Supreme Court Denies Cert in Altera

Despite the glut of high-powered amicus briefs in support of the taxpayer’s petition for certiorari and last week’s landmark APA decision on DACA (the relevance of which to the issues in Altera we covered here), the Supreme Court declined to review the Ninth Circuit’s decision in Altera this morning.

Supreme Court’s DACA Decision May Affect Altera

Altera’s petition for certiorari is pending at the Supreme Court. With the support of several amici, Altera has asked the Court to review the Ninth Circuit’s decision (see our prior coverage here) to uphold the validity of Treasury’s transfer-pricing regulation (Treas. Reg. § 1.482-7A(d)(2)) requiring taxpayers to include employee-stock-option costs in the pool of costs that parties to cost-sharing arrangements must share. Two APA arguments loom large in Altera’s petition. Today’s Supreme Court decision on Deferred Action for Childhood Arrivals (DACA) and the APA in Department of Homeland Security v. Regents of the University of California, No. 18-587, may change the complexion of both arguments and provide the Court with an alternative route for the Court in handling Altera’s petition.

In today’s decision, the Court struck down efforts by the Department of Homeland Security (DHS) to terminate DACA because the initial action by the Acting Secretary of DHS failed to comply with the APA. DHS promulgated DACA in 2012. And in 2014, DHS sought to expand DACA by removing an age cap and creating a new program for parents (DAPA). That expansion was mired in litigation for several years and enjoined by the Fifth Circuit on the grounds that the expansion was more than a mere agency decision to not enforce particular immigration laws.

In 2017, the new administration sought not only to undo that expansion but altogether to rescind DACA, with DHS issuing a memorandum relying on little more than a citation to the Fifth Circuit’s decision (which addressed only the 2014 expansion) and reference to a letter from the Attorney General. The Fifth Circuit decision, however, had been limited to the aspects of the DACA expansion that related to eligibility for some public benefits (and not to the animating policy of forbearing deportations); the Attorney General’s letter reiterated only that the Fifth Circuit decision was correct. The NAACP (among others) challenged the administration’s attempt to rescind DACA based on this DHS memorandum. And in that suit, the D.C. District Court found that DHS’s “conclusory statements [in the memorandum] were insufficient to explain the change in [DHS’s] view of DACA’s lawfulness,” giving DHS a chance to explain itself more fully.

The new DHS Secretary offered up a second memorandum in which she stated that she “decline[d] to disturb” the first memorandum’s DACA rescission. That second memorandum had other conclusory statements and several prudential and policy reasons that were not in the first DHS memorandum. The D.C. District Court found the new explanations insufficient. That case and other related cases were appealed, and the Supreme Court ultimately granted certiorari in the California case in which it issued a decision today. The Supreme Court addressed, among other things, “whether the [DHS] rescission [of DACA] was arbitrary and capricious in violation of the APA.”

The Court held that it was. There are two elements to that decision, both of which may bear on Altera’s arguments in its petition for certiorari. First, the Court held that “[d]eciding whether agency action was adequately explained requires, first, knowing where to look for the agency’s explanation.” And the Court held that it would look only to the first, conclusory DHS memorandum because “[i]t is a ‘foundational principle of administrative law’ that judicial review of agency action is limited to ‘the grounds that the agency invoked when it took the action.’” This means that DHS could have either (1) issued a new memorandum that better explained the reasoning behind the first memorandum (thus propping up the agency action embodied in the first memorandum) or (2) taken altogether new agency action with a distinct explanation (which new explanation would be subject to a distinct APA review). DHS did not take new action but sought instead to explain its earlier action. In doing so, however, DHS did not offer a better explanation of previously identified reasons, but rather offered reasons that were not in the first memorandum at all. (In the Court’s words, the “reasoning [of the second DHS secretary in the second memorandum] bears little relationship to that of her predecessor.”) The Court elaborated on the reasons why administrative law principles bar agencies from introducing new justifications for agency action after the fact, not the least of which is that “[c]onsidering only contemporaneous explanations for agency action … instills confidence that the reasons given are not simply ‘convenient litigating position[s].’” Therefore, the Court held, “[a]n agency must defend its actions based on the reasons it gave when it acted.”

This element of the Court’s decision goes to the heart of one of Altera’s leading arguments for certiorari. Altera observed that the government pivoted from arguing (in the regulatory preamble and before the Tax Court) that its cost-sharing regulation was consistent with the arm’s-length standard to arguing (in its briefs before the Ninth Circuit) that the addition of the “commensurate-with-income” language to section 482 permitted Treasury to adopt a rule under which a “comparability analysis plays no role in determining” the costs that taxpayers must share. Altera argued that by invoking one rationale in its rulemaking and then invoking a different rationale in litigation, Treasury violated the Chenery rule, which “ensures that an agency cannot say one thing in a rule-making proceeding, and then change its mind as soon as the rule is challenged in court.”

Today’s decision provides some reason to think the Ninth Circuit was incorrect in looking to the rationale that the government offered in litigation to decide whether to uphold the cost-sharing regulation. As Altera has argued extensively, the rationale that the government has offered in litigation bears little resemblance to the reasons offered in the regulatory preamble. And because they offer such different characterizations of how the arm’s-length standard operates, it is difficult to reconcile the former with the latter. If the Ninth Circuit was incorrect in entertaining the government’s rationale offered in litigation, then there are significant problems with the Ninth Circuit’s conclusion.

The second element of today’s decision that may be germane to Altera is the Court’s decision that DHS’s action to rescind DACA was “arbitrary and capricious” under the APA. The Court observed that the first DHS memorandum relied almost entirely on the Fifth Circuit’s decision (since the Attorney General letter cited in that memorandum also relied on the Fifth Circuit’s decision). But that Fifth Circuit decision pertained only to the benefit-eligibility features of the DACA expansion and did not address what the Court called the “defining feature” of DACA—“the decision to defer removal (and to notify the affected alien of that decision).” And on that front, the first DHS memorandum “offers no reason for terminating forbearance.” In fact, the Court held, the DHS memorandum “contains no discussion of forbearance or the option of retaining forbearance without benefits” and therefore “‘entirely failed to consider [that] important aspect of the problem’” in violation of the reasoned decision-making standard in the Court’s State Farm decision. In particular, the Court here observed that in taking any action with respect to the forbearance aspects of the DACA rescission, DHS had to consider the consequences of rescission on aliens’ obvious reliance interests.

This second element may affect the outcome with respect to another one of Altera’s APA arguments. Altera argued that the regulation was the result of arbitrary and capricious agency decision-making. Treasury “purported to apply the arm’s-length standard” and “stated that whether that standard is satisfied depends on an empirical and factual analysis of real-world behavior of unrelated parties.” But then, Altera argued, when confronted with “extensive evidence demonstrating that unrelated parties would not share stock-based compensation,” Treasury “ignored or dismissed that evidence because it was inconvenient” and enacted the regulation. There is no dispute that Treasury was aware of that evidence when it finalized the disputed cost-sharing regulation, but Altera has argued that neither Treasury’s regulatory preamble nor the government’s subsequent litigating position adequately address that evidence. Just as DHS’s failure to consider obvious reliance interests in its attempt to rescind DACA created a fatal APA problem, so too, the taxpayer might argue, does Treasury’s failure to consider obvious evidence that runs counter to its cost-sharing regulation when enacting that regulation.

Although the Court’s decision on DACA is directly relevant to issues in Altera, it may not ultimately result in the Supreme Court hearing the case. But the DACA decision gives the Court an opportunity to deal with the Altera decision in a much less labor-intensive way. The Court can issue a “GVR” (grant, vacate, and remand) order, which is a one-paragraph order in which the Court grants certiorari, immediately vacates the judgment below, and remands the case to the court of appeals for “further consideration in light of” a new development not previously considered—usually an intervening Supreme Court decision.

In many cases in which the Court issues such orders, the remanded case is on all fours with the new Supreme Court decision, and the circuit court’s decision on remand is a formality. That would not be true in Altera. Even so, if the Court were to issue such a GVR, it would send a clear message about what the Ninth Circuit would need to do on such a remand. Invoking the GVR procedure would allow the Court to vacate the Ninth Circuit’s Altera decision without having to entertain full briefing and argument. The Court often issues numerous GVR orders on the last day of its Term before breaking for the summer recess. That is usually at the end of June, though the timing could get extended somewhat this year because of the delays in the Court’s spring argument schedule caused by the coronavirus. But some resolution of the pending Altera petition should be expected within the next few weeks.

Supreme Court Opinion – DHS v. Regents of Univ. of Cal

Ninth Circuit Denies Petition for Rehearing

On Tuesday, the Ninth Circuit denied Altera’s petition for rehearing en banc (which petition we discussed in our recent post here). The order issuing that denial includes a strong, 22-page dissent written by Judge Smith and joined by Judges Callahan and Bade. (Ten judges recused themselves, meaning that the vote was 10-3 against rehearing.) The dissent made several arguments for why the petition should have been granted, taking aim at the panel’s reasoning in upholding the regulation and warning about the decision’s broader effects.

Quoting State Farm, the dissent stated that it would have invalidated the regulations because Treasury’s “‘explanation for its decision [ran] counter to the evidence before’ it.” When it promulgated the regulations, Treasury asserted that it was applying the traditional arm’s-length standard, stating that “‘unrelated parties entering into [cost-sharing arrangements] would generally share stock-based compensation costs.’” But the evidence showed that “unrelated entities do not share stock-based compensation costs.”

Although the dissent stated that “[t]his should be the end of our analysis,” it went on to explain why the panel’s decision violates the Chenery rule that courts cannot provide “‘a [purportedly] reasoned basis for the agency’s action that the agency itself has not given.’” The dissent observed that despite Treasury’s clear statement in the preamble that its cost-sharing rule was “based on a traditional arm’s length analysis employing (unsubstantiated) comparable transactions,” the panel upheld “Treasury’s convenient litigating position on appeal that it permissibly jettisoned the traditional arm’s length standard altogether.” That mismatch undermines the regulation’s validity under APA notice-and-comment principles because Treasury cannot offer one rationale in its preamble, dismiss public comments on that rationale, “and then defend its rule in litigation using reasoning the public never had notice of.” Compounding this notice problem, the panel accepted Treasury’s argument that it could jettison a traditional arm’s length analysis because of the addition of the “commensurate-with-income” sentence to section 482 in 1986. But Treasury had stated in the 1988 White Paper that the addition of that sentence did not amount to a “departure from the arm’s length standard.” So not only did the panel uphold the regulation based on a rationale that Treasury did not offer in its preamble, it also upheld the regulation based on a rationale that Treasury itself had previously disclaimed.

The dissent also took up a cause that we’ve explored here before. By its own terms, the commensurate-with-income provision in section 482 applies only to “transfers of intangible property.” The panel concluded that provision was implicated here because there were “future distribution rights” transferred in Altera’s cost-sharing arrangement. The dissent disagreed because (1) cost-sharing agreements contemplate the “development” of intangibles, which implies that not every intangible subject to the arrangement must have been transferred to the arrangement, and (2) the intangibles enumerated in the pertinent regulation do not include future intangibles because they are all “property types that currently exist.” The dissent therefore concluded that the commensurate-with-income language “simply does not apply to” cost-sharing arrangements.

Finally, the dissent detailed three “particularly deleterious” consequences of the panel’s decision. First, the decision will “likely upset the uniform application of the challenged regulation” because the Tax Court’s decision invalidating the regulation still applies to taxpayers outside of the Ninth Circuit. Second, the decision “tramples on the longstanding reliance interests of American businesses,” many of whom relied not just on the Tax Court unanimously invalidating the regulation but also on Treasury reaffirming the primacy of the arm’s-length standard in the 1988 White Paper and the 2003 regulatory preamble. The dissent observed that these reliance interests are far-reaching because at least 56 major companies have noted the Altera issue in annual reports. Third, the decision threatens international tax law uniformity insofar as the arm’s-length standard (setting aside GILTI and the latest from the OECD) has been the method for allocating taxable income among major developed nations.

At a minimum, the dissent should strengthen the Tax Court’s resolve to invalidate the regulation again for taxpayers from other circuits—the dissent remarked on the “uncommon unanimity and severity of censure” in the Tax Court’s decision. And the dissent can be read as encouragement for Altera to seek certiorari—the dissent stated that the panel’s reversal of a Tax Court decision that would have applied nationwide produces “a situation akin to a circuit split.” Unless extended, the time for Altera to file a petition for certiorari will expire on February 10.

Thanks to Colin Handzo for his help with this post.

Altera – Ninth Circuit Rehearing Denial

Reflections on the Ninth Circuit’s Decision in Amazon.com

Although some time has passed (and we’ve fallen short of our hope here to get something up “soon”), we nevertheless wanted to post some thoughts on the Ninth Circuit’s unanimous affirmance of the taxpayer’s victory in the Tax Court in Amazon.com while also revisiting some of the topics that we covered here after oral argument. The panel’s opinion is brief, but it touched on several important aspects of the law under section 482.

Finding Ambiguity in the Regulatory Definition of “Intangible”

As you’ll recall, the primary dispute on appeal was whether the regulatory definition of “intangible” under Treas. Reg. § 1.482-4(b) included residual business assets like goodwill, going concern, and the amorphous notions of “growth options” and “culture of continuous innovation” that the government theorized the taxpayer made available in its cost-sharing agreement.

The taxpayer argued that the definition excluded such residual business assets because it did not expressly list them in any of the six subparagraphs of the definition. And the taxpayer argued that the 28 specified items in the regulation all “can be sold independently” from the business while the residual business assets cannot, invoking the statutory-interpretation canon of ejusdem generis to reason that the regulation therefore excludes residual business assets (which cannot be sold without a sale of the entire business).

The government argued that those residual business assets fell under the sixth subparagraph of Treas. Reg. § 1.482-4(b), which provides that “intangible” includes “other similar items” and that “an item is considered similar … if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” Since residual business assets do not derive their value from physical attributes but from other intangible properties, the government reasoned, they must be included here. And the government went on to argue that residual business assets must be compensable because otherwise, taxpayers could have transferred assets of value to a cost-sharing arrangement without compensation, which the government asserts would have violated the arm’s-length principle that undergirds section 482 and its regulations.

The panel held that although the taxpayer’s “focus on the commonality of the 28 specified items has some force,” that argument did not carry the day. The panel drew this conclusion from the plain language in the sixth subparagraph: that paragraph does not state that the commonality is that each item “can be sold independently” but rather states that each item “derives its value … from its intellectual content or other intangible properties.” The panel reasoned that the regulation therefore “leaves open the possibility of a non-listed item being included in the definition even if it doesn’t share the attribute of being separately transferable.” The panel thus echoed the concern that Judge Fletcher raised at oral argument—that while the 28 specified items share the commonality of being independently transferable, that commonality is “not the one the text [describing what constitutes a ‘similar item’ under the regulation] gives me.”

Resolving the Ambiguity by Looking to the Drafting History of the Regulation

After concluding that the regulatory definition “is susceptible to, but does not compel, an interpretation that embraces residual-business assets,” the panel looked to the overall regulatory scheme but held that to be inconclusive. The panel then turned to the drafting history of Treas. Reg. § 1.482-4(b) and found it to show that Treasury’s 1994 final regulations (which amended the sixth subparagraph of Treas. Reg. § 1.482-4(b)) both (1) exclude residual business assets from the definition of intangible and (2) provide reason to think that the definition of “intangible” includes only independently transferable assets.

The panel described how when Treasury issued temporary and proposed regulations in 1993, it asked “whether the definition of intangible property … should be expanded to include … goodwill or going concern value.” The panel concluded that since Treasury asked whether the definition should be “expanded” to include residual business assets, those assets were not included in the then-existing definition. And when Treasury issued final regulations in 1994 without expressly enumerating goodwill or going concern value in that definition, Treasury stated that its final rule “merely ‘clarified’ when an item would be deemed similar to the 28 items listed in the definition.” The panel concluded that by its own admission, Treasury would have needed to “expand” the definition to include residual business assets but instead opted to merely “clarif[y]” its definition, and therefore Treasury did not intend for the 1994 final regulations to include residual business assets.

Moreover, Treasury’s 1993 regulations limited the universe of compensable intangibles to “any commercially transferable interest.” But when it issued final regulations in 1994, Treasury dropped the “commercially transferable interest” language because “it was superfluous: if the property was not commercially transferable, then it could not have been transferred in a controlled transaction.” The panel concluded that the transfer-pricing regulations thus “contemplate a situation in which particular assets are transferred from one entity to another.” Since Treasury stated that it would have been “superfluous” to expressly state that the definition of “intangible” includes only commercially transferable assets, the panel held that the regulatory history “strongly supports Amazon’s position that Treasury limited the definition of ‘intangible’ to independently transferable assets.”

That the panel found this history dispositive comes as no surprise. We observed in our prior post that both Judge Callahan and Judge Christen recounted the regulatory history, with Judge Callahan questioning government counsel about whether Treasury ever expressed an intent to expand the definition to include residual business assets.

What Is the Rationale for Including Only Independently Transferable Assets in the Definition of Intangible?

Although the panel’s explanation for how it concluded that the definition of intangibles includes only independently transferable assets is explicit, the rationale for why Treasury would include only independently transferable assets is markedly subtler. It’s possible, however, to cobble together an explanation from other statements in the decision.

The first clue is when the panel looked to the genesis of the cost-sharing regulations, where Treasury identified “intangibles as being the product of R&D efforts.” In that sense, the panel reasoned, the “regulations seem to exclude” residual business assets, “which ‘are generated by earning income, not by incurring deductions.’” This distinction is clear enough—businesses incur expenses in undertaking R&D efforts, while goodwill and going concern value are byproducts of a well-run and successful business.

Why does this distinction matter? One answer lies in the legislative history and policy underpinnings for the statutory definition of “intangibles.” As the panel observed in a footnote, the “Senate Report states that the Committee viewed the bill as combatting the practice of transferring intangibles ‘created, developed or acquired in the United States’ to foreign entities to generate income tax free.” Which is to say that one animating concern in defining intangibles was to prevent U.S. entities from developing intangibles domestically but then transferring those intangibles to foreign affiliates whose income is not subject to U.S. tax.

And the reason why this is a concern for intangibles that result from R&D and other independently transferrable assets but not goodwill or going-concern value should be apparent: while the former involve expenditures that are deductible against U.S. income (but where the asset transfer will prevent the income from being taxed in the U.S.), the latter involve assets that exist only if the taxpayer has generated business income in the U.S. in the first place. In other words, the definition of “intangible” was initially meant to prevent taxpayers from incurring expenses to create intangibles in the U.S. and deducting those expenses against U.S. income, but then turning around and transferring those intangibles to foreign affiliates that may not owe U.S. tax on the income resulting from those intangibles.

Distinguishing the Definition of “Intangibles” from the Value of Those Intangibles

On brief and at oral argument, the government repeatedly cited deposition testimony by one of the taxpayer’s experts in which that expert admitted that parties at arm’s length would pay for residual business assets. The government tried to leverage that admission to argue that the arm’s-length standard itself means that residual business assets are compensable because “it is undisputed that a company entering into the same transaction under the same circumstances with an unrelated party would have required compensation.”

The panel addressed that argument in a footnote, holding that the government’s argument “misses the mark.” The panel explained that while the arm’s-length standard “governs the valuation of intangibles; it doesn’t answer whether an item is an intangible.” This is a decisive response to the government’s arguments; it cannot be the case that any value associated with a business falls under the definition of “intangible.”

Putting Footnote 1 in Context

One aspect of the panel’s decision that is certain to receive attention in future transfer-pricing disputes is the discussion in the first footnote. In that footnote, the panel described the 2009 changes to the cost-sharing regulations as “broadening the scope of contributions for which compensation must be made” and explained that the TCJA “amended the definition of ‘intangible property’” in section 936(h)(3)(b). The footnote then stated that “[i]f this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the Commissioner’s position would be correct.”

There are a few things worth noting about this footnote, the first of which is arguably the most important: It’s dicta. The question of whether residual assets are compensable under the 2009 cost-sharing regulations or the 2017 statutory amendment was not before the court. And since the panel says nearly nothing in the footnote about the language in those 2009 regulations or the TCJA amendment, there is no reason to think that the panel gave material consideration to whether the outcome in the case would have been different under either.

Second, given some of the panel’s other statements, it is not so clear that “there is no doubt the Commissioner’s position would be correct” for years after the 2009 changes to the regulations. Recall that the government’s case was predicated on charging a higher buy-in for the purported transfer of “growth options” and a “culture of continuous innovation” to the cost-sharing arrangement. Although the 2009 regulatory amendments changed the cost-sharing regulations and TCJA amended the statutory definition for “intangibles,” there was no change to the definition under Treas. Reg. § 1.482-4(b). That regulation provides that an item not otherwise specified is an intangible only if it “has substantial value independent of the services of any individual.” The panel itself expressed serious doubt about whether the purported intangibles in this case met that requirement, stating that “residual business assets, such as ‘growth options’ and a ‘culture of innovation,’ are amorphous, and it’s not self-evident whether such assets have ‘substantial value independent of the services of any individual.’”

Finally, the TCJA amendments would affect the result in the case only if the purported “growth options” and “culture of continuous innovation” are items of property that fall under the new statutory category of “goodwill, going concern value, or workforce in place” or constitute an item “the value or potential value of which is not attributable to … the services of any individual.” But there is reason to think that the government is itself unconvinced that “growth options” and “culture of continuous innovation” fall under that new statutory category. At oral argument, the panel asked government counsel why, if Treasury meant to expand the definition of “intangible” with its 1994 changes, Treasury didn’t just add “goodwill and going concern” to the list. In response, government counsel argued that merely adding “goodwill and going concern” to the list would not have solved anything because then taxpayers would just fight about whether particular assets fell under those additions to the list. The government cannot coherently maintain both that (1) Treasury could not have achieved the Commissioner’s desired result in this case by expanding the regulatory list to include goodwill and going concern in 1994 and (2) Congress’s addition of goodwill and going concern to the list in TCJA would change the result in this case. Even though Congress meant to change the result in cases like this, government counsel’s argument suggests an absence of faith that expanding the list succeeds in changing the result.

Whether the Commissioner’s Litigating Position Warrants Auer Deference

The government also argued that under Auer, the Tax Court should have deferred to the Commissioner’s interpretation of Treas. Reg. § 1.482-4(b) as including residual business assets. The panel rejected this argument for two reasons.

First, the panel found that pursuant to the Supreme Court’s decision in Kisor, the Commissioner’s interpretation warrants Auer deference only if the regulation is “genuinely ambiguous.” The panel states that Auer thus implicates a higher standard for ambiguity. Under that standard, a regulation is “genuinely ambiguous” for Auer purposes only if ambiguity remains once the court has exhausted the traditional tools of construction, which requires it to consider “the text, structure, history, and purpose of a regulation.” The panel concluded that the text of Treas. Reg. § 1.482-4(b), its place in the transfer-pricing regulations, and its rulemaking history “leave little room for the Commissioner’s proffered meaning.” The panel’s holding is therefore that the definition of “intangible” under Treas. Reg. § 1.482-4(b) is ambiguous but not genuinely ambiguous.

Second, the panel also rejected the government’s deference argument because the government first advanced an interpretation of Treas. Reg. § 1.482-4(b) in the litigation that had never appeared in the drafting history of the regulations or anywhere else. As we remarked earlier, reliance concerns loomed large at oral argument, and especially in Judge Callahan’s questions. The panel’s conclusion that “Amazon and other taxpayers were not given fair warning of the Commissioner’s current interpretation of the regulatory definition of an ‘intangible’” was thus foreseeable from oral argument.

Whether the Cost-Sharing Regulations Provide a Safe Harbor

As we observed in our prior post, at oral argument the government disavowed the notion that the Treasury Regulations create a safe-harbor for cost-sharing arrangements. We surmised that whether the Ninth Circuit agreed with the government on this point might be pivotal in the outcome.

While the extent to which that issue factored into the panel’s decision is not evident, the panel’s decision is entirely consistent with the notion that cost sharing operates as a safe harbor. First, the panel described cost sharing as “an alternative to licensing … under which [the parties to the cost-sharing arrangement] become co-owners of intangibles as a result of the entities’ joint R&D efforts.” If the cost-sharing arrangement qualifies, then it “provides the taxpayer the benefit of certainty because … new intangibles need not be valued as they are developed.” But the panel explained that the certainty comes at a price—the R&D payments by the foreign cost-sharing participants “serve to reduce the deductions the [domestic] taxpayer can take for the R&D costs (thereby increasing tax liability).” What the panel thus described operates like a safe harbor—taxpayers that ensure that their cost-sharing arrangements qualify and sacrifice some deductions for intangible development costs can gain certainty that their intangibles need not be re-valued. The panel’s decision will hamper any future IRS arguments that cost-sharing does not operate like a safe harbor.

Procedural Status

The government did not file a petition for rehearing in the case; the mandate issued on October 8. There is still time for the government to file a petition for certiorari; it is due November 14.

Ninth Circuit Affirms Tax Court in Amazon.com

In a unanimous opinion issued today, the Ninth Circuit affirmed the taxpayer’s victory in the Tax Court in Amazon.com. We previously covered the case and oral argument here. We will take some time to digest the opinion and post on its finer points soon. In the meantime, one key sentence in the opinion is worth noting because it appears to capture the thrust of the Ninth Circuit’s decision about the disputed scope of the relevant regulatory definition for the term “intangible”: “Although the language of the definition is ambiguous, the drafting history of the regulations shows that ‘intangible’ was understood to be limited to independently transferable assets.”

Amazon.com Ninth Circuit Opinion

Petition for Rehearing En Banc Filed in Altera

As most expected, Altera filed a petition for rehearing en banc after the reconstituted three-judge panel decided to reverse the Tax Court’s invalidation of Treasury’s cost-sharing regulations. (A link to the petition is below.) As we explained previously, those regulations have been the subject of much controversy over the last two decades, and the success that Xilinx had with its petition for rehearing several years ago made it likely that Altera would ask for rehearing.

The petition picks up on one of the themes we discussed in our most recent post here. The taxpayer takes aim at the majority’s conclusion that the “commensurate with income” language added to section 482 in 1986 is relevant in the cost-sharing context. The taxpayer argues that language was aimed at addressing a different issue from the one before the court here—“how to value transfers of existing intangible property from one related entity to another” and not “intangible property yet to be created.”

The taxpayer makes four or five (the petition combines arguments (3) and (4) below) arguments for why its petition should be granted:

(1) The decision upsets settled principles about the application of the arm’s-length standard because the majority permitted Treasury to “cast aside the settled arm’s-length standard” for “a new standard” that is “purely internal.”

(2) The decision “validates bad rulemaking” because, contrary to the majority’s account of the regulation’s history, “[n]o one involved in the rulemaking thought the IRS was interpreting ‘commensurate with income’ to justify a new standard that did not depend on empirical evidence.” And under the law in Chenery, the court must assess the “‘propriety of [the agency’s] action solely by the grounds invoked by the [agency]’ in the administrative record.”

(3) The decision is irreconcilable with the Ninth Circuit’s decision in Xilinx, which held that parties would not share in employee stock option costs at arm’s length.

(4) The decision “threatens the uniform application of the tax law” because, under the Golsen rule, the Tax Court will continue to apply its unanimous decision declaring the regulation invalid to cases arising anywhere outside the Ninth Circuit.

(5) As evidenced by the glut of amicus briefs, the treatment of employee stock options in cost-sharing arrangements is “exceptionally important.”

It is likely that additional amicus briefs will be filed in support of the rehearing petition. And given the prominence of the issue, we anticipate that the court will order the government to file a response to the petition. We will report on further developments as warranted.

Altera Petition for Rehearing En Banc July 2019

Observations on Changes in the Ninth Circuit’s Second Altera Decision

As we posted earlier here (with a link to the new decision), the Ninth Circuit issued a new decision in Altera after replacing the late Judge Reinhardt with Judge Graber on the panel. But the result was the same as the withdrawn July 2018 decision—the Ninth Circuit upheld the validity of Treasury’s cost-sharing regulation that requires taxpayers to include the cost of employee stock options under qualifying cost sharing arrangements (QCSAs). Today, we present some observations after comparing the majority and dissent in the new decision with those in the Ninth Circuit’s withdrawn decision.

In the new decision, Judge Thomas recycled much of the language and logic from his withdrawn opinion, and Judge O’Malley reused much of her original dissent. Although they are few, some changes in the two opinions are interesting and notable. Overall, the changes serve to sharpen the disagreements between the parties (and the disagreements between the majority and dissent) in ways that will focus the discussion in the likely event of a rehearing en banc petition (or possible petition for certiorari). We focus here on two aspects of the changes.

Was There a Transfer of Intangibles that Implicated the Commensurate-With-Income Language in the Second Sentence of Section 482?

The majority did not address this issue in its withdrawn opinion, so some background is in order. When Treasury proposed cost-sharing regulations that explicitly required related parties to include employee-stock-option costs in the pool of shared costs, commenters put forward evidence that unrelated parties do not share employee-stock-option costs. But Treasury did not heed those comments and ultimately determined that the arm’s-length standard would be met if the regulations required taxpayers in QCSAs to include the cost of employee stock options in the pool of shared costs, regardless of what a comparability analysis might show about whether unrelated parties share those costs. So in order to uphold the Treasury Regulations, the majority had to conclude that the arm’s-length standard under section 482 does not mandate the use of comparable transactions.

In reaching that conclusion, the majority relied on the history of section 482 and especially on the addition of the second sentence of section 482. That second sentence provides that “[i]n the case of any transfer (or license) of intangible property…, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” The majority held that the Congressional intent behind the addition of that language in 1986 is what made it reasonable for Treasury to conclude that it was permitted “to dispense with a comparable transaction analysis in the absence of actual comparable transactions.”

Was there a “transfer (or license) of intangible property” such that Treasury could invoke the commensurate-with-income language to justify dispensing with a comparable-transaction analysis? There was indeed a transfer of intangibles at the outset of the QCSA in this case; Altera transferred intangible property to its QCSA with its foreign subsidiary. But that initial transfer is unrelated to the disputed employee-stock-option costs. Those stock-option costs relate to subsequently developed intangibles, not to the value of the pre-existing intangibles that Altera initially contributed. Then-applicable Treasury Regulation § 1.482-7A(g)(2) required a buy-in payment only for “pre-existing intangibles.”

It is, then, wholly unclear how those employee-stock-option costs for as-yet undeveloped intangibles constitute a “transfer (or license) of intangible property” such that the commensurate-with-income language is implicated at all. The taxpayer argued—both in its initial and supplemental briefing—that by its own terms, the commensurate-with-income language is not implicated once a QCSA is in place and therefore that language is irrelevant to the dispute. The taxpayer reasoned that “no ‘transfer (or license)’ occurs when entities develop intangibles jointly” because jointly developed intangibles “are not transferred or licensed between the parties, but rather are owned upon their creation by each participant.”

The majority said little about this issue in its withdrawn opinion and did not address the taxpayer’s argument. In its new opinion, the majority addressed the argument and declared itself “unpersuaded.” It held that “[w]hen parties enter into a QCSA, they are transferring future distribution rights to intangibles, albeit intangibles that are yet to be developed.” The majority does not, however, explain how “intangibles that are yet to be developed” are “pre-existing intangible property” under Treas. Reg. § 1.482-7A(g)(2) or, perhaps more importantly, how such undeveloped future intangibles can constitute intangible assets at all under the words of the statute. Instead, the majority leaned on the language in the second sentence of section 482 providing that the commensurate-with-income standard applies to “any” transfer of intangible property, holding that “that phrasing is as broad as possible, and it cannot reasonably be read to exclude the transfers of expected intangible property.”

The dissent seized on whether there was any transfer of intangibles that implicated the commensurate-with-income language. The dissent stated that “[t]he plain text of the statute limits the application of the commensurate with income standard to only transfers or licenses of intangible property.” And it observed that there is a contradiction between the majority’s conclusion that QCSAs “constitute transfers of already existing property” and Treasury’s own characterization (in the very preamble of the disputed regulations) of QCSAs “as arrangements ‘for the development of high-profit intangibles,’” inferring that parties cannot transfer something that is not yet developed. The dissent concluded that Treasury’s failure to make “a finding that QCSAs constitute transfers of intangible property” should be, as a matter of review under the APA, fatal to Treasury’s cost-sharing regulations.

Has the Arm’s-Length Standard Historically Required a Comparable-Transaction Analysis?

The majority made several changes from its withdrawn opinion in its account of the history of the arm’s-length standard under section 482. The changes appear to be aimed at bolstering the majority’s conclusion that Treasury was justified in concluding that the arm’s-length standard does not necessitate a comparable-transaction analysis. These changes take a couple of forms.

First, the changes add justifications for the proposition that the arm’s-length standard has not always mandated a comparable-transaction analysis in all cases. The withdrawn opinion included some evidence for this historical account, recounting the Tax Court’s Seminole Flavor decision from 1945 (where the Tax Court “rejected a strict application of the arm’s length standard in favor of an inquiry into whether the allocation…was ‘fair and reasonable’”). In its new opinion, the majority added the observation that Treasury provided for an unspecified fourth method for pricing intangibles in its 1968 regulations. And the majority refined its discussion of the Ninth Circuit’s 1962 decision in Frank, still quoting the language from that opinion denying that “‘arm’s length bargaining’ is the sole criterion for applying” section 482 (as it did in the withdrawn opinion) but then adding the new assertion that the “central point” of Frank is that “the arm’s length standard based on comparable transactions was not the sole basis” for reallocating costs and income under section 482. (As the dissent pointed out, a later Ninth Circuit decision limited the holding in Frank to the complex circumstances in that case and noted that the parties in Frank had stipulated to apply a standard other than the arm’s-length standard.)

Second, the majority made changes to add a series of new and more sweeping assertions that under section 482, Treasury has always had the leeway to dispense with comparable-transaction analyses in deriving the correct arm’s-length price. For instance, as a rejoinder to the taxpayer’s argument that the arm’s-length standard requires a comparable-transaction analysis, the majority wrote that “historically the definition of the arm’s length standard has been a more fluid one” and that “courts for more than half a century have held that a comparable transaction analysis was not the exclusive methodology to be employed under the statute.” It added similarly broad historical statements elsewhere in the new opinion, all in service of concluding that Treasury acted reasonably in dispensing with a comparable-transaction analysis in its cost-sharing regulations: “[a]s demonstrated by nearly a century of interpreting § 482 and its precursor, the arm’s length standard is not necessarily confined to one methodology” (p. 33); “the arm’s length standard has historically been understood as more fluid than Altera suggests” (p. 41); and “[g]iven the long history of the application of other methods…Treasury’s understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable” (p. 49).

In one of the subtler but more interesting changes from the withdrawn opinion, the majority’s new opinion removed a single word. In its withdrawn opinion, the majority said that Treasury’s 1988 White Paper “signaled a dramatic shift in the interpretation of the arm’s length standard” by advancing the “basic arm’s length return method…that would apply only in the absence of comparable transactions….” (emphasis added). But consistent with its conclusion in the new opinion that “for most of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology,” the majority appears to have concluded that shift in the White Paper was not so “dramatic,” dropping that word altogether in its new opinion. (In this vein, the majority also removed its assertion in the withdrawn opinion that “[t]he novelty of the 1968 regulations was their focus on comparability.”)

The new dissenting opinion disputed the majority’s historical account, stating that the first sentence of section 482 “has always been viewed as requiring an arm’s length standard” and that before the 1986 amendment, the Ninth Circuit “believed that an arm’s length standard based on comparable transactions was the sole basis for allocating costs and income under the statute in all but the narrow circumstances outlined in Frank.” And the dissent observed that even with the 1986 addition of the commensurate-with-income language, “Congress left the first sentence of § 482—the sentence that undisputedly incorporates the arm’s length standard—intact,” thus requiring a comparable-transaction analysis everywhere that comparable transactions can be found. The dissent pointed out that the White Paper clarified that this was true “even in the context of transfers or licenses of intangible property,” quoting Treasury’s own statement in the White Paper that in that context the “‘intangible income must be allocated on the basis of comparable transactions if comparables exist.’”

Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera

The Ninth Circuit issued a new opinion in Altera today after having withdrawn its July 2018 opinion. But today’s opinion does not change the result—by a 2-1 vote, the Ninth Circuit upheld the validity of the Treasury Regulation under section 482 that requires taxpayers to include the cost of employee stock options in the pool of costs that must be shared in qualifying cost sharing arrangements. Judge Thomas again wrote the panel’s opinion, Judge O’Malley again dissented, and Judge Graber—who was added to the panel to replace the late Judge Reinhardt—voted with Judge Thomas.

Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison.

The taxpayer may seek a rehearing of the decision by the full Ninth Circuit (which is likely after the success that another taxpayer had in the Ninth Circuit’s rehearing of a similar issue in Xilinx). A petition for rehearing would be due July 22.

Altera Ninth Circuit Opinion June 2019

Both Parties Face Tough Questions in Amazon.com Ninth Circuit Argument

As we previewed here, the Ninth Circuit heard oral argument in Amazon.com v. Commissioner on Friday, April 12. Before giving a detailed recap of that oral argument, some background on the dispute is in order.

The Primary Issue in Dispute

Amazon.com, the U.S. parent company (Amazon US), entered into a qualified cost-sharing agreement with its Luxembourg subsidiary (AEHT) in 2005. Amazon US contributed the intangible assets required to operate its European website business to that cost-sharing agreement. Then effective Treas. Reg. § 1.482-7(g)(2) provided that AEHT owed Amazon US a buy-in payment for the “pre-existing intangibles” that Amazon US contributed. Although AEHT made a buy-in payment for that contribution of over $100 million, the IRS determined that the buy-in should have been $2.7 billion higher.

At trial, the parties submitted competing valuations of the contributed pre-existing intangibles—the taxpayer used comparable uncontrolled transactions (CUTs) to separately price the website technology, marketing intangibles, and European customer information that Amazon US contributed; the Commissioner used a discounted-cash-flow (DCF) method to determine the present value of the projected future income that AEHT would earn using the contributed intangibles. Underlying the methodological differences between the parties, however, is a fundamental dispute about the scope of the pre-existing intangibles for which AEHT owed a buy-in payment.

The taxpayer’s position was that AEHT owed a buy-in payment for only those intangibles enumerated in the definition of “intangible” in Treas. Reg. § 1.482-4(b), which definition does not expressly include so-called “residual” business assets like goodwill and going-concern value, and that the taxpayer’s CUT method accurately priced the enumerated intangibles that Amazon US contributed. The Commissioner argued that despite not explicitly naming residual business assets, any such assets are included in the definition of “intangible” in Treas. Reg. § 1.482-4(b)(6) and that only his DCF method captured the value of those residual business assets. He also argued that the bundle of compensable pre-existing intangibles that Amazon US made available in the cost-sharing arrangement included its “culture of continuous innovation” and other unspecified “growth options.”

Treas. Reg. § 1.482-4(b) provides that “[f]or purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual—” and then lists 28 specified intangibles in the first five subparagraphs (like patents and trademarks) and concludes with a sixth subparagraph that states that the definition encompasses “[o]ther similar items.” That subparagraph goes on to say that “[f]or purposes of section 482, an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.”

The Tax Court sided with the taxpayer’s reading of Treas. Reg. § 1.482-4(b), concluding that the Commissioner’s DCF included the value of residual business assets that were not “pre-existing intangibles” under the cost-sharing regulations. The Tax Court made some material adjustments to the taxpayer’s CUTs, ultimately finding that AEHT owed a higher buy-in, albeit nowhere near the size of the Commissioner’s proposed adjustment. The government appealed the Tax Court’s decision on legal grounds, arguing that the pertinent Treasury Regulations do not foreclose the DCF method that was the basis for the Commissioner’s adjustments. The government argued in its brief that “[t]he Treasury Regulations broadly define intangibles and do not exclude residual-business assets from the scope of the buy-in requirement.” Oral argument at the Ninth Circuit was held before the three-judge panel of Judges Fletcher, Callahan, and Christen. (The video is available here.)

Plain Language of the Regulation

Government counsel started oral argument by asserting that the plain language of Treas. Reg. § 1.482-4(b) favored the government’s position because the regulatory definition of “intangible” was so broad that it must include residual business assets like “growth options” and “corporate culture.” In support, she argued that the sixth regulatory category of “other similar items” is “written so broadly to include any item that derives its value from anything other than physical attributes.”

Amazon’s counsel responded that the government’s argument proves too much. If the definition of “intangible” truly encompassed any asset that is not tangible, then it would belie the regulation’s enumeration of 28 items that count as “intangibles” under the regulatory definition. As Amazon argued in its brief, “[i]f Treasury intended to capture all intangibles, there would have been no reason to specify any particular types of intangibles, let alone list 28 of them.” Amazon’s brief went on to argue that the court should be guided by the interpretive canon of ejusdem generis. That canon requires the court to “focus ‘on the common attribute’ of the list of items that precedes the catch-all.”

This meant, however, that Amazon’s counsel had to explain what that “common attribute” is. He argued that the 28 listed items share characteristics that the residual business assets do not have—the 28 listed items are independently transferable and created by expenditures, but residual intangibles are not independent of the business and are the product of the operation’s income-producing success. As for why the list includes only items that are independently transferable, taxpayer’s counsel argued that only those assets that can be transferred independent of the entire business are susceptible to valuation while residual business assets like goodwill or so-called “growth options” were inextricable from the entire business and impossible to value with any precision.

But the panel questioned Amazon’s invocation of ejusdem generis. Judge Callahan asked why the court should apply that canon here where the regulation defines what it means to be similar (providing that “an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties”). And in his only remarks of the day, Judge Fletcher called the taxpayer’s ejusdem generis argument “somewhat peculiar.” He went on to remark that he understood Amazon counsel’s explanation of what the 28 enumerated items had in common “but it’s not the one the text gives me,” going on to state that if he were “a pure textualist, you lose.” (Judge Fletcher’s remarks may not indicate how he will vote; he prefaced his remarks with the assertion that “I’m not sure that in the end that I would disagree with your position.”)

The description of “other similar items” was not the only regulatory language that drew the panel’s attention. Judge Christen questioned government counsel about how to reconcile the government’s reading of “other similar items” to include residual business assets like “corporate culture” with the regulation’s limitation that the universe of intangibles was limited to only those assets that have “substantial value independent of the services of any individual.” (That language played a role in the Tax Court’s decision; it found that residual business assets like goodwill and growth options “often do not have ‘substantial value independent of the services of any individual.’”) Amazon made the same point in its brief, arguing that its purported “culture of innovation” is “inseparable from the individuals in the company’s workforce.” And Judge Christen appeared unmoved by government counsel’s attempt to explain away that language by arguing that while the “value” of the intangible needs to be independent of services, the “intangible itself” does not need to be independent and that other expressly listed items—like “know-how”—were not entirely independent of services.

Regulatory History

Taxpayer’s counsel attacked the government’s case as based on reading the regulatory language in the abstract, divorced entirely from its context and history. The applicable definition of “intangibles” in Treas. Reg. § 1.482-4(b) was the result of regulatory changes in 1994. Before making those regulatory changes, Treasury asked for comments on whether it should “expand” the definition of “intangibles” to include observed assets like goodwill and going concern. It received comments that the definition should not be expanded, and when Treasury issued revised regulations, it noted that it added language to the “other similar items” subparagraph but described the change as a “clarifi[cation].” Amazon’s counsel recounted this history and argued that since Treasury acknowledged that the definition would have to be expanded to include residual business assets, “Treasury could not thereafter ‘clarify’ that these intangibles had been included all along.” This was, in the words of taxpayer’s counsel, a classic case of “regulator’s remorse.”

In questioning government counsel, both Judge Callahan and Judge Christen recounted the same regulatory history and observed that Treasury asked if it should expand the definition and ultimately called its change a clarification. Judge Callahan asked whether the government could point the panel to specific language where Treasury said it intended to expand its definition to include residual business assets.

Government counsel acknowledged that Treasury used the word “clarified” in the preamble but offered a different history of the regulatory language. She argued that some initial Treasury guidance included “goodwill, consumer acceptance, and market share” as intangibles (all of which could not be transferred independent of the business) and pointed to other statutory changes and another court decision as narrowing the definition beyond what Treasury initially intended.

Government counsel also had to explain why, if Treasury had in fact expanded the definition of “intangibles” to include residual business assets, it did so by amending the definition of “other similar items” rather than just adding residual business assets to the list. She argued that Treasury opted for the latter because merely listing residual business assets like “goodwill” would just precipitate fights about whether intangibles (like the so-called “growth options” that the government says Amazon US contributed to its cost-sharing agreement) fell within the scope of the listed residual business assets. Judge Callahan acknowledged that potential issue but replied that if Treasury had expressly included “goodwill” or “going concern” the taxpayers “wouldn’t have had as good of an argument” that the disputed residual business assets here are excluded, and government counsel conceded that it was less likely that the taxpayer would have won below in that circumstance.

Subsequent Statutory Changes

In the tax reform legislation enacted in 2017 (the TCJA), Congress took steps to address the concern that government counsel raised at oral argument—the transfer of residual business assets without compensation. Congress amended section 936(h) (which is the operative definition of “intangible” for purposes of section 482 by cross-reference) to expressly include goodwill and going concern. Government counsel acknowledged that with the TCJA, “Congress has codified our interpretation of” the “other similar items” provision.

Judge Callahan observed that Congress did not say that they were clarifying what has always been true, and government counsel agreed. And Judge Callahan rehearsed Amazon’s argument that if Congress needed to amend that definition, then it’s reasonable to infer that—contrary to the government’s interpretation—the definition did not always include those residual business assets. She then gave Amazon’s counsel the opportunity to identify what he thought was the best indication in the legislative history that the statutory addition of goodwill and going concern value is a revision and not a clarification of the definition of “intangible.” He answered that the best indicator is the conference report’s description of the change as a “revision” of the definition. He then went on to argue that given the statutory language, no one could “realistically think that isn’t a vast shift” in the definition’s scope. And he added that because the TCJA effected an enormous rewrite to the Code, it is only reasonable to think that the change to add goodwill and going concern was a substantial revision.

But the legislative change did not categorically favor Amazon’s case. Although Judge Christen remarked that the legislative history for the TCJA change is “compelling,” she pressed Amazon’s counsel on the tension between, on the one hand, the new statutory requirement to include the value of goodwill and going concern as pre-existing intangibles and, on the other hand, Amazon’s argument that Treasury opted to exclude those assets from the definition of “intangibles” because they are “impossible” to value independent of the entire business. And government counsel tried to capitalize on this tension in her rebuttal, arguing that although it is difficult to value residual business assets, the DCF—which values all intangibles together—is the panacea to this problem and that is why the government seeks the Ninth Circuit’s endorsement of that method.

Cost Sharing and the Arm’s-Length Standard

One cornerstone of government counsel’s argument was that the government’s interpretation of the definition of intangible must be correct because “nothing of value can be transferred for free.” And the government—both on brief and in oral argument—made much of the taxpayer’s expert’s admission on cross-examination that parties at arm’s length would have paid for all the value associated with residual business assets because “‘no company is going to give away something of value without compensation.’” The government tried to tie this admission in with the arm’s length principle that is the lodestar of section 482. The government argued on brief that the Tax Court was “not free to disregard” the arm’s-length principle, which meant, according to the government, that the Tax Court was required to adopt a valuation that included residual business assets.

Amazon observed in its brief, however, that the arm’s-length principle also arguably supports its position. The Commissioner conceded that residual business assets “generally cannot be transferred independently from the business enterprise” and thus are not independently transferred in an arm’s-length transaction (absent the extraordinary alternative of selling the entire business), thus making it all the more plausible to think that Treasury did not contemplate taxpayers valuing them and paying a buy-in for those residual business assets in a cost-sharing agreement.

At oral argument, taxpayer’s counsel observed that the government’s argument is hard to reconcile with the very existence of the safe harbor created by the cost-sharing regulations. He argued that those regulations contemplated precisely what happened here—AEHT paid a buy-in for static intangibles, the parties shared R&D and other costs for developing new and better intangibles going forward “in a way that’s formulaic,” and then the parties benefitted from those co-developed intangibles according to that formula. Government counsel flatly disputed the notion that the 1986 and 1994 changes created a safe-harbor for cost-sharing arrangements. Although it didn’t receive significant attention at oral argument, whether the Ninth Circuit agrees with the taxpayer or the government on this point might be pivotal in the outcome.

The Nature and Life of the Residual Business Assets

One interesting feature of the government’s argument—both on brief and at oral argument—was its attempt to articulate the precise nature of the residual business assets that Amazon US transferred to its cost-sharing agreement “for free.” Counsel closely hewed to the brief’s description of those assets in oral argument, saying that the “other similar items” category was broad enough to include residual business assets like “growth options” and “corporate culture” (although the latter of these raises the obvious question of whether that culture can be independent of the services of any individual).

Amazon raised other problems with these purported assets in its brief, including the observation that the residual business assets (at least as the government conceives them) have apparently perpetual useful lives. If the government were to conceive of the assets as having unlimited useful lives, then its theory runs headlong into caselaw and the common-sense notion that no asset, however valuable, lasts forever. The government nevertheless bit the bullet on this issue, arguing in its brief that “[q]uite simply, existing technology begets new technology.” Judge Christen asked government counsel to answer for this position, and government counsel conceded that the government’s argument assumes perpetual lives for “certain assets in the bundle,” stating that under the government’s theory, “the corporate culture will last as long as the corporation is there.” But government counsel tried to downplay this concession, arguing that the terminal value of the perpetual assets was very small and that the Tax Court could have done with those residual assets what it had done with some marketing intangibles in the case—limit their useful lives to something like 20 years.

Taxpayer’s counsel reminded the panel of this useful-life problem in the context of responding to the government allegations that taxpayer transferred assets to the cost-sharing agreement for free. He argued that the Tax Court assigned substantial value to the intangibles that Amazon US contributed to the cost-sharing agreement, and in so doing, characterized those assets “static intangibles” with values that will ultimately dissipate.

Other Issues

A couple of other items from oral argument are worth noting. First, the government had argued on brief that the IRS’s interpretation of the regulation was owed deference. Perhaps wary that this deference principle may disappear in a few months when the Supreme Court decides the Kisor case (see our reports here), government counsel was quick to downplay that argument when Judge Callahan probed the topic: “That is a back-up argument; I don’t think the court needs to get there.” And the panel took issue with the fact that the government had no argument for the reasonableness of the IRS’s interpretation other than pointing to Congress’s 2017 change to the pertinent law as after-the-fact evidence. It was clear that deference argument did not sit well with Judge Callahan or Judge Christen, both of whom questioned how taxpayers were conceivably on notice of the interpretation of “other similar items” that the government was advocating in this case.

Second, Judge Callahan expressed a keen interest in how the court’s decision would affect other taxpayers, including those without Amazon’s “firepower.” Government counsel conceded that if the government were to prevail, the IRS could pursue other taxpayers using the Ninth Circuit’s interpretation of the 1994 regulations. Amazon’s counsel argued that the “entire business community” relied on the understanding that residual business assets were not compensable and structured their cost-sharing arrangements accordingly. But when the panel asked whether a reversal would affect taxpayers in all years before the TCJA, he acknowledged that the 2009 changes to the cost-sharing regulations that require a buy-in for “platform contributions,” which arguably already include some residual business assets.

Finally, at oral argument, government counsel repeatedly raised the “realistic alternatives” principle (which is now part of section 482 and was in the 482 regulations already), arguing that principle is “central to the arm’s-length standard” because no entity is going to accept a price that is less than one of its realistic alternatives and that the Tax Court’s opinion amounted to a “rewriting” of that principle. But on brief, the government posed no alternative transaction that achieved the ends of the cost-sharing agreement. Instead, it argued that the “realistic alternative” to the cost-sharing arrangement was “not entering into the cost-sharing arrangement and continuing to operate the European Business as it had before.” The taxpayer’s brief took this point head on, arguing that the regulations implementing the realistic-alternatives principle “did not allow the Commissioner to consider alternatives to cost-sharing itself.” The Tax Court had rejected the Commissioner’s argument at trial, finding that empowering the Commissioner to use the realistic-alternatives principle to price the transaction as if it never happened at all would “make the cost sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless.”

On balance, the panel’s questions and remarks appear to favor affirmance of the Tax Court. But both parties faced hard questions at oral argument. There is no deadline for the court’s ruling, and it will likely be several months before a decision is issued.

Amazon.com Tax Court Opinion

Ninth Circuit to Hear Oral Argument in Amazon Transfer-Pricing Dispute Friday

We wanted to alert our readers that oral argument in the Ninth Circuit in Amazon.com Inc. v. Commissioner will be held this Friday. Similar to Veritas Software Corp. v. Commissioner, this transfer-pricing dispute is about the value of intangibles that the U.S. parent contributed to a cost-sharing arrangement with a foreign subsidiary. In particular, the parties dispute whether particular intangibles, like goodwill and going concern values, are compensable and thus require a buy-in payment upon their contribution to a cost-sharing arrangement. The government lost in the Tax Court.

The briefs are below. The Ninth Circuit will stream the oral arguments (held in Seattle) live on its website here; Amazon is the last of five oral arguments to be heard beginning at 9:00 a.m. Pacific/12:00 p.m. Eastern Friday. There are 90 minutes of oral argument scheduled before Amazon (see the schedule here). You can also watch or listen to oral arguments after the fact in the Ninth Circuit’s archive here.

Amazon.com Government Opening Brief

Amazon.com Taxpayer Response Brief

Amazon.com Government Reply Brief

Divided Tax Court Decides E&P Computation Issue in Eaton

In Eaton Corp. v. Commissioner, 152 T.C. No. 2 (2019), a divided Tax Court decided (by a 10-2 margin) that the CFC partners in a U.S. partnership must increase earnings and profits (E&P) for the partnership’s subpart F inclusions. Members in the taxpayer’s group owned several CFCs (the “CFC partners”) that were partners in a U.S. partnership. That partnership in turn owned several lower-tier CFCs (the “lower-tier CFCs”) that generated subpart F income. There was no dispute that the U.S. partnership had to include the subpart F income of the lower-tier CFCs. The question before the Tax Court on motions for summary judgment was whether the CFC partners were required to increase their E&P in the amount of the U.S. partnership’s income inclusions (which ultimately determined whether the U.S. parent must include income from a section 956 investment in U.S. property by the CFC partners).

In an opinion by Judge Kerrigan, the majority held that the law required the CFC partners to increase E&P for the U.S. partnership’s income inclusions. Although the opinion does not expressly state so, it appears to adopt the IRS’s arguments for increasing the CFC partners’ E&P.

The court began with the language of section 964(a), which provides that “[e]xcept as provided in section 312(k)(4), for purposes of this subpart the earnings and profits of any foreign corporation…for any taxable year shall be determined according to rules substantially similar to those applicable to domestic corporations, under regulations prescribed by the Secretary….” (emphasis added). The court then held that because the rules “applicable to domestic corporations” are those in section 312 and its accompanying regulations, the computation of foreign corporation E&P under 964(a) should be made under the “elaborate, technical rules” of section 312 and its regulations.

The court observed that under Treas. Reg. § 1.312-6(b), the computation of E&P includes “all items includible in gross income under section 61….” Although there “is no explicit rule in section 312, section 964, or their accompanying regulations specifying how a CFC’s distributive share of partnership income…should be treated for purposes of computing its E&P,” the court looked to “the general rules set forth in subpart F and section 312.” Under those general rules, the court reasoned that the CFC partners should compute gross income “as if they were domestic corporations,” which meant including their distributive share of partnership income under section 702. And since the U.S. partnership’s gross income “includes subpart F income and section 956(a) inclusions from the lower-tier CFCs,” the court concluded that the CFC partners must increase their E&P by the subpart F amounts that are included in their gross income.

According to the court, the taxpayer’s “primary argument” was that “the section 964 regulations supply a freestanding, self-contained, and comprehensive system for determining the E&P of a foreign corporation” without need for recourse to section 312 or its regulations. Specifically, the taxpayer relied on Treas. Reg. § 1.964-1(a)(1), which provides that the E&P of a foreign corporation is computed “as if such corporation were a domestic corporation by” following three enumerated steps. The court portrayed the taxpayer’s argument as interpreting “the preposition ‘by’ in an extremely narrow sense, to mean ‘by doing these three things and nothing else.’”

The court rejected that reading of Treas. Reg. § 1.964-1(a)(1) on the grounds that the three enumerated steps in that regulation are insufficient for computing E&P. To compute E&P at all, it is necessary to know how corporate transactions and events—like property distributions, stock distributions, redemptions, discharge of indebtedness income, and depreciation—affect E&P. And since the regulations under section 964 address none of these transactions or events, the court held that they cannot alone determine foreign corporation E&P. Rather, recourse to section 312 and its regulations is necessary. The court also observed that the section 964 regulations specifically provide that the depreciation rules in section 312(k) do not apply in computing foreign corporation E&P. And the court inferred that this meant that section 312 and its regulations must apply in computing foreign corporation E&P, otherwise there would be no need to explicitly bar the application of the section 312(k) depreciation rules.

Presumably because it dismissed the taxpayer’s primary argument, the court took the opportunity to explain what the three steps enumerated in Treas. Reg. § 1.964-1(a)(1) are meant to do if they are not—as the taxpayer’s argument maintained—the sole mechanism for computing foreign corporation E&P. The court referred to paragraph (ii) of that regulation, which provides that foreign corporation E&P requires conforming the foreign corporation’s P&L statement to U.S. GAAP. The court concluded that the three steps under Treas. Reg. § 1.964-1(a)(1) “specify a preliminary process by which a foreign corporation’s P&L statement is conformed to, or made to resemble, that of a domestic corporation by making a series of tax accounting adjustments.”

The court also addressed the taxpayer’s other argument that the CFC partners’ subpart F inclusions “do not increase the dividend[-]paying capacity of the upper[-]tier CFC partners.” The court observed that “[t]here are many instances in which E&P are increased when amounts are included in income but no cash is received,” citing original issue discount and income accrual as examples.

Most of the rest of the Tax Court joined Judge Kerrigan’s opinion, with Judge Pugh abstaining and Judge Morrison writing a brief concurrence (in which he clarifies his opinion that it is the language in Treas. Reg. § 1.964-1(a)(1)—and not, as the majority stated, the language in section 964(a)—that imports section 312 and its regulations into the computation of foreign corporation E&P). Judge Foley, however, wrote a dissent in which Judge Gustafson joined.

The brunt of that dissent is that if Treasury wanted to import the section 312 regulations into the computation of foreign corporation E&P under section 964, then it should have done so expressly. After criticizing the majority’s inference about the 312(k) depreciation rules excluded under section 964(a), the dissent offers support for the taxpayer’s primary argument that the regulations under 964 are the exhaustive source of instruction on computing foreign corporation E&P. The dissent observes that there were previously five steps under Treas. Reg. § 1.964-1(a)(1) and that the calculation of E&P “was complete upon the conversion to U.S. dollars.” Moreover, the dissent argues that Treasury could have expressly incorporated the rules under section 312 but did not do so. (The majority held that the language under 964(a) instructing that foreign corporation E&P is computed “under regulations prescribed by the Secretary” could be “reasonably read to include regulations promulgated under section 312,” even if those regulations predate section 964(a). The dissent disagreed, asserting that the majority’s analysis “sets bad precedent and is a rickety analytical construct.”)

Given that it involves a purely legal issue and a divided Tax Court, the case seems destined for appeal, so stay tuned for further updates.

Eaton Tax Court Opinion

Tax Court Overrules Its BMC Software Decision in Analog Devices

In its recent reviewed decision in Analog Devices, the Tax Court revisited and overruled its decision in BMC Software. We previously covered the BMC Software decision and the Fifth Circuit’s reversal of the Tax Court here. Analog Devices involves facts nearly identical to those in BMC Software: The taxpayer claimed a one-time dividends received deduction under section 965 for its 2005 tax year. Pursuant to a 2009 closing agreement with respect to some section 482 adjustments, the taxpayer elected to establish accounts receivable via a closing agreement under Rev. Proc. 99-32 in order to repatriate amounts included in U.S. income for the 2005 tax year (among others). And just as it did in BMC Software, the IRS determined that the retroactive creation of those accounts receivable for 2005 constituted related party indebtedness under section 965(b)(3) for the 2005 tax year, thus reducing the taxpayer’s dividends received deduction for 2005.

Analog Devices is appealable to the First Circuit, and therefore the Fifth Circuit’s decision in BMC Software is not binding precedent under the Golsen rule. Nevertheless, the Tax Court’s decision begins with an explanation of why the court was willing to reconsider its prior decision in BMC Software. Acknowledging the importance of stare decisis, the Tax Court stated that it was “not capriciously disregarding” its prior analysis and held that the principles that it articulated in BMC Software are “not entrenched precedent.” The Tax Court also observed that while its BMC Software decision implicates contract rights (specifically, closing agreements under Rev. Proc. 99-32), it was “unlikely” that the IRS would have relied on BMC Software in structuring later closing agreements.

The Tax Court then proceeded to follow the Fifth Circuit on both issues presented in the case. One issue was whether, as a statutory matter, section 965 required the parties to treat the accounts receivable as related party indebtedness. Following the Fifth Circuit, the Tax Court held that there was no such statutory requirement because section 965(b)(3) looks only to indebtedness “as of the close of the taxable year for which the [section 965] election . . . is in effect.” Because the taxpayer’s closing agreement did not create the accounts receivable until 2009—long after the testing period for the taxpayer’s 2005 year—the Tax Court held that the accounts receivable did not constitute related party indebtedness under section 965.

The other issue was whether the parties had agreed to treat the accounts receivable as related party indebtedness under the closing agreement. In what the Tax Court termed an “introductory phrase,” the closing agreement provided that the accounts receivable were established “for all Federal income tax purposes.” The Commissioner argued that with this language, the parties had agreed to treat the accounts receivable as related party indebtedness for purposes of section 965. But looking to the facts and circumstances of the closing agreement, the Tax Court concluded that the taxpayer made no such agreement. The Tax Court cited law for the principle that each closing agreement is limited to the “matters specifically agreed upon and mentioned in the closing agreement” as well as some self-limiting language in the agreement itself. Since there is no specific mention of section 965 in the agreement, the Tax Court held that to treat the accounts receivable as related party indebtedness would be to ignore the intent of the parties.

But the introductory phrase in the closing agreement in BMC Software—which had the phrase “for Federal income tax purposes”— was different from that in Analog Devices—“for all Federal income tax purposes.” Four judges on the Tax Court concluded that this difference was material and dissented. The dissent invoked interpretive canons for giving effect to the word “all” and addressed the equities of the situation, stating that even if the parties did not bargain over the wording of the introductory phrase, the “wording was not foisted on an unrepresented or unsuspecting taxpayer, or rendered in fine print, or hidden in a footnote, or even inserted in the midst of other terms of the agreement.” Several judges joined in a concurring opinion stating that the dissent “points to a distinction without a difference” and observing that the phrase “for Federal income tax purposes” means the same thing as the phrase “for all Federal income tax purposes.”

If the government appeals Analog Devices (which it may well do given the dissent), we will cover that appeal.

Analog Devices Tax Court Opinion

Federal Circuit Decides Interest-Netting Dispute in Wells Fargo Case

On Wednesday, the Federal Circuit issued its decision in the Wells Fargo interest netting case, affirming in part the trial court’s decision in favor of the taxpayer but also reversing in part. We previously covered the trial court decision and the oral argument here. As our prior coverage explained, the case presented three different fact patterns (termed “situations” in the decision) in which the taxpayer’s entitlement to interest netting hinged on the extent to which corporate mergers resulted in distinct corporations becoming the “same taxpayer” under the relevant Code section governing interest netting (§ 6621(d)). And as the questioning at oral argument had indicated, the Federal Circuit’s decision did not categorically adopt either party’s position, finding for the taxpayer in one situation and for the government in another.

The Federal Circuit did not have to address all three situations because in one of them—Situation Two—the government conceded that the taxpayer was entitled to interest netting. In Situation Two, the corporation that made the overpayment had the same Taxpayer Identification Number (TIN) as the corporation that had the later underpayment, even though the corporation had been through several intervening mergers between the time of the overpayment and the underpayment.

The government effectively had to make this concession—that interest netting is available when the underpaying corporation and overpaying corporation have the same TIN—in order to be consistent with its argument regarding Situation Three. In Situation Three, the corporation that had an overpayment (CoreStates) later merged into First Union, and after the merger the resulting First Union entity (which kept First Union’s TIN) had an underpayment. Relying on the decision in Magma Power (see our prior coverage of Magma Power here), the government argued that the taxpayer was not entitled to interest netting because CoreStates had a different TIN when it made its overpayment than First Union had at the time of the underpayment.

As the Federal Circuit observed, however, the only difference between Situation Two and Situation Three was “the choice of who is the named surviving corporation.” The choice of the name (and TIN) of the surviving corporation in a merger is hardly the sort of thing that ought to determine whether a taxpayer is entitled to interest netting. As the Federal Circuit astutely observed, every merger results in the surviving corporation becoming “automatically liable for the underpayments and entitled to the overpayments of its predecessors,” regardless of which TIN the surviving corporation adopts. Hewing to Congress’s intent for the statute to serve a remedial purpose, the Federal Circuit concluded that the CoreStates-First Union merger made the surviving corporation the “same taxpayer” as either of the pre-merger entities under section 6621(d).

With respect to Situation One, however, the Federal Circuit drew a limit on how broadly it was willing to interpret the “same taxpayer” requirement. In Situation One, the 2001 merger of Old Wachovia and First Union came after both Old Wachovia’s overpayment (1993) and First Union’s underpayment (1999). The Federal Circuit agreed with the government that under the decision in Energy East, the “same taxpayer” requirement is applied by asking whether “the entity that made the underpayment at the time of the underpayment is the ‘same taxpayer’ as the entity who made the overpayment at the time of the overpayment.” And since the merger postdated both the underpayment and the overpayment in Situation One, the Federal Circuit denied the taxpayer’s netting claim.

But is the Energy East test correct that entitlement to netting should be measured at the time of the underpayment or overpayment? One might reasonably argue that in applying the “same taxpayer” requirement, it makes more sense to look the period of overlap. Consider Situation One: After the 2001 merger, the surviving corporation would have been entitled to Old Wachovia’s overpayment and liable for First Union’s underpayment. And since the period of overlap extended beyond the September 2001 merger into later periods, there was good reason to conclude that the surviving corporation was entitled to interest netting from the date of the merger until the overlap periods ended. While the taxpayer did not pursue such a partial resolution on appeal, perhaps a future case will present that issue for decision.

Wells Fargo Federal Circuit Opinion

 

Fifth Circuit Reverses Tax Court in BMC Software

The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”

The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.

BMC Software Fifth Circuit Opinion

Taxpayer’s Reply Brief Filed in BMC Software

The taxpayer filed its reply brief in the BMC Software case last week. As in its opening brief, BMC cites Fifth Circuit precedent for the tax law definition of “indebtedness” as an “existing unconditional and legally enforceable obligation to pay.” BMC argues that it is undisputed that the accounts receivable created under Rev. Proc. 99-32 do not meet that definition—they neither existed nor were legally enforceable during the testing period for related-party indebtedness under section 965. (BMC observes that instead of disputing this point, the Commissioner tried to distinguish that case law, much of which comes from the debt-equity context. And BMC points out that the Commissioner’s argument implies different definitions of “indebtedness” may apply depending on the posture of the case.) In our first post on this case, we speculated that the outcome in this case may depend on whether the Tax Court took the legal fictions in Rev. Proc. 99-32 too far. That issue lurks beneath this definitional dispute: That the accounts receivable are deemed to have arisen during the testing period does not settle whether those accounts were “indebtedness” during the testing period.

BMC then turns to the closing agreement, which makes no mention of section 965 or the term “indebtedness.” BMC therefore relies on the legal principle that closing agreements must be construed to bind the parties “only to the matters expressly agreed upon.” BMC also addresses the Commissioner’s other arguments based on the closing agreement.

Finally, BMC makes a strong policy argument against the result in the Tax Court. BMC observes that the Commissioner concedes that the clear purpose of the related-party-indebtedness rule in section 965 is that it is meant to ensure “that a dividend funded by a U.S. shareholder, directly or indirectly, and that does not create a net repatriation of funds, is ineligible for the benefits” of section 965. Of course, no taxpayer could fund a dividend by way of deemed accounts receivable created after the dividend was paid. Therefore, BMC concludes, the case does not implicate the underlying purpose of the related-party-indebtedness rule under section 965.

We will provide updates once oral arguments are scheduled.

BMC Software – Taxpayer’s reply brief

Commissioner’s Brief filed in BMC Software

The Commissioner filed his brief in the BMC Software case last week. The brief hews closely to the Tax Court’s decision below. The brief primarily relies on the parties’ closing agreement and trumpets the finality of that agreement.

The Commissioner argues that BMC’s problem is of BMC’s own making—BMC chose to avail itself of the relief available under Rev. Proc. 99-32 and signed a closing agreement under which the accounts receivable were deemed established during the relevant testing period for the related-party indebtedness rule under section 965. And as if to suggest that BMC deserves the reduction in its section 965 deduction, the Commissioner repeatedly asserts that the underlying adjustments that precipitated BMC’s use of Rev. Proc. 99-32 resulted from BMC’s “aggressive” transfer-pricing strategies.

The Commissioner briefly addresses BMC’s primary argument on appeal, which is that the relevant definition of “indebtedness” for purposes of section 965 is the definition established in case law and not—as the Tax Court had found below—the Black’s Law definition. The Commissioner’s brief argues that most of the cases on which BMC relies for a definition of “debt” are inapplicable because they arise in the context of debt-equity disputes or other settlements where the Commissioner was challenging the taxpayer’s characterization of an amount as debt. According to the Commissioner’s brief, those cases address whether the underlying substance of an instrument or payment was truly debt but that “[f]actual inquiries to ascertain whether, and when, debt was created by the parties’ dealings are irrelevant here.”

The brief also addresses BMC’s arguments that the Tax Court misinterpreted the closing agreement. The Commissioner argues that parol evidence is irrelevant because the agreement is unambiguous and that in any event, the extrinsic evidence does not support BMC’s position.

BMC’s reply brief is due April 28.

BMC Software – Commissioner’s brief

Taxpayer’s Opening Brief Filed in BMC Software

The taxpayer filed its opening brief in the Fifth Circuit appeal of BMC Software v. Commissioner.  As we described in our earlier coverage, the Tax Court relied on the legal fiction that accounts receivable created pursuant to Rev. Proc. 99-32 in a 2007 closing agreement were indebtedness for earlier years (2004-06) in order to deny some of the taxpayer’s section 965 deductions.  There are three main avenues of attack in the taxpayer’s brief.

First, the taxpayer argues that the Tax Court incorrectly treated those accounts receivable as “indebtedness” as that term is used in the exception to section 965 for related-party indebtedness created during the testing period.  The taxpayer contends that the Tax Court looked to the Black’s Law definition of “indebtedness” when it should have looked to the tax law definition.  And the taxpayer argues that the tax law definition—that “indebtedness” requires “an existing unconditional and legally enforceable obligation to pay”—does not include the fictional accounts receivable created under Rev. Proc. 99-32.  The taxpayer argues that those accounts did not exist and were not legally enforceable until 2007 (after the section 965 testing period) and therefore did not constitute related-party indebtedness during the testing period for purposes of section 965.

Second, the taxpayer argues that the Tax Court was wrong to interpret the 2007 closing agreement to constitute an implicit agreement that the accounts receivable were retroactive debt for purposes of section 965.  The taxpayer observes that closing agreements are strictly construed to bind the parties to only the expressly agreed terms.  And the taxpayer argues that the parties did not expressly agree to treat the accounts receivable as retroactive debt for section 965 purposes.  Moreover, the taxpayer argues that the Tax Court misinterpreted the express language in the agreement providing that the taxpayer’s payment of the accounts receivable “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustments.”  The taxpayer then makes several other arguments based on the closing agreement.

Finally, the taxpayer makes some policy-based arguments.  In one of these arguments, the taxpayer contends that the Tax Court’s decision is contrary to the purpose of section 965 and the related-party-indebtedness exception because the closing agreement postdated the testing period and therefore cannot be the sort of abuse that the related-party-indebtedness exception was meant to address.

BMC Software – Taxpayer’s Opening Brief

Fifth Circuit to Address Section 965 Deduction in BMC Software Appeal

In BMC Software v. Commissioner, 141 T.C. No. 5, the Tax Court was faced with considering the effect that some legal fictions (created under a Revenue Procedure regarding transfer pricing adjustments) have on the temporary dividends-received deduction under section 965.  And while both the section 965 deduction and the legal fictions under the Revenue Procedure appear to have been designed to benefit taxpayers by facilitating tax-efficient repatriations, the Tax Court eliminated that benefit for some repatriated amounts.  The taxpayer has already appealed the decision (filed on September 18) to the Fifth Circuit (Case No. 13-60684), and success of that appeal may hinge in part on whether the Tax Court took the legal fictions in the Revenue Procedure too far.

First, some background on the section 965 deduction:  In 2004, Congress enacted the one-time deduction to encourage the repatriation of cash from controlled foreign corporations on the belief that the repatriation would benefit of the U.S. economy.  To ensure that taxpayers could not fund the repatriations from the United States (by lending funds from the U.S. to the CFC, immediately repatriating the funds as dividends, and then later treating would-be dividends as repayments of principal), Congress provided that the amount of the section 965 deduction would be reduced by any increase in related-party indebtedness during the “testing period.”  The testing period begins on the earliest date a taxpayer might have been aware of the availability of the one-time deduction—October 3, 2004—and ends at the close of the tax year for which the taxpayer elects to take the section 965 deduction.  Congress thus established a bright-line test that treated all increases in related-party debt during the testing period as presumptively abusive, regardless of whether the taxpayer had any intent to fund the repatriation from the United States.

BMC repatriated $721 million from a controlled foreign corporation (BSEH) and claimed the section 965 deduction for $709 million of that amount on its 2006 return.  On that return, BMC claimed that there was no increase in BSEH’s related party indebtedness between October 2004 and the close of BMC’s 2006 tax year in March 2006.  In the government’s view, however, this claim became untrue after the IRS reached a closing agreement with the IRS in 2007 with respect to BMC’s 2003-06 tax years.

That agreement made transfer pricing adjustments that increased BMC’s taxable income for the 2003-06 tax years.  The primary adjustments were premised on the IRS’s theory that the royalties BMC paid to its CFC were too high.  By making those primary adjustments and including additional amounts in income, BMC was deemed to have paid less to its CFC for tax purposes than it had actually paid.

The typical way of conforming BMC’s accounts in this circumstance is to treat the putative royalty payments (to the extent they exceeded the royalty agreed in the closing agreement) as deemed capital contributions to BSEH.  If BMC were to repatriate those amounts in future, they would be treated as taxable distributions (to the extent of earnings and profits).  But Rev. Proc. 99-32 permits taxpayers in this circumstance to elect to repatriate the funds tax-free by establishing accounts receivable and making intercompany payments to satisfy those accounts.  The accounts receivable created under Rev. Proc. 99-32 are, of course, legal fictions—the taxpayer did not actually loan the funds to its CFC.  BMC elected to use Rev. Proc. 99-32 and BSEH made the associated payments.

To give full effect to the legal fiction, Rev. Proc. 99-32 provides that each account receivable is “deemed to have been created as of the last day of the taxpayer’s taxable year for which the primary adjustment is made.”  So although BMC’s accounts receivable from BSEH were not actually established until the 2007 closing agreement, those accounts receivable were deemed to have been established at the close of each of the 2003-06 tax years.  Two of those years (those ending March 2005 and March 2006) fell into the testing period for BMC’s section 965 deduction.  The IRS treated the accounts receivable as related-party debt and reduced BMC’s section 965 deduction by the amounts of the accounts receivable for those two years, which was about $43 million.

BMC filed a petition in Tax Court, arguing (among other things) that the statutory rules apply only to abusive arrangements and that the accounts receivable were not related-party debt under section 965(b)(3).  The government conceded that BMC did not establish the accounts receivable to exploit the section 965 deduction, but argued that there is no carve-out for non-abusive transactions and the accounts receivable were indebtedness under the statute.

The court held that the statutory exclusion of related-party indebtedness from the section 965 deduction is a straightforward arithmetic formula devoid of any intent requirement or express reference to abusive transactions.  The court also held that the accounts receivable fall under the plain meaning of the term “indebtedness” and therefore reduce BMC’s section 965 deduction under section 965(b)(3).  So even though both the section 965 deduction and Rev. Proc. 99-32 were meant to permit taxpayers to repatriate funds with little or no U.S. tax impact, the mechanical application of section 965(b)(3) and Rev. Proc. 99-32 eliminated that benefit for $43 million that BMC repatriated as a dividend.

This does not seem like the right result.  And here it seems the culprit may be the legal fiction that the accounts receivable were established during the testing period.  The statute may not expressly address abusive intent, but that is because Congress chose to use the testing period in the related-party-debt rule as a blunt instrument to stamp out all potential abuses of the section 965 deduction.  This anti-abuse intent is baked into the formula for determining excluded related-party debt because the opening date of the testing period coincides with the earliest that a taxpayer might have tried to create an intercompany debt to exploit the section 965 deduction.  BMC did not create an intercompany debt during the testing period; the accounts receivable were not actually established until after the close of the testing period.  Perhaps the court took the legal fiction that the accounts receivable were established in 2005 and 2006 one step too far.  And perhaps the Fifth Circuit will address this legal fiction on appeal.

BMC Software – Tax Court Opinion

Eleventh Circuit Affirms Tax Court in Peco Foods

In an unpublished opinion, the Eleventh Circuit affirmed the Tax Court’s decision in Peco Foods.  As we described in our earlier coverage here, the Tax Court held that the taxpayer could not subdivide broader classes of assets acquired in two transactions into discernible subcomponents for depreciation purposes because the taxpayer had agreed to an express allocation (in both agreements at issue) to the broader classes “for all purposes (including financial accounting and tax purposes).”  The Tax Court decided that because of that express allocation, the Danielson rule and language in section 1060 prevented the taxpayer from subdividing the asset classes (and thereby getting accelerated depreciation for some of those subclasses).

The taxpayer challenged the Tax Court’s application of the Danielson rule on appeal (among other things).  The taxpayer argued that under the Eleventh Circuit’s decision in Fort, the Danielson rule applies only where a taxpayer challenges the form of a transaction.  And since the subdivision of assets for depreciation purposes is not a challenge to form, the taxpayer argued that the Danielson rule did not apply.

The Eleventh Circuit made no mention of its decision in Fort, nor did it explain whether Peco’s attempt to subdivide the acquired asset classes for depreciation purposes was a challenge to the form of the transactions.  Instead, the Eleventh Circuit summarily affirmed the Tax Court’s holding that the express allocation in the agreements was unambiguous and binding under section 1060 and the Danielson rule.  So unfortunately for taxpayers—for whom the Danielson rule is a one-way street in the IRS’s favor—the Eleventh Circuit did nothing to explain how its decision in Fort limits the breadth of the Danielson rule.

Peco Foods – Eleventh Circuit Unpublished Opinion

When Characterizing Golfer’s Endorsement Income, Image Matters

As a follow-up to our posts on the Goosen case regarding sourcing of a golfer’s income from sponsors (see here), we provide this update on the case involving golfer Sergio Garcia.  While they were not technically related cases, the significant overlap in issues and facts—not to mention witness testimony—meant that the outcome in Goosen partially determined the outcome in Garcia.

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

Eleventh Circuit to Address Scope of Danielson Rule

With oral argument scheduled for April 18 in Peco Foods v. Commissioner, No. 12-12169, the Eleventh Circuit will soon decide a case that involves the scope of the Danielson rule.  That rule, established in Danielson v. Commissioner, 378 F.2d 771, 775 (3d Cir. 1967), provides that “a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”  The Eleventh Circuit has expressly adopted the Danielson rule.

In Peco Foods, the Commissioner used that rule (along with the allocation rules under section 1060) to prevent the taxpayer from subdividing broader classes of purchased assets (to which the purchase agreement had expressly allocated a portion of the purchase price) into discernible subcomponents for depreciation purposes.  The taxpayer is a poultry processor that purchased the assets at two poultry processing plants in the mid- to late-1990s.  In each of the purchase transactions, Peco and the seller agreed to allocate the purchase price among listed assets “for all purposes (including financial accounting and tax purposes).”  The first agreement allocated purchase price among 26 listed assets; the second allocated purchase price among three broad classes of assets.

Prompted by the Tax Court’s decision in Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), Peco commissioned a cost segregation study that subdivided the listed assets into subcomponents.  Some of these subcomponents fell into asset classes that are subject to accelerated depreciation methods.  For instance, Peco subdivided the class of assets listed as “Real Property: Improvements” on the original allocation schedule into subcomponents that were tangible personal property subject to a 7- or 15-year depreciation period under section 1245.  If they were classified as structural components of nonresidential real property, the assets would have been subject to a 39-year depreciation period under section 1250.

With the segregation study in hand, Peco applied to change its accounting method for those subcomponents with its 1998 return and claimed higher depreciation deductions on subsequent returns.  The IRS disallowed these deductions and issued a notice of deficiency; the taxpayer filed a petition in Tax Court.

In a Tax Court Memorandum opinion by Judge Laro, T.C. Memo 2012-18, the Tax Court upheld the Commissioner’s deficiencies.  The Tax Court’s decision was based on both the Danielson rule and section 1060(a), the latter of which provides that if the parties in an applicable asset acquisition “agree in writing as to the allocation of any consideration,” the agreement “shall be binding on both the transferee and transferor unless the Secretary determines that such allocation . . . is not appropriate.”  The taxpayer argued that section 1060 serves only to allocate purchase price among assets under the residual method of section 338(b)(5) and that section 1060 does not bar further subdivision of the allocation for purposes of determining useful lives for depreciation.  The Tax Court held that the directive in section 1060 that an allocation by the parties “shall be binding” trumps the application of the residual method of section 338(b)(5).

The Tax Court also rejected the taxpayer’s argument that Danielson was inapposite.  The taxpayer had relied on United States v. Fort, 638 F.3d 1334 (11th Cir. 2011), in which the Eleventh Circuit held that “the Danielson rule applies if a taxpayer ‘challenge[s] the form of a transaction.’”  (citation omitted)  Since the taxpayer in Fort had challenged the specific tax consequences of the form of the transaction but not the form itself, the Eleventh Circuit found that Fort fell outside the scope of the Danielson rule.  The Tax Court held that while the taxpayer in Fort had not challenged the form of the transaction, the taxpayer in Peco—by “seeking to reallocate the purchase price among assets not listed in the original allocation schedules”—sought to challenge the form of the transaction.  Therefore, reasoned the Tax Court, because there was no ambiguity to the allocations in the purchase agreements under the applicable contract laws of the states in which the agreements were entered, Danielson applies to prevent the taxpayer from subdividing the listed into distinct components for depreciation purposes.

On appeal, the taxpayer contests the Tax Court’s holdings with respect to both section 1060 and Danielson.  In its brief, the taxpayer argues that whether an asset is tangible personal property or a structural component of a building is a matter of facts and circumstances and that the words used to describe the asset “are of no utility in connection with its categorization as a structural component.”  The taxpayer also argues that classifying assets for depreciation purposes is not a challenge to the form of the transaction (unlike, for example, treating the transaction as a merger or lease rather than an asset acquisition, which would have been a challenge to form) and therefore, under the holding in Fort, the Danielson rule does not apply.

In his opposition brief, the Commissioner echoes the Tax Court’s holding that the taxpayer’s subdivision of listed assets for depreciation purposes is an attempt to “restructure the form of the transaction” and therefore falls within the purview of the Danielson rule (and is not excluded by the rule articulated in Fort).  The Commissioner then goes a step further, arguing that the taxpayer was not merely “changing the classification of assets” but also “added assets.”  Moreover, the Commissioner insists that what the taxpayer did with respect to depreciation “goes considerably deeper than merely a change to the classification for depreciation purposes.”

Peco Foods – Tax Court Memorandum Opinion

Peco Foods – Taxpayer’s 11th Circuit Brief

Peco Foods – Commissioner’s 11th Circuit Opposition Brief

 

Goosen Appeal Dismissed; Garcia Decision Looms

While this post is significantly belated, it’s still worth noting that the IRS (the original appellant) and Goosen (who had cross appealed) stipulated to dismiss the appeal to the D.C. Circuit back in February.

This doesn’t mark the end of the IRS’s fight with pro golfers over the character and source of income (especially royalty income).  Sergio Garcia disputed deficiencies on similar issues; his case was tried in the Tax Court back in March.  (Case No. 013649-10).  We’ll update you when the decision is issued in that case.

NPR Oral Argument

On December 7th, oral argument was held in the Fifth Circuit in the NPR case before Judges Dennis, Clement, and Owen.  You can find a detailed explanation of the issues here but in summary the questions involve whether, in the context of a Son of BOSS case: the gross valuation penalty applies when the basis producing transaction is not invalidated solely due to a bad valuation; whether other penalties apply; how the TEFRA jurisdictional rules function as to those penalties; and whether an FPAA issued after a non-TEFRA partnership no-change letter falls afoul of the no-second-FPAA rule. 

Although both parties appealed, as the initial appellant DOJ began the argument.  DOJ counsel argued that the Supreme Court’s decision in Nat’l Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), allowed Treas. Reg. § 1.6662-5(d) to override the Fifth Circuit’s position in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), that a valuation misstatement cannot apply where there are grounds for invalidating the transaction other than an incorrect valuation — such as where the transaction is totally disallowed under economic substance or on technical grounds.  In this regard, DOJ requested that the court submit the matter for en banc review to address this issue and to consider the impact of Weiner v. United States, 389 F.3d 152 (5th Cir. 2004), which counsel characterized (as DOJ had in the brief) as calling the “total disallowance” rule into question. 

As to the substantive application of penalties, DOJ argued that the complete concession by the taxpayer of the substance of the transaction compelled the conclusion that the position lacked substantial authority.  Furthermore, counsel argued that there was no substantial authority at the time the transaction was reported on the taxpayer’s return.  In this regard, DOJ posited that although Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), had held that a contingent liability was not a liability for purposes of section 752, it did not address the questions of buying and selling offsetting options and of contributing them to a partnership only to arrange for a distribution and sale.  As to these points, the only authority on point was Notice 2000-44, which stood for the proposition that the transaction did not work.  This appears to be a repackaged version of the argument that there can never be substantial authority for transactions lacking economic substance. 

Argument transitioned to the question of whether the district court had jurisdiction to consider a penalty defense put on by the partners and not by the partnership in this partnership action.  For a prior discussion of this confusing question see our analysis here.  Citing Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), DOJ counsel argued that the Fifth Circuit had already decided that an individual reasonable cause argument (such as one based on a legal opinion issued to the partner) cannot be raised in a TEFRA proceeding.  The court seemed to recognize the impact of Klamath on this point.  DOJ counsel then attempted to box the partnership in (as it had in the brief) on the question of whether the defense was raised by the partner or the partnership (several statements in the district court’s opinion seem to view the defense as a partner-level defense).  

Moving on to the question of the merits of the reasonable cause position, DOJ argued that the district court erred in considering reliance on the tax opinion (which was written by R.J. Ruble) to be reasonable.  Initially, counsel questioned whether the partners’ testimony that they did not believe Ruble had a conflict was reasonable in light of the partners’ knowledge of fee sharing and of the fact that Ruble had written opinions for other shelters for the same promoter.  The court seemed to be honed in on this question.  In closing, DOJ attempted to poison the well of partner good faith by reminding the Court that the partners in this case were repeat tax-shelter offenders and had attempted to hide the Son-of-BOSS losses as negative gross revenue from their law firm business. 

Perhaps indicating a weakness on the penalty issues raised by DOJ, taxpayer’s counsel spent most of his time on the question of whether the second FPAA was invalid.  The Court focused counsel on the fact that an error on the tax return (the Form 1065 did not check the TEFRA box although it did check the flow-through partner box (which would indicate a TEFRA partnership)) led the agent originally to pursue the case as non-TEFRA.  Undeterred, counsel argued that this error was not material and that the agent had indicated in a deposition that he eventually learned that the partnership was TEFRA.  Testimony was also offered in the district court that the reporting was an innocent mistake and not negligent or deceptive.  The Court spent significant time questioning why the agent did not testify at trial (which appears to have been due to a mix-up on the part of DOJ).  In summarizing his position, taxpayer’s counsel tried to focus the court on the language of the partnership no-change letter but to us it appears that the real question has to be whether the agent intended this to be a TEFRA audit.  An FPAA simply cannot come out of a non-TEFRA audit.  Based on the agent’s deposition transcript it seems clear that he did not believe he was involved in a TEFRA audit when he opened the audit and thus it is impossible that the initial notice was an FPAA. 

Rebutting DOJ’s reasonable cause position, taxpayer’s counsel focused on the trial testimony and factual determinations by the district court that the taxpayers were acting reasonably and in good faith.  On the question of jurisdiction, the taxpayer reverted to the tried and true (but not very strong) argument that requiring a later refund suit to address the reasonable cause question would be a waste of judicial resources and, in essence, a meaningless step.  A cynic might say that the purpose of TEFRA is to waste judicial resources and create meaningless steps. 

In rebuttal, DOJ counsel focused on the no-second-FPAA question and did a good job from our perspective.  He noted that you have to have a TEFRA proceeding to have a TEFRA notice.  Undermining the district court’s determination that the finality of the notice is relevant, counsel noted that all non-TEFRA notices are “final” but that doesn’t mean they are FPAAs.  TEFRA is a parallel audit procedure and it is simply not enough that the IRS intended a final determination in a non-TEFRA partnership audit.  The question is whether the IRS intended to issue a final notice in a TEFRA proceeding; since there was no “first” TEFRA proceeding, there was no “first” FPAA.  We think this argument is right on target. 

With limited questions coming from the Court it is difficult to see where this is headed.  Our best guess is that the partnership will prevail on the reasonable cause position (it is difficult for an appellate court to overturn credibility determinations of witnesses) but lose on everything else including the no-second-FPAA issue.

Supreme Court Struggles With Confusing Criminal Tax and Deportation Interplay in Kawashima Oral Argument

We are finally getting around to updating Kawashima, the Supreme Court case involving the question of whether a conviction under section 7206 is a deportable offense under the immigration laws.  The Court heard argument on the case back in November.  A decision likely will be issued this spring.  It’s hard to read which way the Court is leaning based on the arguments.  Several Justices seemed to balk at petitioners’ technical argument that a false statement on a return (under section 7206) can be something less than intending to deceive the IRS (a crime involving “fraud or deceit” is deportable under the immigration laws — see our prior post).

The argument first focused on the Code’s “willfulness” concept and whether the requirement in section 7206 that the false statement be submitted willfully in fact turned an act that — without willfulness — might not be intended to deceive into something that showed intent to deceive.  Petitioners’ counsel tried to focus the Court on the concept that intent to deceive required intent to induce an action or reliance and not merely intent to make a false statement.  This position seemed to concern several Justices given that the false statement was on a document submitted to the government for a specific purpose (reporting taxes).  The argument also briefly turned to the question of the case law — largely Tax Court case law — which historically held that a conviction under section 7206 did not automatically trigger the extended limitations period for fraud unless the IRS independently proved fraud.  The Justices did not substantively comment on this point during petitioners’ time but came back to it during the government’s argument and it seemed to get some traction with the Chief Justice.

Petitioners’ counsel and Justice Scalia spent a substantial amount of time discussing whether the inclusion of both section 7201 and the “fraud or deceit” provision in the deportation law rendered the former superfluous if the government’s reading was adopted.  This involved a discussion of the text of section 7201, which has long been textually framed as an attempt “to evade or defeat any tax” and does not specifically use the words fraud or deceit.  While the Justices did not seem to be happy with the responses by petitioners’ counsel, an amicus brief submitted by Johnnie Walters — a former IRS Commissioner — deals with the history and meaning of section 7201 quite compellingly.  And when questioning the government’s counsel, Justices Ginsburg and Kagan both seemed concerned that the government’s position could read one part of the deportation statute out of the law based on this historic reading of section 7201.  This led Justice Breyer to introduce the idea that section 7206 does not seem to meet the common law definitions of fraud or deceit — a point not raised by counsel as best as we can tell — but something that could be relevant in determining Congressional intent.

Piercing through the government’s argument, Justice Kagan was able to get its counsel to admit that even the evasion-of-payment cases under section 7201 have to involve some sort of fraud in order to be prosecuted under that statute.  Counsel also basically admitted that the IRS/DOJ has never prosecuted a section 7201 case that didn’t involve fraud.  This triggered a question by Justice Breyer as to whether the government’s position would make every single perjury statute a deportable offense — something that would profoundly impact both defendants and the system.  Justice Kagan then returned to the circularity of the government’s arguments regarding superfluity (a point we have made a few times previously).

As we said at the outset, it is difficult to see where all of this is going.  Petitioners do seem to us to have the stronger case when you consider the historic meaning of section 7201 (which is fundamental to criminal tax practice) but the statutory text could be confusing when read outside of that context.  We will update you as soon as we see a decision.

Service Appeals Goosen Tax Court Decision to D.C. Circuit

We posted in November 2011 about the Tax Court’s decision on the character and source of golfer Retief Goosen’s endorsement income.  The Service appealed that decision to the D.C. Circuit in December.  The D.C. Circuit case number is 11-1478.  We’ll post updates as the appeal progresses.

Court of Federal Claims Construes “Same Taxpayer” Requirement for Interest Netting

In Magma Power v. United States, Case No. 09-419T, the Court of Federal Claims tackled the arcane topic of interest netting.  The issue in Magma Power was a narrow question of statutory interpretation, but the broader topic of interest netting warrants a word of explanation. 

The government charges interest on tax underpayments at a higher rate (under section 6601) than it pays on tax overpayments.  Because it often takes several years or more to determine whether a taxpayer has an overpayment or underpayment for a particular tax year and the amount of that overpayment or underpayment, there are sometimes post-return periods during which a taxpayer has overlapping overpayments and underpayments.  When this occurs, the taxpayer should owe no interest on the overlapping amount.  If the overlapping amounts are not netted, however, the rate disparity results in net interest in the government’s favor.  To correct this inequity, Congress enacted section 6621(d), which provides that “to the extent that, for any period, interest is payable . . . and allowable . . . on equivalent underpayments and overpayments for the same taxpayer, . . . the net rate of interest on such amounts shall be zero.” 

The narrow statutory-interpretation issue in Magma Power is the meaning of the term “same taxpayer” under section 6621(d).  The IRS had denied section 6621(d) relief to Magma Power on the theory that Magma Power was no longer the “same taxpayer” after becoming a member of a consolidated group. 

Magma Power filed a return for its 1993 tax year sometime in 1994.  In February 1995, CalEnergy Company acquired Magma Power and subsequently included Magma Power on its consolidated tax returns.  The IRS later determined a deficiency for Magma Power’s 1993 tax year, and Magma Power paid that deficiency and over $9 million in associated underpayment interest in 2000 and 2002.  The CalEnergy consolidated group overpaid its taxes in four consecutive tax years from 1995 through 1998.  Despite some disagreement between the parties, the court found that some portion of these overpayments were attributable to Magma Power’s activities.  In 2004 and 2005, the IRS refunded those overpayments plus the associated overpayment interest to the consolidated group agent (which by then was MidAmerican Energy Holdings Company).  There were overlapping underpayments and overpayments for the period that began with the filing of the 1995-98 returns and ended with the satisfaction of Magma Power’s 1993 underpayment.  Magma Power claimed interest-netting refunds for that period.  The IRS denied the refund on the theory that the consolidated group could not net its overpayments with Magma Power’s underpayments because of the “same taxpayer” requirement of section 6621(d). 

The court’s plain-language analysis of section 6621(d) is straightforward and decisively rebuts what appears to be a flimsy position taken by the IRS.  The essence of the court’s conclusion is that becoming a member of a consolidated group does not fundamentally alter a taxpayer’s identity.  The court rests this decision on the uncontroversial premise that the taxpayer identification number (or EIN, for corporations like Magma Power) is the sine qua non of taxpayer identity.  And because Magma Power retained the same EIN (and therefore same identity) after its inclusion in the consolidated group, the court held that Magma Power was the same taxpayer for section 6621(d) purposes for the 1993 underpayment and its allocable portion of the 1995-98 overpayments. 

Although the court addresses several arguments made by the government, the only notable bump in the court’s road to its conclusion was some language in another Court of Federal Claims decision, Energy East v. United States, 92 Fed. Cl. 29 (2010), aff’d 645 F.3d 1358 (Fed. Cir. 2011).  Interpreting the meaning of “same taxpayer” for interest-netting purposes in Energy East, the lower court cited the dictionary definition of “same” and decided that section 6621(d) requires that the taxpayer must be “identical” and “without addition, change, or discontinuance.”  (The issue on appeal was narrower and the Federal Circuit did not reject or adopt this aspect of the lower court’s opinion.)

The court in Magma Power had little difficulty distinguishing Energy East:  Energy East was trying to net the overpayment years of acquired companies against its own underpayment years.  The hitch was that both the underpayment years and overpayment years came before Energy East acquired those companies.  In Magma Power, the court held that the Energy East situation was “radically different” than Magma Power’s attempt to net its own 1993 underpayment against its own later overpayments (albeit encompassed within the Cal Energy consolidated group).

The government may well appeal Magma Power based on the broad language in the lower court’s decision in Energy East.  If they do, we’ll keep you posted. 

Magma Power opinion 10.28.2011

NPR Calendared for Argument

The NPR case (involving penalty application and TEFRA issues in the context of a Son of BOSS transaction: see latest substantive discussion here) has been calendared for argument in New Orleans on December 7th in the East Courtroom.

Tax Court Addresses Character and Sourcing Issues for Golfer’s Endorsement Income

In what appears may be the first in a series of cases on the endorsement income of non-resident aliens, the Tax Court was tasked with characterizing and sourcing the endorsement income for golfer Retief Goosen.  The court’s decision may impact how other athletes and entertainers structure their endorsement deals and indicates how taxpayers should expect the IRS to source royalty income in similar cases. 

Goosen, a native South African who is a U.K. resident, is subject to U.S. tax because playing professional golf in the U.S. amounts to engaging in a U.S. trade or business.  He had endorsement agreements with Acushnet (which makes Titleist golf balls), TaylorMade, and Izod to use or wear their products while playing golf (these are the “on-course” endorsements).  He also had endorsement agreements with Rolex, Upper Deck, and Electronic Arts (the “off-course” endorsements). 

There were three main issues before the Tax Court:

(1)  Was Goosen’s on-course endorsement income personal services income or royalty income or some combination of the two?  (The parties agreed that all of the off-course endorsement income was royalty income.)   The personal services income of nonresident aliens is subject to regular U.S. tax rates; they typically owe less U.S. tax on royalty income under tax treaties. 

(2)  What portion of Goosen’s royalty income was U.S.-source income?  Under section 872, the gross income of nonresidents includes U.S.-source income. 

(3)  What portion, if any, of that U.S.-source royalty income was effectively connected to a U.S. trade or business?  While U.S.-source royalties are generally subject to a flat 30% withholding tax, if  royalties are effectively connected to a U.S. trade or business, they are subject to the graduated rates that apply to U.S. residents. 

On the first issue, Goosen argued that the on-course endorsements were paid for the use of his name and likeness, which is classic royalty income.  The IRS argued that because the on-course endorsement agreements required Goosen to make personal appearances and to play in a minimum number of golf tournaments (all while using Titleist balls and TaylorMade clubs and wearing Izod), the on-course endorsements were paid for personal services.  The court split the difference, deciding that the sponsors paid for both the use of Goosen’s image and likeness and for personal services. 

On the one hand, the court found that the sponsors were paying for more than just Goosen’s golfing—that the sponsors wanted to be associated with Goosen’s image.  The court cited the morals clause in a couple of Goosen’s endorsement agreements as evidence that the sponsorship was about more than just golfing.  (This morals-clause discussion enabled the court—and, conveniently, this blog entry—to meet the requirement that anything written about golf must mention Tiger Woods.) 

The court also cited expert testimony from Jim Baugh (formerly of Wilson Sporting Goods) for the proposition that image is sometimes more important than performance.  Baugh testified that while Goosen has won more and consistently been ranked higher than golfer Sergio Garcia, the two have effectively identical endorsement agreements with TaylorMade.  Baugh attributed this to Garcia’s “flash, looks and maverick personality.”  This is notable testimony because Garcia has his own Tax Court case pending, which is set for trial in Miami in March 2012. By detailing this testimony, the court gifts Garcia with a tailor-made argument that, relative to Goosen, a greater portion of Garcia’s TaylorMade endorsement income is royalty income. 

On the other hand, the court held that the endorsement income could not be solely attributable to Goosen’s image.  After all, the on-course endorsements required Goosen to make personal appearances and to play in a specified number of tournaments, all while wearing or using the sponsors’ products.  Acknowledging that precision in allocating between royalty and personal service income was unattainable, the court settled on a straightforward 50-50 split. 

As for the second issue, the court was left to decide what portion of Goosen’s royalty income was U.S.-source income.  Generally, the source of royalty income from an intangible is where the property (in this case, Goosen’s image) is used.  With respect to the Upper Deck and EA endorsements, the court looked to the relative U.S.-to-worldwide sales percentages of Upper Deck’s golf cards (92% in the U.S.) and EA’s video games (70% in the U.S.) and then sourced Goosen’s royalty income accordingly.  For the three on-course endorsements and the Rolex endorsement, the court determined that while Goosen was marketed worldwide, the U.S. constitutes about half of that worldwide golf market.  The court therefore treated half of the income from those four endorsements as U.S.-source income. 

Finally, the court had to decide whether any of that U.S.-source income was effectively connected to a U.S. trade or business.  The court held that only the on-course endorsement royalty income was effectively connected to a U.S. trade or business.  The court found that since the off-course endorsements didn’t require Goosen to play golf tournaments or to be physically present in the U.S., that royalty income was not effectively connected to the U.S. 

The aspect of the decision that seems to have scared some practitioners (other than the existence of a worldwide market for collectible golf cards, which maybe scares only this practitioner) was how the court sourced royalty income according to the U.S.-to-worldwide sales percentages.  The fear is that the IRS will simply apply those percentages in every case, and taxpayers will have no room to negotiate a more favorable allocation. 

We’ll keep an eye on where this case heads and will post updates on the Sergio Garcia case. 

 Goosen Tax Court opinion

Supreme Court Briefs Filed in Kawashima

The petitioners’ and respondent’s briefs have been filed in Kawashima v. Holder, Sup. Ct. Docket No. 10-577, appealing 615 F.3d 1043 (9th Cir. 2010).  As described in our original post, that case involves the question of whether pleas to section 7206 offenses (subscribing to false statements and assisting same) are “aggravated felonies” that result in deportation under the immigration laws.  The case turns largely on the statutory interpretation of the relevant portion of 8 U.S.C. §1101(a)(43)(M).

The petitioners’ position is essentially the same as it was below (although more developed).  The primary argument is based on the language of 8 U.S.C. §1101(a)(43)(M), which provides, in relevant part, that an aggravated felony includes an offense that:

(i) involves fraud or deceit in which the loss to the victim or victims exceeds $10,000; or

(ii) is described in section 7201 of the Internal Revenue Code of 1986 (relating to tax evasion) in which the revenue loss to the Government exceeds $10,000.

The crime to which petitioners pled is plainly not an aggravated felony under the second prong, because petitioner pled to section 7206 and not to section 7201.  Petitioners argue that section 7206 offenses cannot be covered by the first prong either.  They base this argument on ordinary principles of statutory construction.

First, petitioners argue that the use of the term “revenue loss” in the second prong of the statute indicates Congressional intent that the term “loss to the victim or victims” in the first prong does not include a revenue loss to the government.  The purposeful use of different terms in each section seems to imply such an intent.  Furthermore, the response that this difference simply reflects a different purpose for each prong (one that focuses on governmental loss and one that does not) ultimately supports petitioners’ overall argument that the first prong was not intended to reach losses to the government such as through non-section 7201 tax crimes.

Second, petitioners posit that interpreting tax crimes to fall into the first statutory prong would render the second superfluous.  As we previously discussed, this seems to be a strong argument.  At a minimum, it would be odd for Congress to place one tax crime in a specific statutory provision and all other tax crimes in a vague and broad provision that covers many other offenses.  And the analysis in Leocal v. Ashcroft, 543 U.S. 1 (2004) (cited by petitioners) strongly implies that Congress should not be considered to have intended that meaning.

Finally, petitioners argue that the reference in the second prong to “tax evasion” helps to define (and limit) the scope of the term “fraud or deceit” in the first prong and that the sentencing guidelines support this view.  Petitioners’ analysis in this respect is largely based on the application of the interpretative canon that the specific limits the more general.  Because terms like “revenue loss” and “tax evasion” are used in the second prong, it is not appropriate — under petitioners’ application of this canon — to read those terms into the first prong. Petitioners’ reliance on the sentencing guidelines seems to be a stretch given that there is no direct support for the premise that Congress actually considered these guidelines when formulating the aggravated felony definition.  (Petitioners argue that Congress “likely” considered same given the timeline of adoption of the various provisions.)

In the alternative, the Kawashimas argue that their pleas did not involve fraud or deceit (and thus could not be included in the first prong anyway) and that, even if they might be included in that prong, the whole scheme is so confusing that the rule of lenity should apply to exempt them from a strict application.  The first argument relies on the elemental approach to the determination of whether a crime is an aggravated felony as applied by the Court in Nijhawan v. Holder, 555 U.S. 1131 (2009) and earlier rulings.  Under that approach, courts are supposed to determine whether the relevant factors for aggravated felony purposes (here, among others, fraud or deceit) were necessarily elements of the crime for which the defendant was convicted and not to focus on the specific conduct committed by the specific defendant.  See also Leocal, 543 U.S. at 7.  Because the elements of section 7206 do not require a finding of fraud or deceit (petitioners characterize it, not altogether unfairly, as a tax perjury statute), under this “elements and nature” approach, a section 7206 offense cannot amount to an aggravated felony under the first prong of 8 U.S.C. §1101(a)(43)(M).  This second argument is a Hail Mary and implicitly relies on the confusing state of the immigration law in this area as demonstrated in the rest of petitioners’ brief.  While immigration rules are ludicrously complex in this area, so is much of criminal law.  Unless the members of the Court are prepared to hold that any issue complex enough to find its way into their hands is necessarily unclear or confusing enough to give rise to the rule of lenity, it would seem an odd way to resolve the case (although a refusal by the Court to apply ludicrously complex rules might convince Congress to be more rational in drafting statutes).

The Solicitor General’s brief generally tracks the petitioners’ arguments in substance but not in order.  The government takes issue with the petitioners’ assertion that section 7206 does not require an element of fraud or deceit by focusing more on the dictionary definition of deceit than the historic application of section 7206 in jurisprudential context.  As to the question of fraud, the government attempts to equate material falsehoods (required for section 7206) with fraud (or at least deceit).  This appears to be a difficult argument to sustain unless the Court is prepared to depart from principles that are fairly well settled in the lower courts.  The Tax Court and several Circuit Courts of Appeals have held that a conviction under section 7206 does not necessarily trigger fraud penalties or the fraud period of limitations in the civil side of the Internal Revenue Code.  See, e.g., Wright v. Commissioner, 84 T.C. 636 (1985).  It is hard to reconcile the government’s argument with these authorities.  Perhaps the best way to distinguish these authorities is on the basis that the material falsehoods at issue did not amount to a showing that the taxpayer intended to prepare a fraudulent return (i.e., to commit tax evasion) and that the aggravated felony test asks the (different) question of whether any fraud was conducted against a “victim.”  The logical problem with this argument is that it assumes that there is some other way for the government to suffer a loss than the fraudulent return.  If the fraud has to be linked to the loss, then the interpretation of section 7206 in cases like Wright seems inconsistent with the government’s argument in its brief.

The government attacks petitioners’ specific-over-general argument on the basis that the second prong does not by its terms encompass all tax offenses (it refers only to section 7201, the capstone tax offense).  While this is true, it raises the question of why Congress would have isolated one tax offense from all of the others (assuming all of the others are included in the first prong).  This, in turn, drives into petitioners’ superfluity argument.  On that question (where much of the merit rests in our opinion), the government starts with the premise that Congress sometimes wishes to be superfluous.  It then argues that the failure of the second prong to cover all tax offenses (as opposed to section 7201) would render that prong ambiguous.  This argument seems baseless.  The only way prong one is rendered ambiguous by petitioners’ argument is if you are predisposed to assume that all tax offenses are either in prong one or in prong two.  If you come to the statutory interpretation exercise without that excess luggage, it is perfectly natural for prong two to deal with the sole exemplar of a tax offense that is an aggravated felony and for prong one to include no tax offenses at all.  (This is arguably the most natural reading of the provision).  The government’s efforts to force ambiguity into prong one by arguing that Congress might have wanted to make really, really, really sure that a tax statute — section 7201 — that for all time has stood as the capstone of tax fraud/evasion would be interpreted as involving fraud or deceit seem to us a bit of a stretch.

The government finishes by focusing on the legislative disconnect between the aggravated felony rules and the sentencing guidelines (fairly chastising petitioners for failing to prove a direct connection).  It also dismisses the applicability of the rule of lenity on the ground that mere ambiguity is insufficient to trigger that rule (the case law indicates the ambiguity must be grievous).  Finally, the government notes that the agency never formally addressed the question of whether non-section 7201 tax crimes can be aggravated felonies.  In the government’s view the agency should be allowed to do so on any remand and any such decision should be accorded Chevron deference.  As mentioned above, we doubt that the Court will resolve the case on either of these bases.

Petitioners’ reply brief is due October 31, and the case is scheduled for oral argument on November 7.

Ninth Circuit Rules for the Government in Samueli

The Ninth Circuit issued its opinion in Samueli v. Commissioner, Nos. 09-72457 and 09-72458, on September 15, 2011, largely affirming the Tax Court (opinion linked below, and see our prior coverage here).  In upholding the decision in favor of the IRS, the Ninth Circuit added a couple of wrinkles to the Tax Court’s rationale in responding to the taxpayers’ arguments on appeal.

The court first dispensed with the taxpayers’ argument that, contrary to the Tax Court’s finding, the transactions at issue did not reduce the purported lenders’ opportunity for gain (a statutory element of I.R.C. § 1058 non-recognition).  The court found that not only did taxpayers have an extremely limited right to recall the securities (the interest strips were recallable on two days out of approximately 450), thereby limiting the opportunity to take advantage of potential short term swings in value, but also the lending agreement further constrained taxpayers by adding another layer of pricing risk that could have made recalling the securities economically infeasible.  Accordingly, the Ninth Circuit ruled that section 1058 was inapplicable as a more or less routine matter of statutory interpretation.

But the court didn’t stop there.  Responding to the taxpayers’ argument that section 1058 is merely a safe harbor and does not definitively delineate securities loans that should be afforded non-recognition treatment, the court held that taxpayers’ purported loan did not align with the policy animating section 1058 (the facilitation of liquidity for the securities markets), and therefore the transaction was not eligible for tax-favored treatment.  The court was clearly exercised by its assessment that the taxpayers’ “loan, a tax shelter marketed as such for which the borrowing broker[] did not pay the lender any consideration, clearly was not ‘the thing which the statute intended.’” (quoting Gregory v. Helvering, 293 U.S at 469).  The court reasoned that, because the taxpayers’ transaction was inconsistent with the purpose of the statutory provision at issue, taxpayers could not avail themselves of some sort of common law penumbra around the statute (assuming one exists in the first instance–a debatable proposition).

As we noted in our earlier post, the taxpayers argued in their reply brief that irrespective of section 1058, the transactions were in substance the purchase of a contractual right later terminated, and therefore eligible for capital gains treatment pursuant to I.R.C. § 1234A.  Noting that the government had successfully argued application of substance-over-form, the court nonetheless opined that “[it] does not mean that [the taxpayers] therefore must have the right to call the transaction whatever they want after the fact.”  Tacitly applying a version of what some practitioners refer to as the Danielson doctrine, the court held that the taxpayers were stuck with their form and could not recast the transactions to avoid the tax consequences of the Service’s recharacterization.  See, e.g., Comm’r v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (“while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, . . .and may not enjoy the benefit of some other route he might have chosen to follow but did not”); Comm’r v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967) (“a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”).

CA9 #09-72457 (Samueli v CIR) Opin 9-15-11 (2)

Bush(un)whacked

The Federal Circuit’s en banc opinion is out.  It affirms the Court of Federal Claims on the reasoning set out in our prior posts and rejects the harmless error analysis of the prior panel opinion.  We are pleased to see the Federal Circuit safely emerge (albeit clutching map and compass) from the TEFRA forest.

Briefing Complete in NPR

As we mentioned in our last post, the only brief remaining to be filed in NPR was the taxpayer’s reply brief.  That brief has now been filed and with it a DOJ motion to strike part of that reply as an inappropriate sur-reply.  The motion concerns a section in the reply in which the taxpayer takes on DOJ for arguing (in its previously filed reply brief ) that the only relevant factor in determining the incidence of the valuation misstatement penalty (between partnership and partner) is whether there are partnership items involved and not where the specific misstatement results in a loss.

The taxpayer’s view is that DOJ is trying to have its cake and eat it too – arguing that the penalty applies at the partnership level because it is related to partnership items but refusing to allow section 6664 arguments to be heard on the grounds that those are specific to the partner.  DOJ’s position is that it would be barred from raising the penalty outside of the context of a partnership proceeding because the penalty relates to a partnership item (or items) and that it is not inconsistent to require section 6664 intent to be evaluated at the partner level (and, in any event, it is required by the regulations).  All of this, as we have extensively discussed, is intertwined in the silliness of trying to separate partner and partnership intent between TEFRA levels something the regulations perhaps should not have done but clearly do.  It will be interesting to see how the Fifth Circuit handles the case.

NPR Update

It has been a while since we published an update on NPR (please no comments on Supreme Court Justices, schoolchildren, and bloggers taking summers off).  Since our last post discussing the government’s opening brief, the taxpayer filed its brief responding to the government and opening the briefing on their cross-appeal.  The government also filed its response/reply.  All that remains now is the taxpayer’s reply brief on its cross-appeal, currently due on August 15.  There are a slew of technical TEFRA issues that are raised by the parties.  The taxpayer is appealing the district court’s rulings regarding whether a no change letter can ever be an FPAA and, if it can be, whether an erroneously checked box on the tax return (claiming that the partnership was not a TEFRA partnership) can constitute a misrepresentation of a material fact such that the no-second-FPAA rule of section 6223(f) is inapplicable.  As we discussed last post, the parties are jointly briefing — in the government’s appeal — the application of the Heasley/Weiner line of cases to the taxpayer’s concession strategically made to circumvent the gross valuation misstatement penalty.  Mayo is implicated by the application of Treasury Regulation section 1.6662-5(d) (DOJ relies on Brand X to argue that the regulation controls over the contrary rule previously announced in Heasley).

However, as we discussed in prior posts, the main issue here is good faith reliance on counsel — R.J. Ruble — by the taxpayer for purposes of the section 6664 reasonable cause defense and when, procedurally, that defense can be raised.  The government continues to hew to the line that reliance is inappropriate (because of a technical conflict and because reliance was just not reasonable under the circumstances).  DOJ also argues that the defense can be raised only in a partner-level proceeding pursuant to then Temporary Treasury Regulation section 301.6221-1T(d) (the judges may want to get a cholesterol test with all of this Mayo being spread around).  For its part, the taxpayer argues that the district court already determined — after seeing the witness testimony — that the reliance was in good faith.  Furthermore, since one of the partners is the TMP, the reasonable cause defense is being raised by the partnership as much as by the partners.  Setting aside whether you believe the testimony (which the district court judge did), if we could decide cases based on the fact that section 301.6221-1T(d) of the TEFRA penalty regulations is stupid, this would be easy.  As we have said before, separating partner and partnership intent in a transaction involving a partnership that was purposefully created by the partners to implement that very same transaction is like trying to dance on a headless pin.  With deference under Mayo, however, “stupid is as stupid does” is not the test for striking down regulations.  We will just have to wait and see how much patience the Fifth Circuit has for this Forrest Gump of a regulation.

Government Files Response in Anschutz

The government filed its response brief in Anschutz Co., et al. v. Commissioner, Nos. 11-9001 & 11-9002 (10^th Cir.), on June 22, 2011 (linked below).  See our prior coverage here.  Not surprisingly, the government argues that the Tax Court got it right in viewing the putatively separate variable prepaid forward contracts and stock loans as two parts of one overall arrangement, designed to monetize the value of the taxpayer’s low-basis stock at the outset of the deal.  The Tax Court held that, in substance, the overall arrangement was a sale for tax purposes because the benefits and burdens of owning the stock had been passed to Anschutz’s counterparty.  Based on the briefing, it appears that the key question in the case will be whether the IRS and the Tax Court were correct in viewing the transactions as an integrated whole, or whether they must be analyzed separately under the technical provisions applicable to stock loans and variable prepaid forwards.

CA10 #11-9002 (Anschutz) Resp Brief (6-22-11)

Briefing Under Way in Anschutz

As we’ve reported in the last few months, several securities lending cases are percolating in the appellate courts (see here and here).  On April 29, 2011, Anschutz Company filed the opening brief in its appeal of the Tax Court’s decision for the government (opinion and brief linked below).

At issue in Anschutz is the appropriate tax treatment of a set of transactions between the taxpayer and Donaldson, Lufkin & Jenrette Securities Corp. (“DLJ”).  The taxpayer sought to leverage long-held shares in publicly-traded railroad companies to obtain financing for other endeavors.  In the taxpayer’s hands, the shares had a low basis relative to their fair market value at the time of the transactions in question.  The transactions involved the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”).  Under the PVFCs, DLJ paid the taxpayer a percentage of the current market value of the shares in exchange for the right to receive a number of shares or their cash equivalent at a point in the future.  The number of shares to be delivered (or their cash equivalent) was to be determined by a formula agreed upon at the outset.  In order to secure its obligation, the taxpayer pledged a number of shares sufficient to ensure consummation of the deal at maturity.  In parallel, DLJ entered into an SLA with the taxpayer under which DLJ would take possession of the pledged shares to use them in short sale transactions.  Although each of the two transactions, viewed in isolation, would have passed muster under relevant authorities as non-taxable open transactions, the government challenged the arrangement as constituting in substance a taxable sale of the shares at the inception of the deal.  After a two-day trial, the Tax Court agreed.

On appeal, Anschutz argues that the Tax Court’s decision to view the transactions as two legs of one overall arrangement was error.  Rather, the taxpayer contends that the two transactions should be respected as stand-alone occurrences to be analyzed separately.  Under the taxpayer’s view, the PVFCs are non-taxable open transactions under Rev. Rul. 2003-7, and the SLAs fall within the ambit of I.R.C. section 1058 (stock loans not taxable provided certain conditions are met).  For the Tax Court, the crux of the case was that the PVFCs had the effect of shifting to DLJ all risk of loss and most of the opportunity for gain on the shares.  Under section 1058, a stock lending arrangement cannot reduce the risk of loss or opportunity for gain if it is to be considered non-taxable.  The taxpayer contends, however, that in spite of a master agreement governing both legs of the arrangement, the facts properly construed require the two transactions to be analyzed separately as independent deals, each with their own tax consequences.

The government’s response is now due on June 24, 2011.  We’ll keep you posted on this and other developments in the securities lending cases.

Anschutz TC opinion

Anschutz Opening Brief

 

Update on Bush-whacked

The en banc Federal Circuit heard oral argument in the Bush TEFRA case on Wednesday the 10th of May.  For those still interested after reading this, you can listen to the argument here.  As we indicated in our prior analysis, we think the resolution of this case is simple.  Unfortunately, although the parties and the court almost escaped the weeds several times, with one of the judges asking a question very close to the mark, it was a dissatisfying oral argument (from our perspective).  The point that needed to be made is that an agreement to “no change” a partnership item is “treatment” of a partnership item in and of itself — you have just treated it the same as it was originally treated.  Thus, a change in tax liability that “reflects” a partnership no change is a computational adjustment.  

To put some more meat on that, section 6221 illustrates the purpose of TEFRA to require “the tax treatment of any partnership item [to be] determined at the partnership level.”  Section 6230(a) coordinates the Code’s deficiency proceedings with TEFRA and mandates that, aside from converted items, notices of deficiency are required only for “affected items which require partner level determinations.”  Claims arising out of erroneous “computational adjustments” can be litigated but the underlying treatment of partnership items resolved in a TEFRA proceeding cannot be re-litigated.  Section 6230(c).  Section 6231(a)(6) defines a “computational adjustment” as a “change in the tax liability of a partner which properly reflects the treatment … of a partnership item.”  

Where you have a change in tax liability of a partner that “reflects” the “treatment” (not the “change” in treatment, just the treatment) of a partnership item and no partner-level determinations are necessary, then no notice of deficiency is required.  In Bush, the partners settled the “treatment” of the partnership items as a no change and agreed to all of the necessary partner level determinations so there was no need for a partner-level determination to determine tax consequences.  Accordingly, no notice of deficiency was necessary.  Contrary to the taxpayers’ position at oral argument (and in the briefs), the fact that there could be other (non-partnership) items contested in a notice of deficiency is irrelevant.  Likewise, it is irrelevant that the partnership items or treatment of those items never changed.  You don’t need a change in a partnership item or a change in the treatment of that item to have a computational adjustment.  Instead, you need a change in tax liability that reflects the treatment of partnership items.  Any TEFRA-based adjustment does that even if the partnership items stay as they are on the original return because their treatment is reflected in that tax liability.  That is the whole point of TEFRA: partnership item treatment is relegated to TEFRA proceedings and everything flows out of that treatment.  So a change in tax liability driven by a change in allowed partnership losses based on a change in a partner’s at-risk amount reflects the treatment of a partnership item (the losses, which are no-changed, which is a form of “treatment”) and thus is a computational adjustment.  

Although the court asked several questions on the period of limitations and assessment issues and asked other questions to determine the scope of the problem, the rest of the taxpayers’ arguments are a sideshow.  It is always tough to tell how a case will be decided based on the arguments, but, even though it was less than satisfying, the court’s questioning indicates to us that the government will prevail and the court will find its way out of this part of the TEFRA forest.

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.

Fourth Circuit Reverses Tax Court in Virginia Historic

On March 29, 2011, the Fourth Circuit rendered its opinion in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (opinion linked below).  As described in our previous coverage, the case involved an IRS challenge to the taxpayer’s treatment of partnerships used as marketing vehicles for state tax credits derived from historic rehabilitation projects.  Agreeing with the government’s disguised sale theory, the court reversed the Tax Court and ruled that the transactions at issue were taxable sales of state tax credits, as opposed to non-taxable capital contributions followed by partnership distributions.

After quickly dispensing with the taxpayer’s argument that the tax credits received by investors were not “property” under the statute, and skipping over the question of whether the funds’ investors were bona fide partners for federal tax purposes, the court took a decidedly statutory approach to resolving the case by focusing on the disguised sale regime under I.R.C. § 707(b).  In applying the statute, the court largely relied on the guidance in Treas. Reg. § 1.707-3, which sets forth a presumption that reciprocal transfers between a partner and a partnership within a two-year period constitute a disguised sale unless facts and circumstances clearly establish otherwise.  The regulation also lists ten factors to consider in determining whether the second transfer in a non-simultaneous pair of transfers is “dependent on the entrepreneurial risks of partnership operations.”

In addition to finding that the transfers-within-two-years presumption required the taxpayer to “clearly establish” that the transfers did not constitute a sale, the court focused on five of the Treas. Reg. § 1.707-3 factors.  First, the court found the timing and amount of the second transfer (the allocation of tax credits to the investors) were determinable with reasonable certainty at the time of the first transfer (the alleged contributions to capital made by the investors), and each investor knew with specificity the size of the credits that he or she could expect.  Second, the investors had legally enforceable rights to the credits per their subscription agreements; they had been promised state credits in exchange for their capital contributions.  Third, the investors’ rights to the credits were secured through a promise of refunds if sufficient state credits were not delivered to the investors.  Fourth, the transfers of credits to the investors were disproportionately large compared to the negligible (0.01 percent) interest that most investors held in the partnerships.  Significantly, in this regard the court found that “the transfer of tax credits to each investor by the partnership had no correlation to each investor’s interest in partnership profits whatsoever.”  Finally, the investors had no further obligations or relationship with the partnership after they received their credits.  In light of the presumption, the court opined that these factors “strongly counsel for a finding that these transactions were sales.”

Further girding its rationale, the court noted that the taxpayer did not follow the form of the subscription agreements, assigning each investor a 0.01 percent interest regardless of their capital contributions.  The Fourth Circuit further noted that the partnership status of the investors was transitory in nature, which echoed a concern expressed in the legislative history to section 707(b).  Also, the court noted that the Tax Court did not analyze the factors in Treas. Reg. § 1.707-3 but rather relied on its own analysis of the investors’ level of entrepreneurial risk.  As an interesting aside (from a regulatory deference point of view), the court opined that the Tax Court was not bound to “tick through [the factors] mechanically[,]” but was “free to” conduct its own evaluation of risk, because the regulation “simply reflects those characteristics the Department of the Treasury, given its experience and expertise, thinks significant.”  Nonetheless, the court found the Tax Court’s independent analysis of entrepreneurial risk unconvincing, viewing the risks cited as “both speculative and circumscribed.”  In the final analysis, the court held that the only risk borne by the investors was “that faced by any advance purchaser who pays for an item with a promise of later delivery.  It is not the risk of the entrepreneur who puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink.”

VA Historic Opinion 3-29-11

More Securities Loan Cases on Appeal

A while ago we reported on a spate of IRS successes in cases involving purported securities loans (here).  The Samueli case is fully briefed in the Ninth Circuit and is expected to be argued in the next couple of months.  As we anticipated, two more of those cases, Anschutz and Calloway, have been appealed to the Tenth and Eleventh Circuits, respectively.  The taxpayer in Calloway filed his opening brief on March 15, 2011 (linked below).  Briefing has not yet begun in Anschutz.

In Calloway, the taxpayer was an IBM employee of many years who had acquired IBM stock during his employment.  By the time of the transaction in question, the stock’s value was five times the taxpayer’s basis.  Desiring to monetize the stock, and by his own admission, seeking to maximize his after-tax return, the taxpayer entered into an arrangement whereby he transferred his stock to a counterparty in return for a loan equal to 90% of the stock’s fair market value.  This resulted in a 10% higher return than a straight sale subject to long-term capital gains tax.   Under the arrangement, the taxpayer had no right to any dividends, no ability to reap any gains from appreciation of the stock, and no right to recall the stock during the loan period.  The counterparty had the right to sell or otherwise dispose of the stock it purportedly held as collateral.  At the close of the three-year loan period, the taxpayer had the option of repaying the principal with interest to redeem his collateral, refinancing the transaction for an additional term, or surrendering his collateral in exchange for extinguishment of the debt.  As the stock had depreciated significantly, the taxpayer chose to surrender his collateral.  Notably, not only did the taxpayer not report the transaction as a sale, he also did not report any cancellation of indebtedness income upon extinguishing the purported debt.

The IRS challenged the taxpayer’s treatment of the transaction as a loan, asserting that in substance the arrangement was a sale of the taxpayer’s securities.  In a reviewed decision, the Tax Court agreed with the IRS that the transaction was indeed a sale, primarily because the benefits and burdens of ownership of the stock had in fact passed to the counterparty (under an application of the test articulated in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)).  Of course, it didn’t help the taxpayer that the counterparty had been sued successfully for promoter penalties and for an injunction to cease all further shelter promotion activities.

On appeal, the taxpayer’s position centers around the arguments that (1) the Tax Court’s finding that the counterparty had the right to sell the stock immediately was clear error, and (2) the finding that the taxpayer could not demand the return of his stock during the three-year period was also clear error.  These arguments apparently are based on the position that the counterparty did not have the right to sell the stock until a “legitimate” loan was already in place, and because the counterparty used the stock sale to finance the purported loan, no such right ever accrued.  Thus, according to the taxpayer, he remained in control of the stock under the terms of the arrangement, and therefore the transaction is subject to the safe harbors under I.R.C. § 1058 and Rev. Rul. 57-451, and furthermore should not be deemed a sale under the applicable common law securities-loan authorities.

We’ll provide an update when the government files its response, and we’ll post on Anschutz when the briefing gets under way (the opening brief is due May 2).  On a related note, the Tax Court recently held for the government in a case involving a transaction materially identical to the one in Calloway.  See Kurata v. Commissioner, T.C. Memo 2011-64 (March 16, 2011).

Calloway Appellant Brief

Update 2 on Bush(whacked)

We have added the taxpayer’s reply brief to the original post.  We will update you as soon as we hear what the en banc court does.

Update on Kawashima

We noted back in November that the taxpayer had filed a petition for certiorari in Kawashima v. Holder, 615 F.3d 1043 (9th Cir. 2010), on the question whether Code section 7206 offenses provide a basis for deportation — an issue on which the circuits are split.  We stated that the Court could be expected to rule on the petition in early 2011, even if the government obtained a fairly routine 30-day extension of its December 2, 2010 response date.

There is no ruling yet because the government has now obtained three such extensions.  That is fairly unusual and may indicate that the government’s lawyers are struggling with how to respond.  In any case, it is unlikely that the Court would grant another extension.  If a response is filed on the current due date of March 4, 2011, then the Court will likely issue its ruling on its April 4 order list.

Update on Bush(whacked)

We have added DOJ’s brief to the original post.  Nothing much surprising in it; the arguments adopted reflect the same approach taken in our initial post (and in the Court of Federal Claims).  A point of interest is that there are 30 related cases holding at the Court of Federal Claims that depend on its resolution.  We will update you as soon as we hear what the en banc court does.

Update on Canal Corp. and NPR Investments

In our prior post on these cases, we compared the different factual findings made by the courts in analyzing penalty exposure under section 6664 and discussed the very factual nature of a reasonable cause and good faith penalty defense.  Both cases were subsequently appealed.  Canal Corp.looks like it is going to settle with the Fourth Circuit granting a motion to hold the appeal in abeyance pending finalization of that settlement (the company is in bankruptcy).  Thus, those hoping for an appellate smack-down of the penalty supporting opinion from the Tax Court will be disappointed.  NPR Investments is a different story.  Briefs are due in that appeal (which lies in the Fifth Circuit) starting on February 19th.  So Government hopes of another Son-of-Boss penalty success live on.  If we see anything interesting, we will report on it.

Notice of Supplemental Authority Filed in Virginia Historic

On January 18, 2011, the taxpayers filed a Notice of Supplemental Authority, drawing the court’s attention to the Tax Court’s recent opinion in Historic Boardwalk Hall, LLC v. Commissioner, 136 T.C. 1 (Jan. 3, 2011). According to the taxpayers in Virginia Historic, the new Tax Court case involves many factual and legal issues similar to those in the instant case. We’ll have an analysis of the recent decision and its potential impact on the issues in Virginia Historic in the near future.

Oral argument is scheduled in Virginia Historic for January 25, 2011.

Bush-whacked

As can be seen by the sheer number of our posts that deal with it, the unified partnership audit procedures of the Tax Equity and Fiscal Responsibility Act (“TEFRA”) can cause confusion.  In fact, they can be downright bewildering.  It is particularly easy to get lost if one walks into the TEFRA wilderness without keeping one eye fixed at all times on the overarching purpose of TEFRA.  The case of Bush v. United States, et. al., Fed Cir. Nos. 2009-5008 and 5009, is a textbook example of what happens when you lose sight of that landmark.  An apparently innocuous TEFRA proceeding resulted in a startling panel opinion authored by Judge Dyk and joined by Judge Linn that has baffled TEFRA practitioners.  (Judge Prost concurred in the result on a theory that comports with the common understanding of TEFRA.)  Bush v. United States, et. al., 599 F.3d 1352 (Fed. Cir. 2010).  Instead of ending the case, that opinion has triggered a flurry of activity that should eventually lead to an en banc decision by the full court.  Thus far, the panel decision has generated two sets of petitions for rehearing and responses, a vacated panel opinion, an order from the en banc court identifying four sets of questions to be addressed in new briefs, and at least one new amicus brief.  And the en banc briefing process is just getting started.  In order to keep from drawing the reader too far into the wilds ourselves, we describe the issue and the law first and then explain what happened to get us to where we are.

The facts in Bush are relatively simple.  The taxpayers had TEFRA partnerships.  Those TEFRA partnerships were audited, and a TEFRA partnership proceeding was brought.  That proceeding was settled by the taxpayers.  The Internal Revenue Service sent notices of computational adjustment to the taxpayers to reflect the adjustments agreed in the settlement; no notices of deficiency were sent.  The taxpayers paid the amounts reflected in the notices of computational adjustment.  Later, the taxpayers filed claims for refund with respect to the amounts they paid pursuant to the settlement and eventually sued in the Court of Federal Claims seeking to recover those amounts.

Now for the law.  The purpose of TEFRA is to determine the tax treatment of “any partnership item” at “the partnership level.”  Section 6221.  This ensures “consistent . . . treatment” among partners and between the partners and the partnership.  Section 6222.  Consistency and unity is so important that the Service is empowered to issue “computational adjustments” to make the partners’ individual returns consistent with the partnership return.  Section 6222(c)(2).  Section 6226 provides the sole mechanism to judicially challenge the Service’s proposed adjustment of a “partnership item” – namely, filing a petition in court in response to the notice of final partnership adjustment issued by the Service.  The notice of deficiency process, found in subchapter B of Chapter 63 of the Code, is specifically integrated with the TEFRA process outlined above (which is found in subchapter C of Chapter 63 of the Code), by section 6230.  As relevant here, section 6230(a) contains the rules for when the IRS is required to issue a notice of deficiency under subchapter B with respect to various items, and section 6230(c) contains rules that allow a taxpayer to challenge a computational adjustment.

Section 6230 leaves a relatively narrow gap within which the standard notice of deficiency process is to operate in TEFRA partner-level proceedings.  Setting aside a very specific (and irrelevant for our purposes) innocent spouse rule, section 6230(a)(2) provides that a notice of deficiency must be issued with respect to “affected items which require partner level determinations” and “items which [although they had been partnership items] have become nonpartnership items.”  For all other “computational adjustments” related to: (i) partnership items; or (ii) affected items that do not require partner level determinations “subchapter B of this chapter shall not apply.”  Section 6230(a)(1).  This limitation on the notice of deficiency requirement, however, does not leave the partner facing a computational adjustment without recourse.  Section 6230(c) allows the partner to file a claim for refund in several cases including, among others: (i) to apply a partnership settlement; or (ii) to seek a credit or refund of an overpayment attributable to the application of such a settlement.  Section 6230(c)(1)(A)(ii) and (B).  Critically, under either of these refund claim provisions, substantive review of the “treatment of partnership items” resolved in the settlement is verboten.  Section 6230(c)(4).  This is necessarily the case because the whole unifying purpose of TEFRA would be undermined if a later proceeding could affect the treatment of items properly agreed in a settlement by the parties at the partnership level.

Readers that are still awake will see that there are really only two nuts to crack in order to resolve Bush.  First, were the items subject to the settlement either partnership items or affected items that do not require partner level determinations (which would mean that there was no notice of deficiency requirement)?  Second, assuming they were, did the questions raised in the claim attempt to substantively re-review the determination of those items (which, again, is a statutory no-no)?  As to the first question, the item at issue in Bush was the section 465 “at-risk” amount (basically, the amount that the taxpayer has placed at risk in the venture and thus as to which deductions are allowed).  At-risk amounts are affected items to the extent they are not partnership items.  Treas. Reg. §301-6231(a)(5)-1(c).  The settlement agreement set out that the taxpayers’ at-risk amounts were equal to their capital contributions to the partnership and actually specified the dollar amount.  Thus, it is arguable that the affected item in Bush is actually a partnership item.  See Treas. Reg. §301-6231(a)(3)-1(a)(4)(i) (considering capital contributions generally as partnership items).  Regardless, it is certainly not an “affected item[] which require[s] partner level determinations” because it was finally resolved in the settlement agreement and the partner’s specific situation doesn’t affect it at all.  Therefore, no notice of deficiency was required under section 6230.  Having made it this far, even a blind squirrel in the dark TEFRA forest can find and crack the second nut; if the settlement agreement resolved the item, and if that item doesn’t require a partner-level determination, then a claim challenging the substantive application of that item is barred by section 6230(c)(4).

The foregoing analysis is consistent with Federal Circuit precedent.  Olson v. United States, 172 F.3d 1311, 1318 (Fed. Cir. 1999) (no notice of deficiency required where the computational notices involved “nothing more than reviewing the taxpayers’ returns for the years in question, striking out the [items] that had been improperly claimed, and re-summing the remaining figures”).  It is also essentially the analytical methodology applied by the Court of Federal Claims in denying the taxpayers’ refund claim.  See Bush v. United States, 78 Fed. Cl. 76 (Fed. Cl. 2007).  But someplace between here and there, the Federal Circuit majority got turned around over the definition of a computational adjustment vis-à-vis section 6230(a)(1).  It affirmed the trial court, but only after a convoluted analysis that began with the conclusion that the Service had erred in failing to issue a notice of deficiency to the taxpayers as a prerequisite to assessing the amounts agreed to in the settlement.

Section 6231(a)(6) defines a computational adjustment as “the change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.”  Perhaps this language, like much in TEFRA, could be clearer, but it is hard to imagine that Congress intended to give it the construction adopted by the Federal Circuit majority.  The majority read the statute as associating the term “change,” at the beginning of the subsection, with the term “partnership item,” at the end of the subsection; meaning that there always has to be a “change” in a “partnership item” in order for any adjustment to be “computational.”  However, based on the language itself, the statute is better read as including all situations involving a change in tax liability driven by any “treatment of a partnership item,” and not just those involving a “change” in that treatment.  The word “change” directly modifies only tax liability and the use of the word “treatment” (as opposed to “change”) to define the connection to a partnership item appears to be an intentional distinction.  Furthermore, any computational adjustment “affect[] items,” and “affected item” is defined as an item “to the extent such item is affected [not necessarily “changed”] by a partnership item.”  If the partner’s tax liability changed (which it did), and that change “properly reflect[ed] the treatment” of a partnership item (and didn’t require any partner-level determinations), it is a computational adjustment.  This reading also harmonizes sections 6230 and 6231 and is consistent with the broader purpose of TEFRA in unifying partnership proceedings and making partners’ returns consistent with partnership returns.  See generally section 6222 (which contemplates changes to partner returns by “computational adjustment” to make them consistent with partnership returns); see also Judge Prost’s concurrence, 599 F.3d at 1366.

But the majority disagreed.  And having made it this far into the woods, it turned around only to find that all of its breadcrumbs had been eaten.  Worse, it could see the right answer (the taxpayer loses), but couldn’t easily get there from its entanglement in the thicket of TEFRA.  Creatively, the majority got to the desired destination by stepping out of the TEFRA forest to stand on the federal harmless error statute, 28 U.S.C. §2111 (a provision, it is fair to say, that is not regularly seen in tax cases).  The Federal Circuit applied section 2111 to find that the Service’s failure to issue a notice of deficiency was harmless because the taxpayer had other methods to challenge the underlying issue including both their original proceeding and a hypothetical collection due process hearing.  See section 6330.  If you are not badly in need of a GPS at this point, you are doing very well.

The parties filed dueling petitions for rehearing.  The taxpayers did their best to take advantage of the panel opinion’s vulnerabilities (vulnerabilities that were created by the majority getting so tangled up in TEFRA it had to reach out of the tax code to solve the problem).  Positing that a valid assessment was a prerequisite for the Government to retain timely made payments, the taxpayer argued that section 6213 must be mechanically followed in order to legitimately assess taxes, and therefore the alternative methods suggested by the Federal Circuit would be ineffective and could not render the error harmless.  For its part, the Government tried to reorient the court to the correct reading of “computational adjustment” and pointed to Lewis v. Reynolds, 284 U.S. 281 (1932), which might allow the taxpayers a refund (due to some of the payments apparently being made after the assessment statute had closed) in spite of the court’s harmless error analysis.  (As an aside, on the valid assessment point, Judge Allegra’s recent opinion in Principal Life Ins. Co. v. United States, 2010 U.S. Claims LEXIS 856 (Fed. Cl. 2010), drawing from Lewis, nicely slays the chimera that is the “requirement” of “valid assessment” for non-time-barred years)

Thankfully, the Court vacated the panel opinion and granted rehearing en banc limited to the following four issues:

a) Under I.R.C. § 6213, were taxpayers in this case entitled to a pre-assessment deficiency notice? Were the assessments the results of a “computational adjustment” under § 6230 as the term “computational adjustment” is defined in § 6231(a)(6)?

b) If the IRS were required to issue a deficiency notice, does § 6213 require that a refund be made to the taxpayers for amounts not collected “by levy or through a proceeding in court”?

c) Are taxpayers entitled to a refund under any other section of the Internal Revenue Code? For example, what effect, if any, does an assessment without notice under § 6213 have on stopping the running of the statute of limitations?

d) Does the harmless error statute, 28 U.S.C. § 2111, apply to the government’s failure to issue a deficiency notice under I.R.C. § 6213? If so, should it apply to the taxpayers in this case?

The parties are in the process of briefing these issues.  We are hopeful that the Court has found its compass and is diligently working its way out of the trees.  Harmless error has nothing to do with the resolution of this case and neither do the technicalities of assessment.  The taxpayers agreed to the treatment of various items in a partnership proceeding.  There was no need for a partner-level determination in order to compute an adjustment with respect to those items.  Therefore, no notice of deficiency was required.  If the taxpayers had a complaint about how those calculations were performed that did not involve a substantive challenge to the agreed at-risk amount, they would have a claim.  They don’t, so they lose.

The Curious Non-Appeal of Veritas

Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial.  The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development.  Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property).  The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.

The Tax Court held for the taxpayer in substantial part.  Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever.  This is Gunnery Sergeant Hartman’s valuation method:

Marines die, that’s what we’re here for.  But the Marine Corps lives forever.  And that means you live forever.  Full Metal Jacket (1987).

Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.

The Tax Court is correct.  The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either.  The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts.  Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former.  Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates.  Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.

In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous.  However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim.  The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas.  The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.

This attempt by the IRS to use an AOD to continue to harass taxpayers should fail.  The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments.  And it did not exclude the possibility of future product value flowing from that original IP.  Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value.  The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity.  (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.)  IP does give competitive advantages that do not necessarily disappear in next generation product developments.  However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business.  Contra Litigating Treas. Reg. § 1.482-7T.

The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences.  The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers.  If it does not believe its position merits an appeal, the IRS should accept its loss.  Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them.  As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.”  The Veritas AOD is nothing but smoke.

Conversation with Bob Kirschenbaum Regarding Great Debate

We previously mentioned the IFA “Great Debate,” held on the campus of Stanford University on October 27, 2010, where the debaters squared off on the debatable utility of the Temporary Cost Sharing Regulations Income Method in valuing intangible transfers for transfer pricing purposes.  As forecast, the debate was extremely well-attended (notwithstanding the conflicting start of the first game of the World Series just up the road in San Francisco).   Bob Kirschenbaum and Clark Chandler drew the “pro” (i.e., you should never use the Income Method) while Jim O’Brien and Keith Reams drew the “con.”  After the debate, Bob and I kicked around his presentation, how things went, and how he feels about the issue generally.  The discussion seemed interesting enough to formalize and post. 

Did you enjoy arguing the “pro” position? Would you have preferred to have the “con” position?

We were prepared for either and I think Clark and I did a good job advocating.  However, I actually would have preferred the “con” position.  It is more interesting analytically because you get to drill down on how the Code and Regulations might be read to permit an income method analysis that would fairly measure the value of the IP actually transferred.   

With most taxpayers fighting the income method at Exam, wasn’t the “pro” position easier?

It is easier in the sense that the argument can be made very simply. That is true.  The argument goes like this: The existing cost sharing regulatory construct already enabled the evaluation of rights to the anticipated income stream without essentially disregarding the transaction as actually structured by the parties.   The “con” position, on the other hand, requires a more nuanced understanding of transfer pricing principles, what they are trying to achieve, and how one might go about constructing a set of variable inputs that could be used to indirectly derive the value of the IP transferred. 

Personally, do you think the income method has a place in transfer pricing practice?

I think it does.  However, Clark made a very persuasive argument that the Income Method as constituted in the Temporary Regs, while not to be discarded out of hand, becomes much more tenuous: (i) if the Regulations are read as mandating a counterfactual perpetual useful life of transferred IP (see Veritas v. Commissioner), and (ii) when coupled with the Periodic Trigger look-back provisions of the Temporary Regulations.  If fairly applied, and in the right circumstances, the Income Method can be a powerful convergence tool for valuing IP.  We have proven that in our dealings with Exam on cases where the IRS seeks to require CIP-compliant outcomes.  Obviously, it will never be as good as a valid CUT, but it can be useful and does have a place in the practice. 

What does the Tax Court’s recent decision in Veritas tell us about the viability of the Income Method?

At the end of the day, probably not much.  Veritas was a gross overreach by the IRS; ultimately, the decision is just Bausch & Lomb revisited.  Taxing a neutral transfer of business opportunity is not going to fly, nor is the imposition of a perpetual life for IP that produces premium profits for some limited number of years. That dog just will not hunt against a sophisticated and well-advised taxpayer.  But it certainly doesn’t mean that the Income Method, properly applied, is never useful. 

What do you see as the biggest errors the IRS makes in applying the Income Method?

 (1) The perpetual useful life edict, and (2) the implicit presumption of unlimited sustention of competitive advantage.  Technology progresses and, the fact is, legacy technology often doesn’t persist for multiple generations.  You could not find too many people in Silicon Valley—where I do a fair amount of my work—who would take the other side of that proposition.  Even where technology does persist for an extended period, the IRS at times contends that fundamentally new products, developed at great risk under Cost Sharing, owe their genesis entirely to foundational IP.  You cannot assume large growth rates decades out and try to allocate all of that value to the original IP.  At some point the competitive advantage associated with the pre-existing IP will dissipate. This is very basic finance theory.  There are certainly other concerns but these are the most glaring weaknesses in the application of the Income Method.

Petition for Certiorari Filed in Kawashima

As we expected, a petition for certiorari has been filed in Kawashima v. Holder, 615 F.3d 1043 (9th Cir. 2010).  To review, that case involves the question of whether pleas by Mr. and Mrs. Kawashima to section 7206 offenses of subscribing to false statements (and assisting same) as to their corporation’s 1991 tax return could be “aggravated felonies” under the immigration laws.  As noted in our initial blog post, the relevant section of 8 U.S.C. §1101(a)(43)(M), if read holistically, would seem to preclude that conclusion but a divided panel of the Ninth Circuit (after changing its mind a few times in the interim) ultimately held that section 7206 offenses do provide a basis for deportation.

In addition to pointing out the circuit split (the Third Circuit – in another divided panel – previously adopted the Kawashimas’ position), the petition cites myriad statutory construction cases for the premise that (M)(i), involving “fraud or deceit,” cannot encompass section 7206 when M(ii) specifically references only section 7201 (the crime of tax evasion).  We were disappointed to see that our favorite case on this subject (United Savings Association of Texas v. Timbers of Inwood Forest Associates, 484 U.S. 365 (1988)) wasn’t cited:

Statutory construction . . . is a holistic endeavor.  A provision that may seem ambiguous in isolation is often clarified by the remainder of the statutory scheme – because the same terminology is used elsewhere in a context that makes its meaning clear . . . or because only one of the permissible meanings produces a substantive effect that is compatible with the rest of the law.

Id. at 371.  Perhaps that gem will make it into a merits brief if certiorari is granted.

The petition also takes on the question of whether a section 7206 crime necessarily involves fraud, citing Considine v. United States, 683 F.2d 1285 (9th Cir. 1982) for the proposition that it doesn’t.  The petition also makes arguments based on rule of lenity as frequently applied in the immigration context.  See generally INS v. St. Cyr, 533 U.S. 289 (2001).

Finally, the petition presents a second question – an interesting procedural question of whether the Ninth Circuit acted outside of its authority under Federal Rule of Appellate Procedure 41 by amending its second opinion as to Mrs. Kawashima (which found she had not committed an aggravated felony on grounds that the loss amount has not been proven) after the date the mandate allegedly was required to issue as to her, because the petition for rehearing was filed only as to Mr. Kawashima.  This is a potential home-run argument for one of the petitioners, but the question lacks the broad applicability that would ordinarily interest the Supreme Court.  The Court is free under its rules to grant certiorari limited to one of the questions presented in the petition if it so chooses.  It will be interesting to see if it does so in this instance.

The government’s response is currently due on December 2, but the government routinely requests extensions of 30 days or more to respond to petitions for certiorari.  The Court can be expected to rule on the petition early in 2011.

Briefing Completed in Castle Harbour (Again)

On October 15, 2010, the government filed its reply brief in TIFD III-E Inc. v. United States, No. 10-70 (2d Cir.) (“Castle Harbour”).  The brief is linked below.  For our prior coverage of the case, see here and here.

In its reply, the government contends that I.R.C. section 704(e)(1) is inapplicable to the facts of the case, and that the provision only applies in the family partnership context, where parties are related.  The government asserts that section 704(e)(1) was not intended to apply, and indeed has never before been applied (and upheld) to an arm’s length transaction between two or more corporate entities.

Even assuming section 704(e)(1) applies, the government argues that the Dutch banks did not possess “capital interests” under the statute, because “capital interests” are legally equivalent to bona fide partnership interests, which the Second Circuit has already determined the Dutch banks did not possess.  In essence, the government argues that the test under section 704(e)(1) is the same as the test under Commissioner v. Culbertson, 337 U.S. 733 (1949), and the Second Circuit having made its determination under that test, it is now law of the case that the Dutch banks did not have “capital interests.”

On a similar tack, the government also argues that under the facts of the case, the banks did not possess capital interests in the purported partnership.  The government attempts to rebut the taxpayer’s fact arguments by arguing that a number of these fact issues were previously considered by the Second Circuit, with the court rejecting them as support for the conclusion that the banks had a meaningful equity participation in the partnership.

With respect to section 704(b), the government asserts that the taxpayer’s discussion of 704(c) is a red herring, and that the section 704(b) substantial economic effect test requires that tax results follow economic results; i.e., tax benefits and burdens must coincide with the related economic benefits and burdens.  The government argues that the transaction at issue plainly fails that test:  the taxpayer received $288 million of the partnership’s actual income, but only paid tax on $6 million.  Meanwhile, the Dutch banks received $28 million of the partnership’s actual income, but were allocated $310 million of it.

The government also reiterates its position regarding penalties:  the District Court’s misconstruction of the facts and misapplication of the law do nothing to abrogate asserted penalties, and that the taxpayer really did not have substantial authority for its return position.

TIFD v US (Appellants Reply Brief 10-15-10)

Response Brief Filed in Castle Harbour Redux

On September 14, 2010, the tax matters partner (“TMP”) for Castle Harbour LLC filed its response brief in TIFD III-E Inc. v. United States, No. 10-70 (2nd Cir.) (brief linked below).  For our prior coverage of this case, see here.  As many readers are no doubt aware, this is the second time this case is before the Second Circuit.

In the response brief , the TMP frames the issues as: (1) whether the district court, upon remand, correctly determined the investment banks were partners under I.R.C. section 704(e)(1), (2) whether the IRS can reallocate income under I.R.C. section 704(b) despite the section 704(c) “ceiling rule,” and (3) whether the district court correctly decided that I.R.C. section 6662 accuracy-related penalties were not applicable.

First, the TMP argues that section 704(e)(1) creates an independent, objective alternative to the Culbertson test, with the critical issue being whether the purported partner holds a “capital interest.”  The TMP contends that, because the banks’ interests were economically and legally equivalent to preferred stock, and because preferred stock is treated as equity for tax purposes even though it possesses many characteristics of debt, the banks held “capital interests” under section 704(e)(1).  Accordingly, the TMP argues that the banks were bona fide partners in Castle Harbour, the Second Circuit’s application of Culbertson notwithstanding.

Second, the TMP contests the IRS’s ability to reallocate income under I.R.C. section 704(b) in spite of application of the section 704(c) ceiling rule (assuming the banks were bona fide partners).  The regulations under section 704(c) were amended to allow such a reallocation for property contributions occurring after December 20, 1993, which is after the contributions at issue in the case.  Accordingly, the TMP takes the position that the IRS is attempting an end-run around the effective date of the amended regulations.

Finally, the TMP also argues that victory at trial, based on the careful findings of fact by the district court, demonstrates that the transactions were primarily business-motivated, and furthermore, that substantial authority existed for the TMP’s return position.  Accordingly, the TMP contends that accuracy-related penalties should not apply, even if the IRS’s adjustment is ultimately upheld.

Taxpayer Response Brief in Castle Harbour II

Schizophrenic Application of Tax Penalties (Part III)

We have been promising a post on the application of the section 6664 reasonable cause and good faith defense to tax penalties as it relates to reliance on tax advisers.  Here it is.

There has been much activity in this area in the district courts and the Tax Court and not much winnowing or rule setting in the circuits.  This is understandable; the application of the standards is highly factual and is well-placed in the hands of trial judges.  We will analyze here some potential inconsistencies in two recent high-profile section 6664 decisions, Canal Corp. v. Commissioner, (Slip Op. attached) (August 5, 2010) (which found reasonable cause and good faith lacking) and NPR Invs., LLC v. United States, (E.D. Tex. Aug. 10, 2010) (which found reasonable cause and good faith met).

Canal Corp.

In Canal Corp., the Tax Court considered the application of section 6664 to a should-level PricewaterhouseCoopers opinion.  (In the parlance, a “should-level” opinion means that the transaction “should” be upheld; it is a higher standard than more-likely-than-not, which means only that the transaction is more, perhaps only 51% more, likely to be upheld than not.)  The Canal Corp. transaction emerged from the decision of a predecessor of Canal Corp., Chesapeake Corporation, to dispose of its tissue business, WISCO.  After seeking advice from PwC and others, Chesapeake decided to dispose of the business by forming a partnership with Georgia Pacific to which WISCO would contribute its assets and liabilities and from which WISCO would receive a distribution of cash.  The cash was funded by the new partnership borrowing money, and that debt was indemnified by WISCO.  In essence, the substantive question presented to the court was whether the contribution/distribution amounted to the formation of a partnership (which would not trigger the built-in gain on the WISCO assets) or, rather, a sale of those assets to GP (which would).

In addition to helping structure and advise on the transaction, PwC was asked to prepare the aforementioned opinion.  The partner writing the opinion was not the historic PwC engagement partner but rather an expert from the Washington National Tax group of PwC.  PwC charged a flat fee of $800,000 for the opinion.  Because the area of the law was relatively unclear, the opinion relied on analogy and analytics to reach its conclusions (including a withdrawn revenue procedure that set out tests to apply for advance rulings in a different area); there was apparently little direct authority available to cite.  The parties effectuated the transaction on the day that PwC issued the opinion.

The Tax Court determined that the transaction was a disguised sale.  This was based largely on the court’s conclusion that the indemnity by WISCO was illusory and thus that WISCO should not be allocated any amount of the partnership’s liabilities.  If WISCO had been allocated these partnership liabilities then the transaction would be viewed as a financing transaction and not a sale.  After all, you can’t call something a sale if the seller gets left holding the bag for the purchase price.  But the court found WISCO’s bag empty and proceeded to penalties.

The Canal Corp. court began its analysis of section 6664 by recognizing that “[r]easonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and, in a manner consistent with ordinary business care and prudence, relies on the adviser’s professional judgment as to the taxpayer’s tax obligations.” Slip Op. at 31.  However, the court noted that such advice “must not be based on unreasonable factual or legal assumptions” and cannot be relied upon when given by an advisor “tainted by an inherent conflict of interest.”  Id. at 32.  Citing Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), a case involving promoters of master recording leasing programs, the Court concluded that a “professional tax adviser with a stake in the outcome has such a conflict of interest.”  Id.

Applying these conceptual standards to the PwC opinion, the Tax Court found it lacking.  At the outset, the court thought it incredible that significant time had been spent on an opinion so “littered with typographical errors, disorganized and incomplete.”  Id. at 33.  The Court’s confidence in the opinion was further undermined by the fact that only a draft could be found and the author (even after presumably being prepared for trial) did not recognize parts of the opinion when asked about them in court.  On the question of assumptions generally, the lack of specific citation in support of the opinion’s premises and the frequent use of terms such as “it appears” in the place of hard analysis was also troubling for the court, which found it unreasonable that anyone would issue a should-level opinion on analogy and analytics with no direct support for the position.  The Court found the author’s testimonial responses to challenges on these points unsettling and bluntly concluded that the only reason the opinion was issued at the should level was that “no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion.”  Id. at 35.

On the question of a conflict of interest, the Court found a large one.  Commenting that it “would be hard pressed to identify which of his hats” the author was wearing when he rendered the opinion, the Court concluded that the author’s work in developing, planning, structuring, and implementing the transaction took away too much of his independence (which the Court found to be “sacrosanct to good faith reliance”) to allow him to objectively analyze the merits of the transaction.  Slip Op. at 36-38.  Given that the only hurdle to closing the transaction was, in the end, the $800,000 flat fee opinion, the Court found that Chesapeake was attempting to buy “an insurance policy as to the taxability of the transaction.”  Id. at 37.  The Court voided the policy.

NPR 

NPR involved a transaction the IRS characterized as a “Son of BOSS” transaction involving offsetting foreign currency options.  As explained by the Court, the IRS’s view of a Son of BOSS transaction is “a series of contrived steps in a partnership interest to generate artificial tax losses designed to offset income from other transactions.”  Slip Op. at 2 n.3.  It is fair to say that Son of BOSS transactions are considered by the IRS to be one of the “worst of the worst,” so much so that they are the only transaction that is specifically barred from being considered by IRS Appeals.  See Announcement 2004-46, Sec. 5 (May 24, 2004).  Indeed, NPR conceded the merits of the transactions at issue prior to the decision.  Accordingly, the only items considered by the district court were a period of limitations issue (which we will not discuss here) and the penalties.

After working through the background elements of section 6662, the district court in NPR began its analysis in a similar way to the Tax Court in Canal Corp., setting out both the restrictions on relying upon unreasonable assumptions and on a conflicted adviser.  Slip Op. at 24-26.  The conclusion, however, was quite different.  Finding that the taxpayers were “not tax lawyers” and were not “learned in tax law” the court held that their reliance on the more-likely-than-not opinion of R.J. Ruble (who, at the time of the court’s ruling, had already been convicted of tax evasion associated with the rendering of tax opinions) was reasonable based on its findings that the opinion reached “objectively reasonable conclusions” and detailed a “reasonable interpretation of the law” (albeit one that the taxpayers conceded before trial).  Id. at 27-28.  Critically, the Court found persuasive the taxpayer’s plea that they, as unsophisticated men, sought out the advice of professionals who they did not know were conflicted and followed that advice; “what else could we have done except follow their advice?” Id. at *28.

Comparison

As shown above, the differences between Canal Corp. and NPR are not differences in legal standards but differences in fact-finding.  Both courts invoked and applied the same standards and prior interpretations of those standards; they just applied them to different facts as each judge found those facts.  That is exactly what trial courts are supposed to do; take legal standards and do the hard work of applying them to the myriad fact patterns that arise.  Viewed from that perspective, there is nothing in conflict between the two rulings; different facts support different results.

In a sense, the “inconsistencies” give a certain comfort in the decisions of both courts.  Judges say what the law is, that is true.  But more relevant to a trial lawyer, in a bench trial, they say what the facts are.  In both Canal Corp. and NPR, the judges reached a conclusion based on their common-sense perceptions of what happened in the courtroom.  While they can (and likely will) be second-guessed, that is their job.  The NPR court was not swayed by all of the IRS’s anti-Son-of-BOSS rhetoric.  Rather, the court evaluated the honesty and integrity of the specific taxpayers before it, their options (not the foreign currency kind) and their knowledge, and decided that no more could reasonably be asked of them.  Similarly, the Canal Corp. court wasn’t swayed by the involvement of a major accounting firm in a business transaction between two large, sophisticated companies.  Instead, the court looked at the analytics and thoroughness of the opinion, the involvement of the author in the transaction (including what he was paid), and his credibility on the stand, and concluded that it was unreasonable for a sophisticated consumer of tax advice to rely on his opinion.  Whether you agree with the fact-finding (which is tough to do if you didn’t sit through both trials), the fact-finding has to be separated from the analytics; the analytics were sound (and consistent).

Viewed from the perspective of the tax planner, however, justifying the different outcomes on the basis of different fact-finding does not provide much comfort.  Most tax planners would turn up their nose at a Son of BOSS opinion given to a group of individual investors to generate relatively large foreign currency options losses on a relatively minor investment.  Yet a significant number have criticized the Tax Court’s opinion in Canal.  Perhaps the distinction is just based on an “I know [a good transaction] when I see it” analysis, but many view what Canal Corp. did as “legitimate” tax planning and believe that a PwC advisor from the esteemed Washington National Tax group should have been viewed as more credible than a convicted felon.  However, when a judge looks into the eyes of the adviser and doesn’t like what she sees, the taxpayer is at grave risk on penalties.  Similarly, when the written product is capable of being analytically questioned, even undermined, based on sloppiness and lack of support or detail, a judge can be expected to have a negative reaction to that work product.  That negative reaction will carry over to the credibility of its author, particularly where a substantial fee was received.  On the flip side of the coin, if the judge finds the taxpayer honest and forthcoming about what he believed and what he tried to do to confirm that belief, the judge is likely to find reasonable cause and good faith.  In short, the way the judge perceives the facts determines the outcome; that is why they call it a facts and circumstances based test.

Asking for “consistency” in such matters amounts to nothing less than the neutering of the trial court.  “The ordinary lawsuit, civil or criminal, normally depends for its resolution on which version of the facts in dispute is accepted by the trier of fact.”  NLRB v. Pittsburgh S.S. Co., 337 U.S. 656, 659 (1949).  Indeed, rather than chasing the siren song of legal consistency, it is better to accept that fact-based tests like section 6664 belong to the trial lawyers to prove and to the trial judges to find.  While that may appear to create a lack of consistency, it doesn’t.  As we have shown, the inconsistency some see in Canal Corp. and NPR does not flow from an inconsistency in the law.  Rather, there is always unpredictability as to how the facts will be perceived by different decision-makers.  That is merely the uncertainty of litigation: the risk that a given judge on a given day may or may not believe your witnesses or your theory of the case.  This is necessarily so; “[f]indings as to the design, motive and intent with which men act depend peculiarly upon the credit given to witnesses by those who see and hear them.”  United States v. Yellow Cab Co., 338 U.S. 338, 341 (1949).  Said differently, what a lawyer (or a client) thinks the facts are doesn’t matter if they can’t convince the judge they draw to perceive the facts as they see them.  Making choices between “two permissible views of the weight of evidence” (id.) is precisely what trial judges are supposed to do and precisely what both of the judges in these cases did.  Appeals in both cases, if they are filed, will have to take this into account.

Securities Loan Case Before the Ninth Circuit

Lately, the IRS has had a successful run of attacking transactions involving purported securities loans.  See Anschutz Co. v. Commissioner, 135 T.C. 5 (July 2010); Calloway v. Commissioner, 135 T.C. 3 (July 2010); Samueli v. Commissioner, 132 T.C. 4 (March 2009).  Two of the cases, Samueli and Anschutz, involve the construction of I.R.C. section 1058, which provides for non-recognition treatment of a loan of securities that meets the following criteria: (1) the loan agreement provides for the return of securities identical to the securities transferred; (2) the agreement provides for payments to the transferor of amounts equivalent to all interest, dividends, and other distributions which the owner of the securities is entitled to receive during the period of the loan; and (3) the agreement does not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred.

In Samueli, the Tax Court held that a series of transactions between a taxpayer and a broker/dealer did not qualify for section 1058 treatment because the purported securities loan reduced the taxpayer’s opportunity for gain (the taxpayer was the lender of securities under the form of the transactions).  The transactions consisted of: (1) taxpayer’s purchase of $1.7 billion in mortgage-backed interest strips on margin (the broker/dealer allowed the taxpayer to purchase the securities on credit); (2) a securities loan of the interest strips back to the broker/dealer, with a transfer of $1.7 billion in cash collateral to the taxpayer; and (3) the taxpayer paying interest on the cash collateral at a variable rate (with the broker/dealer paying a relatively small amount of interest on taxpayer’s funds deposited in its margin account).  The arrangement further provided that taxpayer could recall the securities only on two specified dates during the term of the loan, or at maturity.  Ordinarily, securities loans are callable at any time.  The Tax Court determined that the limited ability of the taxpayer to retrieve its securities reduced the taxpayer’s opportunity for gain, because taxpayer did not have the right to take advantage of favorable swings in the price of the securities if they occurred at a time when taxpayer did not have the right to call the loan.

Interestingly, the Tax Court went a step further than merely holding that non-recognition treatment was improper under section 1058.  Cursorily invoking the substance-over-form doctrine, the court also held that as a matter of economic reality there was no securities loan at all; rather, in the court’s view there was a wash sale at the outset (purchase of the securities by taxpayer immediately followed by a resale to the broker/dealer for no gain), and a subsequent purchase under a constructive forward contract followed by a resale to the broker/dealer, resulting in a modest short-term capital gain.  Because there was no true indebtedness, the court held, taxpayer’s interest deductions were not allowable.

The taxpayer has appealed the Tax Court’s decision to the Ninth Circuit, and the case has been fully briefed.  The Tax Court’s opinion and the appellate briefs are linked below.  In the opening brief, the taxpayer argues that the Tax Court: (1) misinterpreted section 1058 by adding a “loan terminable upon demand” requirement, (2) erroneously construed the section 1058 requirements as the sine qua non of securities loans for federal tax purposes (cf. Provost v. United States, 269 U.S. 443 (1926) (for purposes of the stamp tax, the borrowing of stock and the return of identical stock to the lender are taxable exchanges)), (3) recharacterized the transactions in a manner inconsistent with their economic reality, and (4) even if the recharacterization stands, improperly treated the deemed disposition of the forward contract shares as short-term capital gain.

In its response, the government contends that the Tax Court correctly determined that the arrangement was not eligible for non-recognition treatment under section 1058 because it reduced the taxpayer’s opportunity for gain in the securities, contrary to section 1058(b)(3).  Furthermore, the government argues, the court correctly held that the overall arrangement was not a loan in substance, and therefore the purported interest paid on the collateral is not deductible.

In the reply, the taxpayer changes tack somewhat and argues that the focus on section 1058 heretofore has been a mistake by all involved.  The taxpayer contends that the tax treatment of the transactions should be the same regardless of the application of section 1058—long-term capital gain and deductible interest, based on the notion that taxpayer received basis in a contractual right at the outset, which was later disposed of at a gain, and that taxpayer’s payment of interest on the collateral was consideration for the broker/dealer’s forbearance of the use of the collateral.

We will continue to follow the case as it develops.  According to news reports, the taxpayer in Anschutz intends to appeal the Tax Court’s decision as well, and we will post on that case as soon as the appeal is filed (which will likely be in the 10th Cir.).

Samueli TC opinion

Samueli Opening

Commissioner’s Response in Samueli

Samueli Reply

The Best Minds in Transfer Pricing Spar Over the Income Method

Practitioners interested in the more interesting conceptual aspects of transfer pricing should mark October 27th on their calendars.  On that day, the International Fiscal Association is sponsoring a debate on the usefulness of the income method to value intangibles in the transfer pricing context.  Dubbed “The Great Debate” by IFA, this year’s event will pit the best transfer pricing practitioners in the world (including Miller & Chevalier’s Bob Kirschenbaum and Baker & McKenzie’s Jim O’Brien) against each other.  Neither will know which position they are arguing prior to a coin toss.  The gloves will surely come off and our current understanding is that the only thing missing will be a steel cage.  Attendance is limited to IFA members and special guests (which you can become by being sponsored by an IFA member).

Reply Brief Filed in Virginia Historic

The government filed its reply brief in Virginia Historic Tax Credit Fund 2001, LLC v. Commissioner, No. 10-1333 (4th Cir.), on September 1, 2010.  The brief is linked below.

In its reply, the government argues that the tax characterization of the investor transactions, i.e., whether the investments were equity contributions or merely the purchase of state tax credits, is subject to the de novo standard of review.  Accordingly, the government contends that the Tax Court’s determination that the taxpayers were bona fide equity investors is a question of law not subject to the more deferential “clear error” standard of review, as argued by the taxpayers.

In addition to reiterating its positions presented in the opening brief, the government also contends that the IRS has the power to recharacterize, for tax purposes, a transaction according to its substance, in spite of the fact that the parties may have adopted the form of the transaction for purposes other than tax avoidance.  The taxpayers argue that the form of the transactions was adopted in order to comply with state law limitations on the transfer of historic preservation tax credits, and therefore the form of the transactions should be respected for federal tax purposes.

The government also supplements its statutory disguised sale theory with the arguments that the transactions were “transfers” of “property” as those terms are employed in I.R.C. § 707 and the regulations thereunder, and that the taxpayers’ arguments regarding the existence of meaningful entrepreneurial risk are not supported by the record.

IRS Reply Brief (9-1-10)

Supreme Court in the Future for Kawashima?

On August 30, 2010, the Ninth Circuit granted Petitioner’s Motion to Stay the Mandate in Kawashima.  This stays the mandate in the case pending the filing of a petition for writ of certiorari and confirms our prior speculation that petitioner is going to try to make a run at the Supreme Court.  We will be watching the case with interest and will post the petition when it appears.

It’s No Fun Being a Legal Alien Either (If You Plead to a Tax Crime)

On August 4, 2010, the Ninth Circuit denied panel and en banc rehearing in a case applying 8 U.S.C. § 1101(a)(43)(M)(i) to hold that a tax offense other than tax evasion is a crime involving fraud or deceit and thus an aggravated felony under the immigration laws (which allows for deportation).  Kawashima v. Holder, 2010 U.S. App. LEXIS 16125 (9th Cir. Aug. 4, 2010).  This is actually the fourth opinion issued by the Ninth Circuit in the case, appending a three-judge dissent from denial of en banc rehearing to the third panel opinion issued back in January 2010. Kawashima v. Holder, 593 F.3d 979 (9th Cir. 2010).  (The first two panel opinions (Kawashima v. Mukasey, 530 F.3d 1111 (9th Cir. 2008), and Kawashima v. Gonzalez, 503 F.3d 997 (9th Cir. 2007)), were withdrawn so that the panel could reconsider the case in light of new Ninth Circuit and Supreme Court decisions.)  The Ninth Circuit has now placed itself squarely in conflict with the decision of a divided panel of the Third Circuit (Ki Se Lee v. Ashcroft, 368 F.3d 218 (3d Cir. 2004), in which then Judge (now Justice) Alito was the dissenter.  The Fifth Circuit, however, adopted the same basic reasoning as Kawashima in Arguelles-Olivares v. Mukasey, 526 F.3d 171 (5th Cir. 2008), cert. denied, 130 S. Ct. 736 (2009).

The primary question in these cases is one of statutory interpretation.  8 U.S.C. §1101(a)(43)(M) provides that an aggravated felony includes an offense that:

(i) involves fraud or deceit in which the loss to the victim or victims exceeds $ 10,000; or

(ii) is described in section 7201 of the Internal Revenue Code of 1986 (relating to tax evasion) in which the revenue loss to the Government exceeds $ 10,000;

Mr. Kawashima pled guilty to section 7206(1), a tax crime that involves subscribing to a false statement on a tax return; his wife pled to section 7206(2), a tax crime involving aiding and assisting in the preparation of a false tax return.  Neither pled to section 7201, tax evasion.

The dispute between the circuits rests on how much the interpretation of (M)(i) should be guided by the existence of (M)(ii).  As the Third Circuit and a strongly worded dissent in Kawashima both note, “statutory text must be read in context.”  2010 U.S. App. LEXIS 16125 at *28.  When read in context, it appears that the only tax crime that was intended to be covered is tax evasion as set out in (M)(ii).  This is so because if tax crimes are governed by (M)(i), then (M)(ii) would be superfluous.  Superfluities are a red flag in statutory interpretation.  See, e.g., Market Co. v. Hoffman, 101 U.S. 112, 115 (1879) (“We are not at liberty to construe any statute so as to deny effect to any part of its language. It is a cardinal rule of statutory construction that significance and effect shall, if possible, be accorded to every word.”).

The majority in Kawashima evaded this reasoning on the basis that if Congress had not wanted (M)(i) to apply to tax offenses “Congress surely would have included some language in that provision to signal that intention.”  U.S. App. LEXIS 16125 at *13.  Apparently, the language in the next clause, (M)(ii), doesn’t count.  And the majority’s opinion does not convincingly address the problem of creating superfluities.  Merely because the language of (M)(i) is broad enough to cover tax offenses other than tax evasion when that subsection is read in isolation, that doesn’t mean that one can divine Congressional intent to actually do so when the statute is read holistically.  Regardless, two circuits have now adopted the view that a tax offense other than tax evasion can be an “aggravated felony.”

It is too early to tell if a petition for certiorari will be filed in Kawashima but given the split and the substantial number of amici involved in the circuit filings, one might reasonably expect one.  That said, the same conflict was presented in Arguelles-Olivares yet the Court denied certiorari, apparently persuaded by the Solicitor General’s suggestion that the Court “should wait for further developments.”  Having the Ninth Circuit join the Fifth Circuit in agreeing with the government may not be the kind of development the Supreme Court had in mind.  A petition for certiorari would be due on November 2, 2010.  The final Ninth Circuit opinion and the United States brief in opposition in Arguelles-Olivares are attached.

Xilinx AOD Straightforward but Finds the IRS Still Intent on Redefining the Arm’s Length Standard

On July 28, 2010, the IRS released AOD 2010-33; 2010-33 IRB 1.  The AOD acquiesces in the result but not the reasoning of Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1196 (9th Cir. 2010) which held that stock option costs are not required to be shared as “costs” for purposes of cost sharing agreements under old Treas. Reg. §1.482-7.  For prior analysis of Xilinx see this.  The AOD in and of itself is relatively unsurprising.  New regulations (some might say “litigating regulations”) have been issued that explicitly address the issue, and those regulations will test the question of whether Treasury has the authority to require the inclusion of such costs.  The IRS surely realized that from an administrative perspective it was smart to let this one go.  The best move for most taxpayers is likely to grab a bucket of popcorn and watch the fireworks as a few brave souls test Treasury’s mettle by challenging the validity of the new regulations.  Including a provision in your cost sharing agreements that allow adjustments in the event of a future invalidation of the regulations might go well with the popcorn.

The only really interesting item in the AOD is the gratuitous bootstrap of the Cost Sharing Buy-In Regs “realistic alternatives principle.”  The still warm “realistic alternatives principle” – the IRS assertion that an uncontrolled taxpayer will not choose an alternative that is less economically rewarding than another available alternative – “applies not to restructure the actual transaction in which controlled taxpayers engage, but to adjust pricing to an arm’s length result.”  AOD, 2010 TNT 145-18, pp.4-5.  That assertion appears to ignore that “arm’s length” is not some obscure term of art cooked up by the IRS, but rather an established concept that lies at the heart of most countries’ approach to international taxation.

Still clinging to the withdrawn Ninth Circuit opinion, the AOD offers in support of this premise that “the Secretary of the Treasury is authorized to define terms adopted in regulations, especially when they are neither present nor compelled in statutory language (such as the arm’s length standard), that might differ from the definition others would place on those terms.”  Xilinx, Inc. v. Comm’r, 567 F.3d 482, 491 (9th Cir. 2009).

In short, the IRS appears to have dusted off the rule book of the King in Alice and Wonderland:

The King: “Rule Forty-two. All persons more than a mile high to leave the court.”

“I’m not a mile high,” said Alice.

“You are,” said the King.

“Nearly two miles high,” added the Queen.

“Well, I shan’t go, at any rate,” said Alice: “besides, that’s not a regular rule: you invented it just now.”

“It’s the oldest rule in the book,” said the King.

“Then it ought to be Number One,” said Alice.

Alice’s Adventures in Wonderland at 125 (Giunti Classics ed. 2002).  The IRS has often been disappointed with the real rule Number One (the arm’s length principle) when the results of real-world transactions do not coincide with the results the IRS desires.   Now the IRS looks to magically transform that rule into one that replaces those real-world transactions with the IRS’s revenue-maximizing vision.  Tax Wonderland is getting curiouser and curiouser.

Schizophrenic Application of Tax Penalties (Part II)

The last post in this series discussed differences in procedural posture that cause differences in the application of penalties.  Court splits in how the various and sundry penalty provisions in the Code are applied is an even more confusing area.  The two principal confusions are in the areas of TEFRA and valuation misstatements.  We will deal with TEFRA in this post.

Partnerships are not taxpaying entities.  They flow income, losses, deductions, and credits through to their partners who pay the tax.  Nevertheless, since Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324, 648-71 (TEFRA), some partnerships have been subject to audit (and litigation of those audit adjustments in court) directly at the partnership level.  Because individual partners still have tax issues that are not related to the partnership, tax items have to be divided between those that are handled in the partnership proceeding (so-called “partnership items”) and those that are handled at the level of the partners (so-called “non-partnership items”).  (There is a third category of items that are affected by partnership items, appropriately named “affected items,” which we don’t need to address for purposes of this discussion.)  As one can imagine, dividing the partnership tax world up into these two sorts of items is not always the easiest thing to do where you have items that are factually affected both by actions taken by the partnership and by actions taken by the partners.

In an apparent attempt to clarify this treatment in a small way, in 1997 Congress decreed that penalties that relate to partnership items are determined at the partnership level (i.e., the penalties themselves are partnership items).  Seesection 6221.  The difficulty implementing this provision is that, although partnerships are subject to audit, they are often owned and run by people and those people are often the partners.  When one takes this fact into account in the context of the various penalty defense provisions, such as section 6664, which protects against penalties if a taxpayer has “reasonable cause and good faith,” you have a dilemma.  Namely, if penalties are determined at the partnership (and not partner) level, whose conduct can you look at to determine if the partnership (and not the partners) had reasonable cause and good faith?

Regulations require that if an individual partner invokes section 6664 as a personal defense, that invocation has to be done in a partner level proceeding (generally, a refund action after the TEFRA proceeding is completed).  Treas. Reg. § 301.6221-1(d).  The IRS position as to how this applies in practice appears to be that the only conduct that is relevant for purposes of applying section 6664 in a TEFRA proceeding is what the partnership did through its own non-partner employees or, perhaps (it is unclear), the “tax matters partner” who manages the tax affairs of the partnership.  From the IRS perspective, if a partner asserts conduct for purposes of section 6664, that assertion has to be parsed to see if the partner intended his or her conduct to be attributed to the partnership or, rather, asserted it on their own behalf.  See Pet. for Rehearing at 8-10, Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009) (Docket No. 07-40861) (the petition was denied, it is included here to show the IRS position).  Exactly how one is to conduct this hair-splitting (some might say hare-brained) analysis is hard to fathom.  The best evidence of whether a partner’s conduct was on his or her behalf, or the partnership’s, will be the partner’s own statement.  Presumably, any well-advised partner will say that he or she intended the conduct on behalf of the partnership if the desire is to raise the defense on behalf of the partnership, and only badly advised partners won’t.  Surely, this is not a sustainable test.

Courts are split.  The Fifth Circuit in Klamath rejected the IRS theory and looked to the actions of partners to impute reasonable cause and good faith to the partnership.  568 F.3d at 548.  The Court of Federal Claims had at least two competing views.  Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 703 (2008) generally went the same way as Klamath, looking to the managing partners’ actions.  But in what has to be the most thorough analysis of the issue, Judge Allegra in Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 520 (2009) ruled for the Government giving deference to: (i) the regulatory edict that actions of the partners are only to be considered in the later refund proceeding and not in the TEFRA proceeding; and (ii) the language of section 6664 and regulations thereunder, which focuses on “taxpayers” and distinguishes partnerships from taxpayers.  Based on the docket, Clearmeadow is not being appealed.

Regardless of your persuasion, at least Clearmeadow seemed to have debunked the idea that it could somehow matter (and, even more strangely, somehow be determined by the judge) whether the partner intended the conduct on his or her own behalf or on behalf of the partnership.  Id. at 521.  Relying on the discretion of a litigant to determine jurisdiction does seem off-base.  Yet that is exactly what the Federal Circuit did on appeal in Stobie Creek, affirming on the basis that the Court had jurisdiction because the partnership “claim[ed] it had reasonable cause based on the actions of its managing partner.”  Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1381 (Fed. Cir. 2010).  Given that the Court went on to find that there was no reasonable cause, a cynic might say that the Court was anxious to give itself jurisdiction so it could reject the penalty defense definitively and prevent the taxpayer from taking another bite at the apple in a later refund proceeding, perhaps in district court.  In any event, Stobie Creek has reignited the debate about whether a self-serving statement about intent controls jurisdiction and doesn’t seem to resolve the questions of: (i) when a partner is acting on his or her own behalf versus the partnership’s or (ii) whether the rules apply differently to managing versus non-managing partners.  The state of the law in this area of penalty application is indeed still schizophrenic.

The next post in the penalties series will skip past valuation allowances (where there is also a circuit split we will come back to) and deal with reasonable reliance on tax advisers (for which we will surely get some hate mail).

Schizophrenic Application of Tax Penalties (Part I)

Based our recent post on the Sala decision here, we have had several comments inquiring about the varied application of penalties in the “tax shelter” cases.   This is the first in a planned series of responses to those comments that will try to explain, iron out, or at least flag, some of the irregularities.

When looking at the application of penalties to “shelter” cases generally, procedural posture matters.  A good example of this is Sala.  Why did the 10th Circuit discussion in Sala omit penalties?  Because it was a refund case in which the taxpayer appears to have filed a qualified amended return (“QAR”) prior to being “caught” by the IRS.  See generally 26 C.F.R. § 1.6664-2(c)(2).  There is a discussion of whether Sala’s amended return was qualified in the district court opinion and that ruling apparently was not a subject of the appeal.  Sala v. United States, 552 F. Supp. 2d 1167, 1204 (D. Colo. 2008).  Thus, in a refund suit posture, there may be procedural reasons why penalties are inapplicable.

The refund claim situation is contrasted for penalty purposes with either deficiency proceedings or TEFRA proceedings.  In either of the latter, penalties cannot be abated by a QAR (at least as to the matter at issue) because the taxpayer must have a deficiency or adjustment (to income) in order to bring either action.  See generally sections 6212 and 6225-6.  Thus, in cases such as Gouveia v. Commissioner, T.C. Memo 2004-25 (2004), the Tax Court addressed (and imposed) penalties in a deficiency context.  And, in Castle Harbor, the courts addressed (but did not impose) penalties in the context of a TEFRA proceeding.  TIFD III-E Inc. v. United States, 2009 U.S. Dist. LEXIS 93853 (D. Conn 2009).  (We previously discussed the pending appeal in Castle Harbour here.)

While there is nothing mysterious about the foregoing, the different routes tax cases take can often cause an illusion that there is inconsistency in the application of penalties when, in fact, the cases are just procedurally different.  One other area in which this confusion is particularly common (and an area in which there is a bit of a dispute as to the correct application of the law) concerns whose behavior “counts” for purposes of the sections 6662 (reasonable basis) and 6664 (reasonable cause and good faith) defenses in the context of a TEFRA proceeding.  We will address that issue in our next post on penalties.

Appellees’ Response Filed in Virginia Historic

The Appellees filed their response brief yesterday in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (4th Cir.) (linked below).  Our previous discussion of the case is here.

The government has advanced two basic arguments.  First, it argues that the partners of the state tax credit partnerships were not bona fide partners that made capital contributions; rather, the government contends, the alleged partners were, in substance, purchasers of state tax credits.  As such, the proceeds of these sales transactions are gross income to the partnerships, not non-taxable contributions to capital.  In making this argument, the government focuses on the fact that the alleged partners had no possibility of realizing any economic benefit from their purported investments other than the acquisition of state tax credits at a discount from their face value.  Second, the government argues that even if the partners were bona fide partners, the disguised sale rules under I.R.C. § 707 apply to recharacterize the transactions as taxable sales of property by the partnership to the partners acting in non-partner capacities.

The Appellees (comprised of two of the tax credit funds at issue and their tax matters partner) contend that the investors in the tax credit funds were bona fide partners for federal income tax purposes because they pooled their capital with the intent of sharing in a pool of non-federal-tax economic benefits pursuant to partnership allocation provisions under state law.  Relying on Frank Lyon Co. v. United States, 435 U.S. 561 (1978), Appellees further contend that the partnership form of the transactions at issue was compelled by state-law regulatory realities (Virginia law prohibits the direct transfer of historic preservation tax credits), and thus the form should be respected.  With respect to the government’s I.R.C. § 707 argument, Appellees argue that the disguised sale rules do not apply where, as here, the partners were acting in their capacities as partners, the alleged consideration constitutes a contribution to capital, the partnership allocates tax attributes as opposed to transferring property (i.e., the state tax credits are not property), and there is a meaningful sharing of risk among partners.

Stay tuned—the Fourth Circuit’s decision could have a substantial impact on the question of the nature of a partner for federal income tax purposes and the scope of the disguised sale rules, as well as substance-over-form principles generally.

Virginia Historic Appellee Brief

Tenth Circuit Reverses District Court in Sala

In a brief (and some might say terse) opinion, the Tenth Circuit has reversed the District Court in Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008)  (decision linked below).  As many readers will recall, Sala was considered an outlier among the tax shelter cases litigated over the past few years, with the taxpayer winning at trial in a Son-of-BOSS case.  See our prior discussion of the case here.

Citing to Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356 (Fed. Cir. 2006), and Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4th Cir. 2006), the Tenth Circuit focused narrowly on the specific transaction that gave rise to the claimed tax benefits, thus adding to the emerging trend of using a narrow definition of the transaction to defeat the efforts of tax planners. It remains to be seen whether the Tenth Circuit and other courts will embrace Coltec as closely when confronted with more traditional tax planning, rather than a Son-of-BOSS tax shelter.

Following its own precedent and a well-established approach to analyzing economic substance, the court concluded that the loss-generating transaction lacked economic substance.  In making this determination, the court considered both the taxpayer’s subjective business motivation in entering into the transaction, as well as whether the transaction had “objective economic substance.”  After engaging in a “common-sense examination of the evidence as a whole,” the court found it “clear that the transaction was designed primarily to create a reportable tax loss that would almost entirely offset Sala’s [tax year] 2000 income with little actual economic risk.”  The court also held that the “existence of some potential profit” is insufficient to imbue a transaction with economic substance where the purported tax benefits substantially outweigh the potential economic gains.  Holding for the government on the dispositive economic substance issue, the court declined to reach any of the other issues raised.

With this decision, Sala moves from being an interesting outlier to just another case in the mainstream of tax shelter decisions.  It is very unlikely that the taxpayer will be able to interest the en banc court or the Supreme Court in further review.  If he wants to try, a rehearing petition would be due on September 7 and a cert petition would be due on October 21.

Sala Tenth Circuit Opinion

Welcome to the Tax Appellate Blog!

The Tax Appellate Blog is a new blog dedicated to covering important tax cases pending before the various federal  courts of appeals that are of interest to practitioners and others who follow the development of federal tax law. We will try to post regularly as developments warrant, and we welcome commentary from the broader tax law community. We also plan to provide links to the pleadings and other pertinent documents in those cases.  So, welcome aboard.

Tenth Circuit Engaged in Lengthy Deliberation in Sala

In what is considered by many an anomaly among the so-called “Son-of-BOSS” cases, the IRS lost the trial of a refund claim before the United States District Court for the District of Colorado in 2008.  See Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008).  As many readers are no doubt aware, “Son-of-BOSS” is the nickname given to a type of loss-generating transaction described in IRS Notice 2000-44 (“BOSS” stands for “Bond and Option Sales Strategy”).  In one variation of such transactions, a taxpayer both buys and sells options on a given position and then contributes these options to an investment partnership.  Relying on Helmer v. Commissioner, T.C. Memo 1975-160, which held that liabilities created by short option positions are too contingent to affect a partner’s basis in a partnership, the taxpayer takes a basis in its partnership interest equal to the value of the long options position (i.e., not offset by the short options position).  Later, the investment partnership is liquidated and the assets sold, or the taxpayer’s interest is sold, with the taxpayer claiming substantial losses on what, economically speaking, was a pretty safe bet.

In Sala, the taxpayer invested in foreign currency options and contributed them to a partnership managed by renowned foreign currency trader, Andrew Krieger.  The amount of losses generated by the transactions at issue coincidentally offset a huge slug of income the taxpayer had in 2000 (approximately $60 million).  Despite the government’s best efforts, the court found for the taxpayer, holding that the transactions possessed economic substance.  The court also rejected the government’s attempt to retroactively apply regulations that reject the Helmer decision mentioned above.

The government appealed the case to the Tenth Circuit (briefing is linked below).  The government argues that the trial court erred in a number of respects, including: (1) determining that the transactions to be analyzed for economic substance are the entire array of transactions associated with a “legitimate” investment program, as opposed to the discrete options transactions giving rise to the claimed losses; (2) implicitly determining that the loss was a bona fide loss within the meaning of I.R.C. § 165; (3) invalidating or refusing to apply Treas. Reg. § 1.752-6 (which contains a basis-reduction rule designed to nullify “Son-of-BOSS” transactions); and (4) denying the government’s motion for a new trial after one of the taxpayer’s key witnesses (Krieger) recanted his testimony after accepting a plea agreement on criminal charges of promoting illegal tax shelters.

The taxpayer responded by arguing that: (1) the rule of Helmer was applicable law at the time of the contested transactions and should be followed; (2) the court blessed each phase of the contested transactions as having substance, not just the entirety; (3) the government did not adequately raise the § 165 argument at trial, and the provision nonetheless does not disallow the taxpayer’s loss; (4) Treas. Reg. § 1.752-6, as applied, is beyond the authority granted by the statute; and (5) the government did not meet its burden for obtaining a new trial.

Oral argument was held on November 16, 2009, and subsequently the government has directed the court’s attention pursuant to FRAP 28(j) to three of its recent wins in similar cases (supplemental submissions linked below).  Given that the case has been fully submitted for several months now, a decision could be imminent. The length of deliberation also may indicate that the court will engage in a detailed analysis that could depart from the opinions of other courts.  Should the taxpayer prevail, the case could be viewed as giving rise to a circuit split on the appropriate framework for analyzing alleged tax shelters, which could also have far-reaching implications for the recently codified economic substance doctrine.

Sala District Court Opinion

Sala Appellant Brief

Sala Appellee Brief

Sala Reply Brief

Supplemental 1

Supplemental Response 1

Supplemental 2

Supplemental Response 2

Supplemental 3

Supplemental Response 3

Briefing Underway in Castle Harbour Redux

As many if not most tax practitioners are aware, Castle Harbour is the nickname of a partnership taxation case that has been the subject of a great deal of attention in recent years.  See TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94 (D.Conn. 2004), rev’d, 459 F.3d 220 (2d Cir. 2006).  The case involved a partnership arrangement that allocated 98% of the taxable income derived from fully depreciated aircraft leases to two foreign banks, even though the banks received only a relatively meager debt-like return on their partnership interests.  The IRS attacked the structure on two basic grounds: (1) that the overall arrangement was a sham, and (2) that the foreign banks were not bona fide equity partners, but rather held interests economically in the nature of secured loans.

The district court decided the case in the taxpayer’s favor, holding that the partnership arrangement was not a sham because there were legitimate business purposes for the deal, and the arrangement did have appreciable economic effects, even though the partners had tax avoidance motives in entering into the deal.  The Second Circuit reversed the district court on the IRS’ second argument, namely that the banks were not bona fide partners because they had no meaningful stake in the entrepreneurial success or failure of the venture.  The court’s holding was based on an application of the Supreme Court’s facts and circumstances test for bona fide partner status set forth in Commissioner v. Culbertson, 337 U.S. 733 (1949).  The Second Circuit remanded the case for further consideration of an alternative argument by the taxpayer—that the partnership was a “family partnership” under I.R.C. section 704(e).

In a somewhat surprising turn, the district court held that the banks were partners in a partnership under section 704(e), irrespective of the Second Circuit’s ruling applying Culbertson.  The government, of course, has appealed to the Second CIrcuit, No. 10-70.  The government’s brief is linked below.  The taxapayer’s brief is due September 14, 2010.

United States opening brief in TIFD

Fourth Circuit Briefing Underway in Partnership Disguised Sale Case

The Tax Court and the U.S. District Court in New Jersey recently issued the first two opinions construing I.R.C. section 707(a)(2)(B), which is somewhat remarkable given that the partnership disguised sale rules have been on the books since 1984. See Va. Historic Tax Credit Fund 2001 LP v. Comm’r, T.C. Memo 2009-295; United States v. G-I Holdings Inc. (In re: G-I Holdings, Inc.), 2009 U.S. Dist. LEXIS 115850 (D.N.J. Dec. 14, 2009).  The Government has appealed the Tax Court’s decision in Virginia Historic to the Fourth Circuit.

In Virginia Historic, the Tax Court rejected the IRS’s challenge to the use of partnerships as marketing vehicles for state tax credits.  Under Virginia law, taxpayers can receive tax credits for investment in historical renovation projects.   The tax credits are made available to stimulate investment in such projects because they are often unprofitable, and as a result, financing for the projects is often difficult to obtain.   Because of restrictions on the direct transfer of the tax credits, the taxpayers in this case set up several investment partnerships that pooled funds from many investors and then contributed the funds to several lower-tier developer-partnerships.   In exchange for investment in the developer-partnerships the upper-tier partnerships received partnership interests that entitled them to tax credits generated by specific projects.   The tax credits would then be pooled by the upper-tier partnerships and distributed to the investors.  The IRS took the position that the scheme was a disguised sale of tax credits in exchange for the investors’ cash.

In a memorandum opinion by Judge Kroupa, the Tax Court rejected the IRS’s disguised-sale contention largely on the basis that the investments were subject to the entrepreneurial risks of the enterprise.   There was a possibility that developers would not complete the projects on time or in a manner acceptable to the state agency overseeing the projects, which placed receipt of the tax credits at risk.   There was also the possibility that the upper-tier partnerships would not be able to pool sufficient credits to be able to make all of the promised distributions.  Although distribution of the credits was guaranteed by the partnerships, there was no guarantee that the partnerships would have sufficient resources to make the investors whole.  Accordingly, the court held that the investors’ capital was sufficiently at risk in order to avoid disguised sale treatment.  Significantly, the degree of risk associated with the acquisition of state tax credits was relatively small, especially given that the investment partnerships spread risk through the pooling of resources and the dispersion of those resources over many developer-partnership projects.

The government has filed its opening brief.  The taxpayer’s brief in response is due July 26, 2010.   We will continue to monitor the case and post the briefs as soon as they are available.

The district court in GI-Holdings, by contrast, did apply the disguised-sale rule of Code section 707(b).  The unpublished decision, linked below, contains a detailed discussion of the issue, but it is not yet an appealable order.  Proceedings in the district court have been stayed until September 2010, but there is a strong possibility that the case will be appealed to the Third Circuit after the remaining issues are resolved in the district court.

Virginia Historic Tax Court opinion

U.S. Opening Brief in Virginia Historic

GI-Holdings district court opinion