NPR Still Dragging Itself Out of the Minefield

The Government has filed its brief in its Fifth Circuit appeal from the denial of penalties in the NPR Investments case (for prior discussion go here).  There are no surprises.  The Government takes the position that the district court’s reliance on Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (likely abrogated by Treas. Reg. § 1.6662-5(g) and certainly weakened on these facts by Weiner v. United States, 389 F.3d 152 (5th Cir. 2004)) is misplaced.  Thus, the government argues that the mere fact that the taxpayer’s entire transaction (and not just a valuation or basis item) was concededly devoid of substance is not a bar to valuation misstatement penalties.  The Government also takes issue with the alleged consideration by the district court of the partners’ (as opposed to the partnership’s) reasonable cause defenses in this TEFRA proceeding contrary to Temp. Treas. Reg. § 301.6662-1T(c)-(d).  At a big picture level, the Government is still none-too-pleased with the district court’s open reliance on an R.J. Ruble opinion as contributing to such defenses, an act of reliance that it argues is contrary to case law prohibiting a taxpayer from relying on conflicted advisers for reasonable cause and also contrary to, among other things, the restriction on relying on a legal opinion that is based on representations the taxpayer knows are untrue.  Treas. Reg. Sec. 1.6662-4(c)(1)(i).

This case has the potential to be another Mayo/Brand X battle-royale (what tax case doesn’t these days?) given that there are at least three regulations explicitly relied on by the Government some of which post-date contrary court opinions.  But at bottom the case is just about a district court judge who looked into the eyes of the taxpayers and found not malice but, rather, an objectively good faith belief in the adviser who was hired to bring them safely past the landmines and snipers that fill the no-man’s land also known as the tax code.  Although they didn’t make it across (the taxpayers abandoned defense of the claimed tax benefits and R.J. – metaphorically shot – is serving time), the district court apparently couldn’t fault them for trying.  The government’s view is much harsher.  In essence, it thinks that in trying to find a way to make it to the tax-free promised land, the taxpayers should have tried a little harder to explore the obstacles in their way before taking their guide’s word for it.  At least their place shall never be with those cold and timid souls who know neither victory nor defeat.

The taxpayer’s brief is due May 17th.  We will keep you posted.

Rehearing Denied in Burks

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.

Taxpayer Petitions for Rehearing in Grapevine

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.

Grapevine – Petition for Rehearing

Government Opening Brief Filed in Entergy

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.

Entergy- Government’s Opening Brief

The Ninth Circuit Rejects the Government’s Effort to Disregard “Economic Realities” in Washington Mutual

[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.

Washington Mutual – Ninth Circuit Opinion

Washington Mutual – Taxpayer Opening Brief

Washington Mutual – U.S. brief

Washington Mutual – Taxpayer Reply Brief

Washington Mutual – District Court Opinion

Seventh Circuit Denies Rehearing in Beard

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.

Fourth Circuit Denies Rehearing in Home Concrete

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.

D.C. Circuit Leans Toward Government at Intermountain Oral Argument

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.