Both Parties Questioned Extensively at Rodriguez Oral Argument

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.

ExxonMobil Victory in Interest Netting Case Is Final

[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.

Exxon Mobil Second Circuit Opinion

Supreme Court Briefing Underway in Woods on Penalty and TEFRA Issues

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.

Woods – Government’s Opening Brief

Petition for Certiorari Filed in Quality Stores

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.

Quality Stores – Petition.for Certiorari