Supreme Court will answer those questions soon.
Oral argument in the Mayo Foundation case is scheduled for November 8.
October 4, 2010
As we previously reported, a district court in Michigan disagreed with the Federal Circuit’s decision in CSX Corp. v. United States, 518 F.3d 1328 (2008) (opinion linked here), and held that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes. The employer, Quality Stores, has now filed its answering brief in the Sixth Circuit defending the district court opinion and addressing the arguments made by the government in its opening brief, and the government has filed its reply brief. (The briefs are attached below.)
The employer’s main argument is a textual one, based on the interplay between the FICA and income tax withholding provisions of the Code. Asserting that “wages” should mean the same thing in both sets of provisions, the employer relies on Code section 3402(o), which states that “supplemental unemployment compensation benefits” should be “treated as . . . wages.” Implicit in this provision, the employer asserts, is the proposition that such “SUB pay” would not otherwise be wages. Since the severance payments are encompassed within “SUB pay,” it follows that they are not “wages” for FICA purposes. (FICA does not contain a provision analogous to section 3402(o)).
The Federal Circuit in CSX had rejected the logic of this argument, reasoning that section 3402(o) might imply that some SUB pay is not “wages,” but not that all SUB pay is not “wages.” In addition to that relatively narrow argument, the government has suggested more broadly that the meaning of “wages” in the income tax withholding context “has no bearing” on its meaning in the FICA context. The Federal Circuit did not fully embrace that suggestion in CSX, stating that “we disagree with the government’s argument that after 1983, the term ‘wages’ in FICA must be interpreted without reference to the same term in the income tax withholding statutes.” In its reply brief in Quality Stores, the government focuses primarily on a narrower argument that accords with the Federal Circuit’s approach, contending that section 3402(o) was addressed only to the subset of SUB pay that had been exempted from withholding by certain Revenue Rulings. Because the payments in this case would not fall within those Rulings, the government reasons, section 3402(o) is irrelevant.
The employer also argues that the Sixth Circuit is bound by the Supreme Court’s decision in Rowan Cos. v. United States, 452 U.S. 247 (1981), to treat SUB pay the same for income tax withholding and FICA purposes. The government responds that Rowan cannot have that precedential effect after Congress overruled it and passed the “decoupling provision.”
With the briefing now concluded, the parties await the assignment of a date for oral argument, which will likely occur in the winter. The briefs are complex, and it remains to be seen whether the Sixth Circuit will immerse itself deeply in the issue or, instead, give considerable deference to the decision of its sister circuit in CSX.
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.
August 30, 2010
The Supreme Court has released the oral argument schedule for its November session. The argument in Mayo Foundation is scheduled as the second case on Monday November 8, meaning it will begin around 11:00. A decision is expected to issue in the spring, almost certainly no later than June 2011. We will provide a report on the argument in November.
August 20, 2010
Confounding the expectations of this observer (and others), the government has allowed the deadline to pass without seeking rehearing of the Deloitte case in the D.C. Circuit. That development does not mean, however, that the government has decided to live with the Deloitte decision. To the contrary, the most likely explanation for the government’s inaction is that it plans to seek Supreme Court review and does not want to delay that process. A petition for certiorari is currently due on September 27. If the government files by that time, the Court will act on the petition in enough time for it to schedule oral argument in the spring and decide the case by June 2011 (assuming that the Court decides to grant certiorari). If the government had sought rehearing, it would have lost control of the schedule. Depending on how long the D.C. Circuit took to rule on the rehearing petition, it is possible that Supreme Court consideration then could have been pushed off until the 2011-12 Term.
So the government has until September 27 to figure out how to explain to the Court why the issue that it said was so unimportant last May in Textron suddenly requires Supreme Court intervention. As noted in our previous post, one thing that the government will likely argue is that Deloitte has created a circuit conflict that did not previously exist, because it is the first court of appeals decision to find work product protection for tax accrual workpapers prepared as a routine part of the audit process. In Textron, the government had argued that cases approving work product protection like United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006), and United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998), did not actually conflict with Textron and El Paso because the tax documents in question were prepared in anticipation of litigation and not in the ordinary course of business for use by auditors. (A copy of the government’s brief in opposition to the certiorari petition in Textron is attached.)
August 16, 2010
The taxpayers have filed their opening brief in Mayo Foundation, a copy of which is attached. They argue primarily that the statutory language of the exemption unambiguously includes medical residents, and therefore there is no occasion to consider the reasonableness of the IRS regulation. Secondarily, they argue that the regulation is in any event arbitrary and unreasonable.
With respect to the question of the correct deference analysis discussed in our previous post, the brief relies heavily on the National Muffler Dealers factors. It identifies five factors that militate against the reasonableness of the regulation: (1) does not harmonize with the origin and purpose of the statute; (2) not contemporaneous; (3) did not “evolve in an authoritative manner” because it was designed to overturn adverse judicial decisions; (4) has not been in effect for long; and (5) the government’s position has been inconsistent. Although the first factor is basic to any analysis of the reasonableness of a regulation, the other four all come from National Muffler Dealers and are not commonly associated with the Chevron deference analysis applied to non-tax statutes.
The taxpayers have not asked the Court to choose between Chevron and Muffler Dealers. To the contrary, they have finessed the possible tension between two lines of cases by purporting to examine “the factors that indicate the reasonableness of a tax regulation under this Court’s decisions in Chevron and National Muffler” and observing that the “Court has given special consideration to several factors identified in National Muffler” “in determining the reasonableness of a regulation interpreting a revenue statute.” As discussed in our previous post, this approach is entirely consistent with the way the Supreme Court has approached this issue in recent years – that is, citing to the National Muffler Dealers factors in tax cases without addressing whether the analysis is fully consistent with Chevron. But the courts of appeals have begun to question whether the two approaches are compatible. It will be interesting to see whether the government’s brief challenges the continuing vitality of the National Muffler Dealers analytical framework. That brief is due on September 27.
August 11, 2010
Virginia has filed an amicus brief in the Fourth Circuit in support of the taxpayers in the Virginia Historic case. (See here and here for previous coverage of the appeal). The brief focuses primarily on policy, arguing that Virginia created these tax credits to facilitate historic preservation and expected that partnership vehicles might be necessary for businesses and individuals to make use of the credits. According to the Commonwealth, “the IRS’s aggressive position threatens the effectiveness of the program and its benefits for all Virginians.” Although the amicus brief is light on analysis of the federal tax issues, it may well help persuade the Fourth Circuit that this is not a case where it needs to step in to prevent some kind of taxpayer “hanky-panky,” but rather that going along with the Tax Court would be “doing the right thing.”
August 6, 2010
The parties are poised to brief the appeal of Tax Court’s decision in Container Corp. v. Commissioner, 134 T.C. No. 5 (Feb. 17, 2010), in the Fifth Circuit. The issue concerns the “sourcing” of income earned by a Mexican corporation from loan guarantee fees paid by its U.S. subsidiary. Code sections 861-63 identify certain items of income and specify whether they should be treated as U.S-source or foreign-source income. But there are items of income not specified in those sections, like loan guarantee fees, and it falls to the courts to determine how to source them, using analogies to items that are listed.
In Container, a U.S. subsidiary had to raise capital to finance corporate acquisitions, but needed the larger Mexican parent to guarantee the notes in order to make them marketable. The parent charged a standard 1.5% annual fee for providing the guarantee. The companies treated the fees as foreign-source income, analogizing them to “compensation for labor or personal services,” which are generally sourced to the location where the services are performed. I.R.C. §§ 861(a)(3), 862(a)(3). Therefore, the U.S. subsidiary did not withhold 30% from the fees, as would have been required if the fees were U.S.-source income. I.R.C. §§ 881(a), 1442(a). The IRS objected, arguing that the fees were better analogized to interest, which is sourced to the location of the interest payor. I.R.C. §§ 861(a)(1), 862(a)(1). The IRS also relied on one of the leading precedents, Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982), which had ruled that acceptance and confirmation commissions paid in connection with letters of credit should be treated like interest for sourcing principles.
The Tax Court opted for the taxpayer’s analogy. It distinguished Bank of America and the interest analogy by stating that the Mexican parent did not put its money “directly at risk”; it “was augmenting [the sub's] credit, not substituting its own.” The Tax Court’s reasoning seems strained, as the proffered distinction does not come to grips with the reasoning in Bank of America or obviously relate to the policy underlying the sourcing rules. Although the guarantee fees are not identical to interest, they have some similarities and also serve the same function of facilitating the subsidiary’s ability to obtain capital. Without the guarantee, the subsidiary would surely have had to pay more interest to obtain the financing, and the guarantee fee thus is in some sense a substitute for interest. Conversely, while the parent can be said to have provided a service in promising “to possibly perform a future act” through the guarantee, the Tax Court’s approach appears to approve a much broader reading of the concept of performing “labor or personal services” than did the Bank of America case.
Congress has introduced legislation to reverse the outcome of the case by specifically providing that guarantee fees are to be sourced like interest. That legislation, contained in a provision of the Small Business Jobs Act that the Senate is expected to take up when it returns in September, would operate prospectively and is estimated to raise $2 billion over ten years. The legislation is not intended to provide any inference for the treatment of guarantee fees before the date of enactment; the appeal in Container is the government’s route to relief for those earlier years. And the Fifth Circuit’s decision may well provide more guidance beyond guarantee fees for how courts should approach the problem of sourcing analogies. The government’s opening brief is currently due September 15, 2010.
August 2, 2010
In Mayo Foundation, et al. v. United States, No. 09-837, the Supreme Court will consider whether medical residents are exempt from FICA taxation, with the decision likely to turn on the level of deference the Court is willing to accord to a recent regulatory change. Although the issue may seem obscure, there are 8,000 residency programs in the United States, and the government estimates that $700 million in taxes per year is at stake, with $2.1 billion in refund claims pending.
The issue involves the meaning of the “student exemption” to FICA, which excludes from the definition of “employment” “service performed in the employ of a school” by a “student who is enrolled and regularly attending classes at such school.” I.R.C. § 3121(b)(10). The regulations implementing that statute long provided that “student” status depends on the relationship between the employee and the institution and that when the services are performed “incident to and for the purpose of pursuing a course of study,” the employee can qualify for the student exemption. Beginning in the late 1990s, there have been several cases addressing whether this exception applies to medical residents, who work more than full-time and earn a $40,000-$60,000 stipend, but perform their duties as part of an educational process in which they also attend classes.
In 2003, a federal district court in Minnesota ruled that the Mayo Clinic’s residents qualified for the student exception under the statute and existing regulations. The government responded by amending the regulations, effective April 1, 2005, to provide a bright-line rule that does not allow full-time employees to qualify for the exception. Thereafter, four other courts of appeals ruled against the government, stating that the residents fell within the terms of the statutory exception. All four of those cases, however, involved pre-2005 periods, and therefore the courts did not directly consider the impact of the amended regulation. In this case, the first to address the new regulation, the Eighth Circuit held that it owed Chevron deference to the new regulation as a reasonable interpretation of an ambiguous statute. Thus, contrary to the other four circuits, it sided with the government and held that the residents are subject to FICA taxation.
Most tax cases reach the Supreme Court on the strength of a request for further review by the government, but in this case the Court granted a petition filed by the taxpayers over the government’s opposition. The taxpayers predictably argued that the circuit conflict, and dollars at stake, necessitated Supreme Court review. In situations like this, the government often acquiesces in certiorari, because the IRS likes to get circuit conflicts resolved to promote its own institutional interest in uniformity. In this case, however, the government sought to avoid taking its chances in the Supreme Court by arguing that there was no genuine circuit conflict, because the other four circuits had not considered the new regulation. Evidently, the government hoped that it could build on this decision and use it to get the other circuits to retreat from their prior decisions and adopt a rule going forward under the new regulation that would subject medical residents to FICA taxation. The Court, however, was apparently persuaded by the taxpayers that the new regulation is unlikely to lead to a different result in those circuits – because they had already indicated a view that medical residents qualify for the exception under the unambiguous statutory language, which would leave no room for Chevron deference to the new regulation.
A decision by the Court will, of course, resolve the question of FICA taxation of medical residents — unless Congress steps in. But the decision could have a much broader impact because it implicates the general topic of deference to IRS regulations, particularly the question whether Chevron deference principles have superseded the more specialized analysis developed over the years in tax cases dating back to National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979). In recent years, courts of appeals have begun to trend towards applying standard Chevron analysis in tax cases, but the Tax Court has resisted. See, e.g., Swallows Holding Ltd. v. Commissioner, 126 T.C. 96 (2006), rev’d, 515 F.3d 162 (3d Cir. 2008). The Supreme Court has not specifically addressed the issue.
There is not a huge difference in the two deference approaches, and, in most cases, choosing between them is not likely to affect the outcome. Like Swallows Holding, however, this case could be an exception. Among the factors listed in Muffler Dealers for determining deference that have been oft-applied in later cases are whether the regulation is contemporaneous with the statute and “the consistency of the Commissioner’s interpretation.” 440 U.S. at 477; see also, e.g., United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 (2001); Cottage Savings Ass’n v. Commissioner, 499 U.S. 554, 561 (1991). In this case, those factors support the taxpayers’ rejection of the regulation, as the government is arguing for reliance on a new regulatory approach that departs from a 65-year old regulation. Contemporaneity and consistency, however, play no role in the Chevron analysis, which does not penalize the agency for inconsistency or for promulgating new regulations designed to overturn adverse court decisions. Indeed, the Court has specifically ruled that prior contrary judicial constructions of a statute do not foreclose owing Chevron deference to a subsequent regulation, unless the court decision had determined that the statute is unambiguous. National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967, 982-86 (2005).
The parties did not tee up this potential issue in the briefs filed at the certiorari stage. The court of appeals’ opinion straddled the fence, purporting to apply Chevron but also stating that the Muffler Dealers factors were “instructive” on the second part of the Chevron inquiry – whether the regulation is a reasonable interpretation of the statute. The certiorari petition focused mostly on the circuit conflict. To the extent it discussed the merits of the case, it argued that the Eighth Circuit’s decision was inconsistent with Chevron and and did not cite the Muffler Dealers line of cases. (The petition argued that the Eighth Circuit had “effectively eliminate[d]” the first step of Chevron analysis in tax cases when it stated that, when common words are found in “a provision of the Internal Revenue Code, a Treasury Regulation interpreting the words is nearly always appropriate.”) The government’s brief was happy to embrace the notion that Chevron governs the deference inquiry. It will be interesting to see whether the taxpayers try to get more mileage out of Muffler Dealers and its progeny at the merits stage.
The parties will be briefing the case over the summer, with the taxpayers’ opening brief currently due on August 6, 2010. Oral argument is expected to be scheduled for November or December. One important note is that this is one of the cases in which Elena Kagan has stated her intent to recuse because she participated in the case as Solicitor General. That means the case will be decided by an eight-Justice Court, with the possibility of a 4-4 split. If that occurs, the Court would issue a one-line order affirming the Eighth Circuit’s decision by an equally divided court. The government’s victory in this case would stand, but the decision would have no precedential value, and the issue would remain in play outside the Eighth Circuit.
The opinion of the Eighth Circuit and the parties’ briefs at the certiorari stage are linked below. We will provide the briefs on the merits after they are filed.
July 22, 2010
On July 13, 2010, the government filed its opening brief in the Sixth Circuit in In re Quality Stores, Inc: United States v. Quality Stores, Inc., No. 10-1563. In that case, the government is appealing the district court’s surprising decision holding that severance payments made to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes if they qualify for exclusion from income tax withholding as “supplemental unemployment compensation benefits” (“SUB pay”) under Code section 3402(o)(2). As the district court acknowledged, its decision directly conflicts with the Federal Circuit’s ruling in CSX Corporation v. United States, 518 F.3d 1328 (2008), which had appeared to resolve this issue definitively in favor of the IRS. (This Miller and Chevalier Tax and Employee Benefits Alert contains a fuller discussion of the district court’s opinion and the steps that companies can take to protect their rights pending the outcome of the appeal.)
Although the government’s opening brief relies extensively on CSX, it also addresses the issues comprehensively as if the Sixth Circuit were the first circuit court to consider the issue. Primarily, the government argues that the case is controlled by Code section 3121, which broadly defines wages as “all remuneration for employment” — a definition that encompasses severance pay. The government criticizes the district court’s reliance on Code section 3402(o) both because that section relates to income tax withholding, rather than FICA taxes, and because its terms in any event do not dictate that SUB pay is not “wages.” With respect to the district court’s reliance on Rowan Cos. v. United States, 452 U.S. 247 (1981), the government argues that Rowan does not support exempting SUB pay from FICA taxation and, in any event, Congress’s enactment of the “decoupling provision” in the wake of Rowan eliminates any possible support that the case could lend to the companies’ position.
The answering brief for Quality Stores is currently due September 8, 2010. Links to the government’s brief and the district court opinion are attached.
July 6, 2010
The D.C. Circuit has now decided the Deloitte case that was previously discussed on this blog. (See D.C. Circuit Considers Work Product Issues in Deloitte for that discussion and links to the briefs in the case.) The decision addresses two basic issues, and on both scores it gives comfort to taxpayers who do not want to furnish the IRS with their counsel’s candid assessment of litigation prospects on potential tax disputes.
With respect to the mental impressions of taxpayer’s counsel embodied in documents that are acknowledged to be work product, the court held that a taxpayer does not waive the privilege by sharing the analysis with its auditors. The court explained that a company’s auditor is not its adversary, and that the company has a reasonable expectation that the auditor will preserve the confidentiality of that information. Deloitte now becomes the leading appellate decision on the waiver issue, reaching the same outcome as the since-vacated decision of the First Circuit panel in Textron.
With respect to the issue that the Supreme Court recently declined to review, the court held that the “Deloitte memo” did contain work product in the form of orally transmitted opinions of Dow’s counsel, even though the memo was prepared by accountants. The court distinguished the two decisions from other circuits that have taken a much dimmer view of work product protection for tax accrual workpapers or similar documents. The court distinguished the Fifth Circuit’s old decision in United States v. El Paso Co., 682 F.2d 530 (1982), because that circuit uses a more restrictive standard for the work product inquiry into whether the document was prepared “in anticipation of litigation” — the “primary purpose” test — rather than the “because of” test applied by most circuits. With respect to the Textron decision, which comes from a circuit that has nominally adopted the “because of” test, the court noted that Judge Torruella’s dissent from the en banc decision in Textron had questioned whether the majority had truly adhered to the First Circuit’s stated standard. And the court suggested that there could be some difference in the content of the documents that warranted the different results. (This Miller and Chevalier Tax Alert contains a fuller discussion of the D.C. Circuit’s opinion as well as some observations on how it might affect the IRS’s initiative in Announcement 2010-9 to require disclosure of uncertain tax positions.)
Despite the court’s efforts to avoid a direct rebuff to the First Circuit, the reasoning of Deloitte is difficult to square with the Textron decision. And there is now a clear conflict with the Fifth Circuit’s El Paso decision, both with respect to the result in the case of tax accrual workpapers and with respect to the more general issue of the proper standard for assessing whether a document is work product. Therefore, if presented with a petition for certiorari in Deloitte, the Supreme Court may be more inclined to step into the fray than it was in Textron.
Before considering Supreme Court review, the government is almost certain to seek rehearing en banc from the full D.C. Circuit. That approach proved successful in Textron after the First Circuit panel had initially ruled in favor of the taxpayer. In the likely event that the D.C. Circuit does not rehear the case, the government will have to decide whether to seek certiorari after telling the Supreme Court a few months ago in Textron that this issue did not warrant Supreme Court review. That decision may depend in part on tactical considerations, such as whether the government believes that the Deloitte case presents a favorable factual setting in which to determine the correct test for work product, as well as the relative importance that the Solicitor General attaches to the workpapers issue.
The D.C. Circuit’s opinion is linked below. A petition for rehearing is due Aug. 13.
June 30, 2010
On March 5, 2010, the government filed its reply brief in its appeal from the Tax Court’s decision in Sunoco Inc. v. Commissioner, 122 T.C. 88 (2004), thus completing the appellate briefing. The case raises a novel issue concerning the Tax Court’s jurisdiction to determine overpayment interest. Sunoco filed a petition seeking redetermination of deficiencies for its 1979, 1981, and 1983 tax years. In an amended petition, Sunoco reported that certain issues had settled but argued that the IRS had committed errors in calculating the interest on underpayments and overpayments arising out of those issues because it used incorrect starting and ending dates. The IRS moved to dismiss Sunoco’s claims for additional overpayment interest on the ground that Code section 6512 does not give the Tax Court jurisdiction to make a determination of overpayment interest with respect to overpayments not at issue in the case. The Tax Court denied the motion, holding that it had jurisdiction over Sunoco’s claims because the court would be resolving the same issues regarding starting and ending dates in connection with disputes over underpayment interest that were unquestionably before the court.
The Tax Court’s decision is a narrow one, finding that the settled principles of Estate of Baumgardner v. Commissioner, 85 T.C. 445 (1995), apply in Sunoco’s unusual circumstances because the date issues necessarily affect both underpayment interest and overpayment interest. The government, however, objects that Baumgardner is limited to underpayment interest and that Sunoco opens a Pandora’s box with broad implications by holding that section 6512 can give the Tax Court jurisdiction to resolve a dispute over overpayment interest. In the government’s view, there are no circumstances in which the overpayment jurisdiction of section 6512 can cover a claim for overpayment interest.
Because the appeal of Sunoco was delayed for years while a motion for reconsideration was pending, actual events cast some doubt on the government’s claim of broad implications. The case was decided in 2004 and in the past six years, the Tax Court has had little occasion even to cite it, much less to use it to open the gates to all sorts of taxpayer claims for overpayment interest. Nonetheless, the case has finally reached the Third Circuit, and that court will now decide whether the Tax Court overstepped its bounds in applying the principles of Baumgardner to overpayment interest in this context.
The key documents in the case are here:
June 22, 2010
The Supreme Court’s recent denial of certiorari left intact the First Circuit’s en banc decision in United States v. Textron, Inc., 577 F.3d 21 (1st Cir. 2009), holding that Textron’s tax accrual workpapers had not been created “in anticipation of litigation” and therefore were not entitled to work product protection. The Supreme Court’s decision, of course, does not make Textron the law of the land, but rather leaves considerable uncertainty over whether other circuits will follow the First Circuit’s lead or instead place greater weight on a company’s interest in protecting from the IRS the company’s lawyers’ assessments of the strength of its tax positions.
The next insight into these issues could come soon from the D.C. Circuit in United States v. Deloitte & Touche USA LLP, 623 F. Supp. 2d 39 (D.D.C. 2009), appeal pending, No. 09-5171 (argued Feb. 26, 2010). The dispute in Deloitte arises in a different context from Textron, but it touches on similar issues. In the course of tax litigation with a partnership owned by Dow Chemical, the government sought discovery from Deloitte of three documents that contained opinions of Dow lawyers concerning the merits of the tax issues. The government agrees that two of these documents (a tax opinion prepared by Dow’s outside counsel and a legal analysis prepared by Dow’s in-house counsel) are attorney work product, but it argues that Dow waived the work product protection when it disclosed the documents to Deloitte. The third document is an analysis prepared by Deloitte that contains opinions of Dow attorneys that had been conveyed orally to Deloitte. The government argues that this document, prepared by accountants, is not work product.
The district court denied the government’s motion to compel in a brief opinion. It ruled that the Deloitte memo was work product because it recorded the thoughts of Dow’s counsel concerning the prospects in litigation. And it ruled that Dow did not waive the privilege by sharing its legal analysis with its auditors. The government’s appeal potentially could lead the D.C. Circuit to address several recurring issues.
The threshold issue of whether the Deloitte memo is work product presents the Textron issue, and the D.C. Circuit thus could directly address whether it agrees with the First Circuit’s view on tax accrual workpapers. The government repeats its winning argument in Textron that work product protection does not attach to tax accrual workpapers or similar documents that are prepared for the business purpose of preparing accurate financial statements. Dow, which has intervened as the real party in interest to oppose the government’s document request aimed at Deloitte, argues that work product protection attaches because of the documents’ content – namely, lawyers’ opinions of the prospects of litigation.
Both parties, however, have advanced arguments for distinguishing Textron that could allow