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.

Exxon Mobil Second Circuit Opinion

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.

Woods – Government’s Opening Brief

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.

Quality Stores – Petition.for Certiorari

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.

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.

PPL – Supreme Court opinion

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.

Both cases involved the character of the golfers’ endorsement income.  Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade.  The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).

Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%).  Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights.  So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement.  The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services.  But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.

Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement.  But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services.  And the Tax Court determined that a 50/50 split was unwarranted.

In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen.  As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income.  But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s.  The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.”  Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.

The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty.  Perhaps the IRS will appeal that legal issue.  Will Garcia appeal?  The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen.  On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal.  Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.

Garcia – Tax Court Opinion

Five former IRS Commissioners filed an amicus brief in support of the Government’s appeal of the district court decision invalidating the IRS’s registration regime for paid tax return preparers.  The former Commissioners “take no position regarding whether the manner in which the Treasury has chosen to regulate tax return preparers is advisable, but they strongly disagree with the District Court’s view that Congress has not empowered Treasury to do so.”  Under 31 U.S.C. § 330, the Treasury Department is authorized to “regulate the practice of representatives of persons before the Department of Treasury.”  The district court held that, although the statute did not define “the practice of representatives,” the surrounding statutory text made clear that Congress used “practice” to refer to “advising and assisting persons in presenting their case,” not simply preparing returns.  In their amicus brief, the former Commissioners argue that filing a tax return does, in fact, constitute presenting a case.  The amicus brief explains that an increasingly wide variety of government assistance programs are administered through the federal income tax system, including a number of refundable tax credits (the earned income credit, health insurance cost credit, etc.).  Accordingly, the tax return preparer is not simply calculating tax liability; he or she also is often representing the taxpayer in pursuing claims for federal assistance.  Because disbursements of benefits under these government assistance programs is administered largely through self-reporting on a tax return, it is essential, the former Commissioners argue, that paid tax return preparers be regulated so that taxpayers can identify the credits and benefits to which they are entitled and so that both the government and taxpayers are protected against fraud.

The National Consumer Law Center and National Community Tax Coalition also filed a joint amicus brief arguing for reversal of the district court’s decision.  That brief documents “rampant” fraud and incompetence in the paid preparation industry, especially on the part of fringe return preparers, such as payday loan stores.

Loving – Former Commissioners’ Amicus Brief

Loving- NCLC/NCTC Amicus Brief