Briefing Complete and Argument Scheduled in CIC Services

The Supreme Court has scheduled oral argument in the CIC Services case for December 1.  As has been the practice at the Court since March because of the pandemic, the argument will not occur in person, but rather will be conducted by telephone.  And the questioning therefore will be more structured instead of the traditional free-for-all.  After the advocate is allowed to give a brief, two-minute introduction without interruption, each Justice then will have a turn to ask questions — approximately three minutes for each Justice beginning with the Chief Justice and moving on in descending order of seniority from Justice Thomas down to new Justice Amy Coney Barrett — with the advocate allowed a minute or so at the end to sum up.

The taxpayer’s reply brief (linked below) reemphasizes the textual arguments made in its opening brief.  It contends that the government’s efforts to distinguish unfavorable precedent essentially amount to trying to revive the old principle of “tax exceptionalism,” which the Supreme Court explicitly rejected in 2011 in the Mayo Foundation case.  By contrast, the taxpayer asserts, the government makes no “serious attempt to interpret the words of the statutory text” — even though textual analysis is the correct way to resolve the case.

In addition to the textual analysis, the reply brief argues that the taxpayer’s position is supported by examining the purposes of the Anti-Injunction Act and argues at length that a ruling for the government would create constitutional problems because it would require a taxpayer to run the risk of criminal prosecution in order to raise a pre-enforcement challenge to a reporting requirement.

CIC Services – Taxpayer Reply Brief

Government Brief Filed in CIC Services

The government has now filed its answering brief in CIC Services, defending the divided Sixth Circuit’s decision to dismiss an APA challenge to a reporting requirement on the ground that the lawsuit violated the Anti-Injunction Act.  See our previous reports here.

Like the taxpayer’s brief, the government focuses most of its attention on analyzing the statutory text.  Like the court of appeals, it argues that the terms of the statute literally apply because the penalties for noncompliance with the reporting requirements are defined in the Code as “taxes” and the lawsuit, if successful, would have the effect of preventing collection of those penalties if a taxpayer did not comply with the requirements.  The government distinguishes Direct Marketing Ass’n v. Brohl, 575 U.S. 1 (2015), on which the taxpayer relies, on the ground that that case did not involve requirements that were “enforced by taxes.”  The government rejects the argument that its position undermines the broad purposes of the APA, contending that the taxpayer does not need a pre-payment remedy because it would have an adequate post-payment remedy if it incurred the penalty and then filed a refund suit.  Contrary to the taxpayer’s argument, the government maintains that pursuing the post-payment remedy would not expose the taxpayer to criminal liability for “willfully” disregarding the reporting requirements.

The taxpayer’s reply brief is due October 8.  Oral argument has not yet been scheduled in the case and therefore will occur no earlier than November 30.

CIC Services – Government Answering Brief

Ninth Circuit Addresses Rules Governing Waiver of Work-Product Protection in Sanmina

In the Sanmina case, the Ninth Circuit dealt the government a defeat on appeal in its efforts to obtain the legal analysis contained in memoranda prepared by a taxpayer’s in-house counsel.  As we have described in our prior coverage of the case, the dispute involves in-house analysis of the tax consequences of a transaction.  DLA Piper later relied upon those memoranda in preparing a valuation report that was disclosed to the IRS.  The district court ruled that the memoranda were privileged to begin with, but the taxpayer’s actions waived both the attorney-client privilege and the work-product protection.

The Ninth Circuit affirmed in part and reversed in part.  It affirmed that Sanmina waived attorney-client privilege when it furnished the memoranda to DLA Piper for preparation of the valuation report.  But the Ninth Circuit held that there was no waiver of the work-product protection that required disclosure of Sanmina’s opinion work product.  As a result, Sanmina will not have to produce the legal analysis of its in-house counsel in response to the government’s summons.  (The court’s opinion does require production of the factual content contained in the memoranda.  Importantly, it also observes that its decision applies only now at the summons enforcement stage, but the waiver analysis might be different if the dispute were before a court.)

The court first made clear that the Ninth Circuit aligned with the law in other circuits that “work-product protection is not as easily waived as the attorney-client privilege” because of “the distinct purposes of the two privileges.”  It pointed specifically to United States v. Deloitte LLP, 610 F.3d 129, 140 (D.C. Cir. 2010), which explained that voluntary disclosure waives attorney-client privilege “because it is inconsistent with the confidential attorney-client relationship” but it does not necessarily waive work-product protection “because it does not necessarily undercut the adversary process.”  Rather, the Ninth Circuit held that work-product protection is waived only when voluntary “disclosure is made to an adversary in litigation or ‘has substantially increased the opportunities for potential adversaries to obtain the information'” (quoting the Wright and Miller treatise).  Quoting from Deloitte, the court emphasized that “fundamental fairness” is the touchstone for examining whether a waiver of work-product protection should be implied from a disclosure, observing that “self-interested selective disclosure” can be unfair to adversaries to whom the information is not disclosed.  The Ninth Circuit added, however, that “a court must be careful to impose a waiver no broader than needed to ensure the fairness of the proceedings before it.”

The court then applied these principles to Sanmina’s case.  It determined that there was clearly no waiver when Sanmina provided the attorney memos to DLA Piper because Sanmina had a reasonable expectation that DLA Piper would keep those memos confidential in the process of producing its valuation analysis.  But Sanmina’s disclosure of the valuation report to the IRS presented a more difficult question.  In the court’s view, Sanmina’s reasonable expectation that the attorney memos would remain confidential “became far less reasonable once Sanmina decided to disclose to the IRS a valuation report that explicitly cited the memoranda as a basis for its conclusions.”  That disclosure “increased the possibility that the IRS, its adversary in this matter, might obtain its protected work product” and thus Sanmina “engaged in conduct inconsistent with the purposes of the privilege.”

That conclusion by the court, however, did not end its analysis because the scope of any waiver must be “limited to what is necessary to rectify any unfair advantage gained by Sanmina from its conduct.”  And, the court observed, it was unclear “how the IRS has been unfairly disadvantaged” by Sanmina’s conduct while the case remains in the investigation stage.  In particular, the court expressly disagreed with the district court’s statement that, absent disclosure, the IRS would be required to accept the DLA Piper opinion without access to the foundational material.  “At this audit stage, the IRS is not required to accept the conclusions in the DLA Piper Report at all.”  Rather, it “could still proceed with its examination of Sanmina’s returns, conclude that Sanmina has failed to adequately support its claimed deduction with the DLA Piper Report and other documents provided, and disallow the deduction.”  The court concluded that Sanmina had implicitly waived its protection over the factual work product contained in the memos but that the scope of the implied waiver should not encompass the opinion work product found in the memos, which should not be “critical to [the IRS’s] assessment of the deduction’s legal validity.”  Therefore, that latter work product need not be disclosed to the IRS “at this stage of prelitigation.”

A petition for rehearing would be due on September 21.  A petition for certiorari would be due on November 5.  It does not seem likely, however, that either party will seek further review.

Sanmina – Ninth Circuit opinion

 

 

 

 

 

 

Briefing Underway in CIC Services

The opening briefs have now been filed in CIC Services, which involves the applicability of the Anti-Injunction Act, 26 U.S.C. § 7421(a), to an Administrative Procedure Act challenge to a reporting requirement that carries with it a “tax” penalty for noncompliance. See our prior report here. Showing a restraint that is fairly unusual today in Supreme Court litigation, the taxpayer’s brief (linked below) comes in well under the maximum length permitted by the Court’s rules. Showing somewhat less restraint, a variety of organizations and individuals filed a total of ten different amicus briefs in support of the taxpayer’s position.

The taxpayer’s brief argues that this is a simple case, controlled by the statutory text. In particular, the taxpayer argues that use of the terms “assessment” and “collection” in the statute refute the notion that it could apply to a challenge to a reporting requirement. According to the taxpayer, the prohibition against suits that “restrain” those activities means that the statute applies to “suits that actually stop the assessment or collection of a tax–not suits that merely inhibit future assessment or collection.” The brief relies for support on both the opinion of the Sixth Circuit judges dissenting from denial of en banc review and on Direct Marketing Ass’n v. Brohl, 575 U.S. 1 (2015), a Supreme Court decision involving the Tax Injunction Act, 28 U.S.C. § 1341, which the taxpayer describes as “a similarly worded state tax analog.”

The taxpayer makes two additional points apart from its focus on the statutory text. It argues that the Sixth Circuit’s decision frustrates the policy of the APA to facilitate pre-enforcement review while doing nothing to advance the purposes of the Anti-Injunction Act. And the taxpayer argues that the Sixth Circuit’s decision creates an unconstitutional system by allowing a taxpayer to challenge the reporting requirement only by first violating the requirement and thus exposing itself to criminal liability.

The government’s answering brief is due September 8.

CIC Services – Opening Brief for Taxpayer

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

Supreme Court to Hear Tax Anti-Injunction Act Dispute in the Fall

The Supreme Court granted certiorari in CIC Services, LLC v. IRS, No. 19-930, to address the scope of the Tax Anti-Injunction Act, 26 U.S.C. § 7421(a). The briefing in the case will occur over the summer, with oral argument to occur sometime in the fall.

The basic issue in the case is how narrowly to read the Act’s prohibition on actions seeking to enjoin “the assessment or collection of any tax.” That prohibition means taxpayers who dispute a tax assessment must pay their taxes first before they can litigate the dispute in a refund suit. The CIC case, however, did not involve a tax assessment or, really, tax liability at all (except in a very tangential way). Rather, the dispute was over the validity of an IRS notice imposing reporting and recordkeeping obligations on taxpayers entering into certain “micro-captive” insurance transactions. The plaintiffs sought to halt enforcement of the notice on the ground that it did not comport with APA notice-and-comment requirements. The district court, however, agreed with the IRS that the suit was barred by the Anti-Injunction Act because taxpayers who failed to report their transactions were subject to penalties that are classified by the Code as “taxes,” and the suit would have the effect of restraining the imposition of those penalties. The court reasoned that the lawsuit “necessarily operate[d] as a challenge to both the reporting requirement and the penalty or tax imposed for failure to comply with the reporting requirement.”

A sharply divided Sixth Circuit affirmed, denying the plaintiffs’ petition for a rehearing en banc by a narrow 8-7 vote. On top of that, Judge Sutton, who provided the swing vote for denial, wrote separately to explain that he thought the dissenters had the better reading of the Act but that the issue ultimately turned on the meaning of Supreme Court precedent and should be resolved by that Court without an unnecessary detour into en banc review.

Building off the dissents in the Sixth Circuit, and supported by several amicus briefs, the taxpayer argued in its cert petition that the decision below meant that “even patently unlawful IRS regulations can be insulated from review unless an individual is willing to risk the imposition of enormous fines and—in this case—prison time.” The government devoted most of its response to defending the Sixth Circuit’s construction of the statute on the merits, without saying much about the policy implications. The Supreme Court was persuaded that it needs to step in and resolve the issue, which may bode well for the taxpayer’s position.

The taxpayer’s opening brief is due July 15, and the government’s response is due September 8. The Court has not yet scheduled an argument date, but a November or early December date is likely.

Linked below is the cert petition (with an attached appendix that includes the decisions of the courts below), the government’s brief in opposition, and the taxpayer’s reply brief.

CIC Petition for Certiorari

Government Brief in Opposition in CIC

CIC Reply in Support of Certiorari Petition

Waiver of Attorney-Client Privilege and Work-Product Protection Issues Return to Ninth Circuit in Sanmina

We previously reported on the Ninth Circuit’s earlier consideration of attorney-client privilege and waiver issues in the Sanmina case here. That first appeal ended with a whimper of an unpublished opinion when the court of appeals decided that it could better assess the issues after the trial court had reviewed the relevant documents in camera. As explained in more detail in our previous reports, the taxpayer sought to protect the contents of two memoranda prepared by in-house counsel concerning the tax consequences of certain transactions. Those memoranda were furnished to DLA Piper for its use in preparing a stock valuation report. That 102-page report, which was turned over to the IRS in discovery, mentioned in a footnote that the authors had reviewed and relied upon these memoranda, but said nothing about their contents. In its remand order, the Ninth Circuit directed the trial court to determine whether (1) the memoranda were privileged and (2) whether the privilege was waived.

The case is now before the Ninth Circuit for a second time. After in camera review, the district court concluded that the memoranda were privileged, but it also held that both the attorney-client privilege and work-product protection were waived. The court stated that the attorney-client privilege was waived “when Sanmina voluntarily disclosed the memoranda to DLA Piper, not for the purpose of receiving legal advice, but for the purpose of determining the value” of the stock. That disclosure standing alone would not waive work-product protection because only a disclosure to an “adversary” waives that protection. But the district court concluded that work-product protection was also waived because it was contemplated that the DLA Piper report would be disclosed to the IRS, and the report “explicitly stated that DLA Piper based its conclusions on ‘the related documents provided by management’ and then referenced the memoranda by name.” The trial court found this analysis “dispositive,” but then stressed that, because the report explicitly stated that it relied on the memoranda, those memoranda also became discoverable because “it would be fundamentally unfair for Sanmina to disclose the valuation report while withholding its foundation” (citing Federal Rule of Evidence 502(a)). “Otherwise, the IRS or any other reader would be forced to simply accept the opinion without access to the foundational material.”

The taxpayer has appealed again from the ruling on remand. With respect to the attorney-client privilege, the taxpayer argues that it sought “tax advice” from DLA Piper, which it claims is a form of “legal advice” even if furnished by an accountant. It also argues that, even if the DLA Piper report were treated like expert testimony, the discovery rules would require disclosure only of “facts and data” considered by the expert, not the opinions of lawyers. The taxpayer’s appeal stresses that the content of the memoranda was not disclosed to the IRS and hence there was no waiver of work-product protection. And it rejects the court’s citation of Rule 502(a), maintaining that the rule addresses only the scope of a waiver, but cannot provide a basis for finding a waiver in the first place.

The government defends the trial court’s opinion, arguing that the taxpayer waived the privilege on two separate occasions. First, it states that the attorney-client privilege “was waived with respect to both memoranda when Sanmina voluntarily gave the IRS the valuation report that explicitly relied on them.” Second, it states that the taxpayer also waived the privilege as to both memoranda “when it gave them to DLA Piper for use in preparing the valuation report.” That latter disclosure, when combined with the subsequent disclosure of the valuation report to the IRS, “also resulted in the waiver of any work-product privilege” that attached to the memoranda. The government rejects the taxpayer’s focus on the fact that the “contents” of the memoranda were never disclosed to the IRS, contending that the taxpayer’s position misstates the law. (The government, however, abandons its previous position that the memoranda were not privileged in the first place, deferring to the adverse district court ruling on that point.)

This case should provide the court of appeals an opportunity to provide additional clarity regarding its precedents in this area. The government’s brief relies heavily on Weil v. Inv./Indicators, Research & Mgmt., Inc., 647 F.2d 18 (9th Cir. 1981), a case in which the court held that an investment fund’s disclosure that it had received certain advice from its Blue Sky counsel waived its ability to claim attorney-client privilege to withhold other portions of that advice. The taxpayer, for its part, relies heavily on a more recent decision, United States v. Richey, 623 F.3d 559 (9th Cir. 2011), which did not find a complete waiver where an appraiser had referred in his report to the contents of a file that contained privileged material. The taxpayer argues that Richey is the more analogous precedent, and in fact is “simply irreconcilable with the Government’s position here.” The government, by contrast, emphasizes that the Richey court remanded for further proceedings and followed Weil, and the government treats the case as having little bearing on the outcome here.

Oral argument in the case is scheduled for tomorrow, February 11, before a three-judge panel consisting of: Circuit Judge Johnnie Rawlinson (appointed in 2000 by Clinton), Circuit Judge Consuelo Callahan (appointed in 2003 by Bush), and Senior District Judge Susan Bolton (appointed in 2000 by Clinton). It is perhaps revealing that the court has allocated only 10 minutes per side for the argument, while the other three cases on the docket are scheduled for 15 minutes per side. That allocation may indicate that the taxpayer faces long odds in getting the district court decision reversed.

Sanmina II – District Court Decision on Remand

Sanmina II – Taxpayer Opening Brief

Sanmina II – Government Response Brief

Sanmina II – Taxpayer Reply Brief

Ninth Circuit Preparing for Oral Argument in Mazzei

We have previously reported at length on the taxpayers’ pending appeal in Mazzei involving the Tax Court’s rejection on substance-over-form grounds of what the IRS has described as an “abusive Roth IRA transaction,” notwithstanding the Sixth Circuit’s pro-taxpayer ruling in Summa Holdings regarding essentially the same kind of transaction.

Oral argument in the case is scheduled for February 14, and the Ninth Circuit has now announced the three-judge panel that will hear the case:  Senior Circuit Judge Jay Bybee (appointed by Bush in 2003), Circuit Judge Daniel Collins (appointed by Trump in 2019), and Senior District Judge Barry Ted Moskowitz (appointed by Clinton in 1995).

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

Briefing Complete in Mazzei

The taxpayers have filed their reply brief in Mazzei, completing the briefing.  The reply brief is colorful–perhaps to a fault–in critiquing the government’s arguments.  For example: the issue is whether a Roth IRA can hold stock in a DISC “without suffering multitudinous nasties at the hands of the Commissioner”; the government’s arguments are “disingenuous” and “odd” and the Tax Court performed “judicial alchemy”; and the cases cited by the government are “as devoid of landing space herein as Noah’s crow” [actually a raven, according to the King James Bible].

Looking beyond the rhetoric, which is unlikely to make a favorable impression on the Ninth Circuit judges, the reply brief makes the same basic points as the opening brief.  See our prior reports here.  It argues that the transaction in question fully complied with the Code and is materially indistinguishable from the Summa Holdings/Benenson transaction that has survived IRS challenges in three other circuits.  The government’s position assertedly boils down to arguing that “the tax result was too good to be true,” and that argument does not respect Congress’s decision to allow the use of the FSC structure.  And the taxpayers state that the cases the government relies upon are “inappropriate to the unique characteristics inherent” in a FSC.

Oral argument is yet to be scheduled and likely will not occur for several months.

Mazzei – Taxpayer Reply Brief

 

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

Government Brief Filed in Mazzei

The government has filed its response brief in Mazzei urging the Ninth Circuit to accept the Tax Court’s recharacterization of the taxpayer’s transaction using the substance-over-form doctrine.  See our prior reports here.  The government’s brief starts by highlighting the IRS’s issuance of Notice 2004-8, which related to certain “abusive Roth IRA transactions” between: (1) a taxpayer’s pre-existing business, (2) the taxpayer’s Roth IRA, and (3) “a corporation (the Roth IRA Corporation), substantially all the shares of which are owned or acquired by the Roth IRA.”  Notice 2004-8 identified potentially abusive situations where the Roth IRA’s acquisition of shares, the overall transactions, or “both are not fairly valued and thus have the effect of shifting value into the Roth IRA.”  A few years later, the Joint Committee on Taxation referenced Notice 2004-8 in discussing “abusive Roth transactions.”  The government cites Notice 2004-8 to attack the taxpayers’ argument that the transaction complied with Congressional intent.  But the Notice was issued years after the taxpayers in Mazzei entered into the transactions at issue, and the examples of “abusive transactions” referenced in the notice did not involve Foreign Sales Corporations (“FSCs”), which were used in Mazzei, or Domestic International Sales Corporations (“DISCs”), which were used in Summa Holdings.

The government also takes on the taxpayer’s reliance on the Summa Holdings cases by asserting that the courts in those cases did not address the “same issue.”  In particular, the government argues that the Tax Court’s decision in Summa Holdings v. Commissioner, did not reach the issue presented in Mazzei.  In that case, the Tax Court used the substance-over-form doctrine to recharacterize the entire transaction between the taxpayers, the operating business, the DISC, and the Roth IRAs.  The government points out that the Tax Court did not address the argument presented in Mazzei that the formal issuance of stock to Roth IRAs violated the substance-over-form doctrine.  Because the Tax Court did not address the stock issuance the First, Second, and Sixth Circuits were not presented with that issue on appeal.  Thus, the government argues that in Mazzei it is not asking the Ninth Circuit to “disagree with three other Circuits . . . but to consider a distinct issue that the other circuits did not consider.”

The government also argues that the Tax Court’s analysis of the Roth IRAs’ ownership of the FSC stock was appropriate because FSCs are “not immune from the operation of fundamental tax principles” (that is, substance-over-form). The focus of this argument is on the discrepancy in value between what the FSC could be expected to earn in commissions from the operating company and what the Roth IRAs paid for the stock in the FSC.  The government acknowledges that FSCs were created to produce a tax benefit but asserts that the rules providing for FSC tax benefits “do not extend to the purchase of FSC stock.”  Rather, the tax benefit provided by FSCs applies “only to transactions between FSCs and their related supplier regarding qualifying export sales.”  After acknowledging that regulations allow entities related to the owners of an operating company to own FSC stock and that an FSC does not require an economic purpose, the government contends that those facts do not support the conclusion “that dividends paid to that entity will automatically be respected for tax purposes as earnings from a genuine investment.”

Finally, the government argues that the Tax Court’s determination that the Roth IRAs did not own the FSC stock was supported by the record and that the taxpayers did not identify any error in the Tax Court’s factual analysis that would support reversal.  The Tax Court determined that the taxpayers (not the Roth IRAs) owned the FSC stock because the Roth IRAs paid very little for the FSC stock, the Roth IRAs put nothing at risk, and at the time the Roth IRAs entered into the transaction they could not have expected to receive any economic benefits (because the taxpayers retained complete control over the payment of commissions).  But those facts are likely applicable to most FSCs.  Disregarding a transaction because the owner of an FSC’s stock paid very little, put nothing at risk, and could not have expected to receive economic benefits (due to the FSC structure) appears to be at odds with the Congressional intent that FSCs would be valid entities that could be used by taxpayers to reduce their tax liability.  Under the government’s theory, it would be very difficult for anyone to be the “real” owner of an FSC, even though Congress sanctioned the use of these entities despite their lack of economic purpose.

The reply brief is due on April 26, 2019.

Mazzei – Government Answering Brief

 

Briefing Complete in Kisor

The petitioner has now filed his reply brief in Kisor, and the case is fully briefed in preparation for the oral argument later this week on March 27.  Given the government’s partial retreat from defending Auer deference (see our prior post here), which the petitioner describes as a “sharp retreat,” the reply brief responds to two different briefs.  First, it responds directly to an amicus brief by a group of law professors (linked in our prior post) that put forth a full-throated defense of Auer deference.  Second, it acknowledges that the government’s “Auer-light” position is “preferable to existing Auer deference,” but it still rejects that position and argues that complete overruling of Auer is the correct approach.  The reply brief concludes that the existing principles of Skidmore deference satisfactorily address the policy goals described in the government’s brief without improperly permitting “an agency to exert its expertise in binding fashion without any participation by the regulated public.”

Kisor – Petitioner 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

Government Brief Filed in Kisor

The government was faced with something of a dilemma in filing its response brief in the Kisor case addressing the level of deference owed to an agency’s interpretation of its own regulation. See our prior reports here. On the one hand, the government was defending the agency action in this case and the decision below, which rested on paying Auer deference to the agency’s interpretation. On the other hand, conservative legal theorists have long been critical of Auer deference, following Justice Scalia’s lead, and the views of the political appointees in this administration about Auer likely range from unenthused to hostile. But on the third hand, the government’s institutional interests would generally be better served by a strong principle of Auer deference, since that would make challenges to agency action more difficult.

The government’s brief attempts to juggle these conflicting imperatives, and the result is a bit schizophrenic. The bottom line is that the government argues that Auer should not be overruled, but that its applicability should be substantially narrowed. In the end, the government does not rely on Auer to defend the agency action in this case, but instead argues that the regulation is clear on its face without the need to consider the agency interpretation at all.  (Although outgunned by the cascade of amicus briefs filed in support of the petitioner, two amicus briefs were filed on the government’s side, including one by a group of administrative law professors (linked below) who argue that Auer “is sound and should be maintained.”)

The first, and longest, section of the government’s brief is a full-fledged assault on the doctrine of Auer deference. The government contends that the doctrine: (1) is not well grounded historically; (2) is not supported by any consistent rationale; (3) is in tension with the APA’s distinction between interpretive and legislative rules; and (4) can have harmful practical consequences by discouraging agency resort to notice-and-comment rulemaking. Notably, the government states that the reasons that support Chevron deference do not apply to Auer, and thus the brief does not signal that the current administration will argue against Chevron deference in a future case.

The government argues, however, that Auer should not be overruled because of stare decisis considerations, including that doing so “would upset significant private reliance interests” because it allegedly “could call into question” earlier decisions that rested on Auer deference. In contrast to the opening part of its brief, this section praises Auer deference where it is limited to “its core applications,” such as “when the agency announces its interpretation in advance in a widely available guidance document.” The government states that the task of choosing among reasonable interpretations is more appropriately performed by administrators than by judges, that Auer deference would promote national uniformity, that it recognizes the technical expertise of agencies, and that it fosters regulatory certainty and predictability—in contrast to a system “in which the meaning of a regulation must be determined de novo in every judicial proceeding.” In addition, the government disagrees with the petitioner’s argument that Auer deference poses a separation-of-powers problem, stating that an agency’s actions in making rules and conducting adjudications are both exercises of “executive power.”

Accordingly, the government proposes “significant limits” on the doctrine that will thread the needle, neither overruling Auer nor further entrenching it. First, the government states that deference should not be paid to an agency interpretation that is “unreasonable,” describing this seemingly benign limitation as a “rigorous predicate.” If the agency interpretation is judged to be within the range of reasonable readings of the regulation, then the government argues that deference is appropriate “only if the interpretation was issued with fair notice to regulated parties; is not inconsistent with the agency’s prior views; rests on the agency’s expertise; and represents the agency’s considered view, as distinct from the views of mere field officials or other low-level employees.”

It is hard to say at this point what the Court will do with the various permutations that have been presented to it for moving forward, but it appears that Auer deference in its current form stands on very shaky ground.

Oral argument is scheduled for March 27.

Kisor – Government Response Brief

Kisor – Amicus Brief by Administrative Law Scholars in Support of Auer

Briefing Underway in Kisor

The opening salvo has been filed in the Supreme Court challenge to the continuing vitality of what is usually called either Seminole Rock or Auer deference – the rule that a court owes deference to an agency’s interpretation of its own regulations. See our prior report here. The petitioner, a Vietnam veteran seeking disability benefits, has filed his opening brief, supported by 25 different amicus briefs.

The petitioner argues that Auer deference is unjustified for three principal reasons. First, petitioner contends that it is incompatible with the Administrative Procedure Act (APA) because it allows an agency to exercise lawmaking authority through administrative interpretation without adhering to the APA’s procedural safeguards of public participation and agency accountability through notice-and-comment rulemaking.

Second, petitioner argues that Auer is a judge-made rule that destabilizes administrative law because it allows an agency to receive deference to what may not be the best interpretation of a regulation, even if it is “reasonable.” That can unfairly confound an individual who can only try to conform his or her conduct to what appears to be the best interpretation of the regulation. Petitioner adds that Auer deference is “especially suspect . . . where the agency has an economic interest in the outcome,” such as when the interpretive issue relates to a monetary claim against the government.

Third, petitioner contends that Auer is incompatible with separation-of-powers principles because it “renders an agency simultaneously a law’s maker and its expositor.” That is in contrast to Chevron deference, which respects Congress’s power because it “rests on agency compliance with the APA.”

The petitioner adds that principles of stare decisis should not deter the Court from overruling Auer. He notes that this is a purely judge-made rule and that the seminal 1945 decision in Seminole Rock provided no reasoning for the doctrine. The petitioner also argues that “no private reliance interests rest on Auer’s continuing vitality” and that reexamination is warranted because of the substantial expansion of the role of administrative agencies in our government since Seminole Rock was decided.

Linked below is the petitioner’s brief and the amicus brief of Professor Thomas Merrill, a leading academic expert on administrative law, who argues that Auer should be overruled and that instead agency interpretations of regulations should be afforded the much more modest recognition of so-called Skidmore deference, which gives weight to an agency interpretation to the extent it has the “power to persuade.” Professor Merrill argues that “the persuasiveness standard would require reviewing courts to engage with and give respectful consideration to the agency’s experience in implementing the statutory regime and familiarity with its own regulations, respect that de novo review would not require.” Like the petitioner, Professor Merrill states that Chevron deference is consistent with the APA, and he does not suggest that the Court should retreat from Chevron. The other 24 amicus briefs can be found on the Supreme Court’s website.

The government’s response brief is due February 25. Oral argument has been scheduled for March 27.

Kisor – Petitioner’s Opening Brief

Kisor – Amicus Brief of Professor Merrill

Briefing Underway in Mazzei

The taxpayers have filed their opening brief in Mazzei urging the Ninth Circuit to reverse the Tax Court’s use of the substance-over-form doctrine to recharacterize transactions between Roth IRAs, a Foreign Sales Corporation (“FSC”), and an export company. The brief focuses on the similarities between the FSC-Roth IRA structure in Mazzei and the Domestic International Sales Corporation (“DISC”)-Roth IRA structure that the taxpayers implemented in Summa Holdings. Citing principles of comity and uniformity, the brief urges the Ninth Circuit to follow decisions of the First, Second, and Sixth Circuits in Summa Holdings and the related Benenson cases, which held that the IRS (and the Tax Court) could not use the substance-over-form doctrine to recharacterize code-compliant transactions between the DISC and the taxpayers’ Roth IRAs. See our prior report here. Rejecting the Tax Court’s attempt to distinguish its analysis in Mazzei from Summa Holdings, the brief characterizes the Tax Court’s fundamental holding as “yet another ‘substance over form’ attack on a transaction the Tax Court just doesn’t like.” And borrowing a pithy formulation from Fabreeka Prods. v. Commissioner, 294 F.2d 879, 879 (1st Cir. 1961), the brief contends that the Tax Court impermissibly overreached in recharacterizing the transaction because “[i]f there really is a hole in the tax revenue dike, the Congressional ‘thumb’—not the Tax Court’s—should be applied.”

The government’s answering brief is due on March 11, 2019.

Mazzei – Taxpayer Opening Brief

 

Ninth Circuit to Scrutinize Tax Court’s Invocation of Substance-Over-Form Doctrine in Light of Apparently Conflicting Decisions From Three Different Courts of Appeals

We present here a guest post from our colleague Nicholas Metcalf.

In Mazzei v. Commissioner, a divided Tax Court (12-4) relied on the substance-over-form doctrine to disregard transactions between the taxpayers, their Roth IRAs, and an FSC purportedly owned by the Roth IRAs. The Mazzei decision is at odds with three recent appellate decisions that rejected the IRS’s use of the substance-over-form doctrine to recharacterize similar transactions.

The Mazzei Decision.  The taxpayers—a husband, wife, and their daughter—owned and operated a company (“Injector Co.”) that sold and distributed injectors in both the United States and foreign markets. The husband was a member of the Western Growers Association (“WGA”), a trade association, which, among other things, created and sold interests in FSCs to its members before FSCs were phased out beginning in 2000. The taxpayers had joined the WGA FSC program, opened and funded Roth IRAs, and directed each Roth IRA to purchase 33-1/3 shares of a WGA FSC for $5 per share.

Pursuant to several agreements, each year Injector Co. had the option of paying the taxpayers’ FSC a commission based on the FSC rules set forth in former Code sections 921-927. When Injector Co. paid a commission, that commission was deductible to Injector Co. The commissions earned by the taxpayers’ FSC were taxed at a preferential rate, and the FSC issued dividends to the Roth IRAs for the remainder of the commission payment. Earnings on Roth IRA accounts and withdrawals upon retirement are generally tax-free. From 1998 through 2002, Injector Co. paid over half a million dollars in commissions to the taxpayers’ FSC, which then distributed the after-tax balance to the taxpayers’ Roth IRAs. The IRS was unhappy with the tax benefits achieved by this structure and asserted that the amounts transferred from Injector Co. to the Roth IRAs (through the FSC) were in substance dividends to the taxpayers and contributions to their Roth IRAs—a recharacterization that yielded substantial excise tax liabilities under Code section 4973. The taxpayers maintained that the payments at issue were income to the Roth IRAs (not contributions from the taxpayers) and therefore did not trigger the excise tax.

The Tax Court majority opinion resolved the case in the government’s favor by concluding that the taxpayers, not the Roth IRAs, were the “substantive owners” of the FSC. The Tax Court stated that the proper recipient of a dividend is determined under Commissioner v. Banks, 543 U.S. 426, 434 (2005), “by asking whether a taxpayer exercises complete dominion over the income in question.” The majority and dissent disagreed on the starting point for this inquiry, however, with the majority holding that the FSC was the income-generating asset, while the dissent concluded that Injector Co. was the income-generating asset because it generated the commission payments.

To determine who had dominion and control, the majority evaluated the purported ownership of the taxpayers’ FSC shares by the Roth IRAs from the perspective of an unrelated party. The Tax Court concluded that the Roth IRAs did not have the benefits and burdens of ownership because: (1) they were not subject to any risk given the negligible sum paid for the FSC shares (the court had found that all but $1 of the purchase price was actually a “fee” for access to the FSC); and (2) Injector Co. retained complete control over the decision to pay commissions to the FSC and therefore a FSC shareholder could not count on any upside benefits. The court concluded that “the Roth IRAs effectively paid nothing for the FSC stock, put nothing at risk, and from an objective perspective, could not have expected any benefits.” Hence, the majority ruled that the substance of the transaction did not match its form, and it disregarded the Roth IRAs’ purported ownership. Instead, the Tax Court held that the substantive owners of the FSC shares were the taxpayers, and therefore it recharacterized the transactions as dividends from the FSC to the taxpayers, followed by contributions from the taxpayers to the Roth IRAs. Those contributions were subject to excise taxes because they exceeded the applicable contribution limits.

The Sixth Circuit Decision in Summa Holdings.  The fact pattern in Mazzei was similar to the fact pattern in Summa Holdings v. Commissioner (“Summa I”), T.C. Memo. 2015-119, where the IRS also relied on the substance-over-form doctrine to recharacterize transactions between taxpayers, Roth IRAs, and a Domestic International Sales Corporation (“DISC”). As in Mazzei, the IRS argued in Summa I that the Roth IRA-DISC transactions should be recharacterized as deemed dividends from Summa to its shareholders followed by $1.1 million in contributions to the Roth IRAs—triggering excise taxes for excess contributions. The Tax Court agreed.

The taxpayers in Summa I appealed, and those appeals went to three different circuits because of the diverse residences of the taxpayers. While Mazzei was still pending in the Tax Court, the Sixth Circuit reversed the Summa I decision. Summa Holdings, Inc. v. Commissioner (“Summa II”), 848 F.3d 779 (6th Cir. 2017). The Sixth Circuit’s opinion opened with an acerbic reference to Caligula and his reported penchant for posting tax laws “in such fine print and so high that his subjects could not read them.” The Sixth Circuit analogized Caligula’s tax policy to the Commissioner’s exercise of the power to recharacterize transactions using the substance-over-form doctrine and thus produce different tax outcomes from those called for by the plain language of the Code. The court explained that the Summa transactions produced their intended results under a technical reading of the Code, stating that “[i]f this case dealt with any other title of the United States Code, we would stop there, end the suspense, and rule for Summa Holdings and the Benensons.” Recognizing that the Internal Revenue Code is treated differently, however, the court went on to consider the IRS’s arguments under the non-statutory anti-abuse doctrines of substance over form and economic substance. The court rejected those arguments, holding that neither the Commissioner’s perception of the transactions’ “substance” nor Congressional intent could justify recharacterizing the original transactions.

The Tax Court’s Response to the Sixth Circuit.  The Tax Court in Mazzei then ordered supplemental briefs to address Summa II, even though that decision was not directly controlling under the Golsen rule because appeal in Mazzei lies to the Ninth Circuit. The parties agreed that the only difference between the Mazzei transactions and the Summa transactions was the use of an FSC rather than a DISC. And the government agreed that the differences between an FSC and a DISC had no impact on the tax consequences of the transaction. The government argued, however, that Summa II was wrongly decided and urged the Tax Court to recharacterize the Mazzei transactions notwithstanding the Sixth Circuit’s decision.

When the Tax Court is reversed on an issue by an appellate court, custom dictates that the next case addressing that issue is considered in court conference where all the Tax Court judges evaluate the case and vote on whether to follow the appellate decision. In Mazzei, Judge Holmes was the trier of fact, and it is clear that his initial report would have upheld the taxpayer’s position following Summa II. Judge Holmes drafted a report to that effect that was submitted to court conference, but the majority disagreed with Judge Holmes’ report. The case was then reassigned to Judge Thornton who wrote the majority opinion joined by eleven other Tax Court Judges. Five of those twelve judges (including Judge Thornton) also joined a concurring opinion authored by Judges Paris and Pugh that sought to “emphasize” certain points in the interest of reducing the chances that the majority opinion would be given a broad reading. Finally, Judge Holmes issued a dissenting opinion joined in part by three other Judges.

The majority in Mazzei found that Summa II was not directly on point because it addressed only corporate-level issues with the Summa structure, not shareholder-level issues involving payments to Roth IRAs. (Those shareholder-level issues were the subject of appeals from Summa I to the First and Second Circuits). The majority also distinguished Summa II on the basis of the differences between DISCs and FSCs, though even the government had stated that those differences were immaterial. Specifically, the majority noted that Code section 995(g) “expressly contemplates that tax-exempt entities like traditional IRAs may own DISC shares,” which supported the Sixth Circuit’s determination that the Summa structure did not violate congressional intent. Summa II, at 848 F.3d at 782-784. By contrast, in Mazzei the taxpayers had to rely on caselaw to support the assertion that Roth IRAs can own FSCs (though that assertion was not contested by the IRS).

The Concurring and Dissenting Opinions in Mazzei.  The Mazzei concurring opinion stressed that the majority opinion did not require that FSCs have economic substance, did not disregard the Roth IRAs or the FSC, and did not hold that Roth IRAs could not own shares in FSCs. Rather, the concurrence emphasized that the majority opinion focused on one step in the transaction: “the purported purchase of FSC stock by the Roth IRAs for the nominal price of $1.” On the specific facts of the Mazzei transaction, the Roth IRAs’ purchase price for the FSC stock “did not reflect the substance of the transaction in the light of petitioners’ established capacity and intention to direct large commission payments from Injector Co. to the FSC.”

The dissent sharply (and colorfully) disagreed with the majority’s distinction of Summa II. The opinion began by noting the Sixth Circuit’s reversal in Summa II, describing it as “a case that was nearly identical to this one.” In an homage to the Sixth Circuit’s reference to Caligula, the dissent criticized the majority’s decision as follows: “[T]oday we have to choose either a well-reasoned opinion by a highly respected judge in America’s heartland, or Caligula. We pick Caligula.” The dissent explained that the majority’s distinction of Summa II was unpersuasive because DISCs and FSCs were “very similar—barely-there entities” that were “intentionally nothing more than ways to reduce exporters’ effective tax rates.”

More fundamentally, the dissent questioned the majority’s derivation of a dominion and control test from Commissioner v. Banks, which involved attorney contingency fees rather than dividends or corporate payments, and in any event disagreed with the majority’s determination that the FSC was the “income-generating asset.” Instead, the dissent concluded that Injector Co. generated the income at issue. The dissent asserted that the majority was failing to give effect to a determination made by Congress because the taxpayers’ FSC was simply a “congressionally sanctioned vehicle for reducing Injector Co.’s effective tax rates on exports.” Expressing concern over the broader potential ramifications of the decision, the dissent cautioned that the dominion and control test established by the majority could be used to attack other taxpayers who made small initial investments in their corporations and did not accurately predict future earnings.

The dissent also questioned whether the IRS was actually attempting to invoke the economic-substance doctrine rather than the substance-over-form doctrine. The dissent explained that while there is overlap between the two doctrines, “one way of thinking about substance-over-form is that it is a rule of tax law that directs courts to decide ambiguous questions of fact by looking to the realities of a situation and not the labels parties put on them.” And “[o]ne way of thinking about the economic-substance doctrine is that it is a rule of tax law that directs courts to decide questions of law by construing ambiguous parts of the Code by looking to the economic realities of the situation and not the labels parties put on them.” But the dissent concluded that the substance-over-form doctrine was not applicable because it was uncontested that the taxpayers’ FSC was “exactly what it purports to be: a corporation . . . organized precisely in accord with the statutory rules.” And the economic substance doctrine also was not applicable because the provisions at issue were defined with “great precision” in the Code and “Congress set up both the FSC structure and Roth IRAs not to have any purpose other than tax reduction or avoidance.”

The dissent broadly criticized the majority for “abandon[ing] general principles of statutory construction in favor of using judge-made doctrines that undermine or ignore the text of the Code to recast transactions to avoid . . . a result inconsistent with a judge’s notion of a Code section’s purpose.” The dissent cited the Supreme Court’s decision in Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991), noting that “there are times in tax law where courts ought to put form over substance, and should respect transactions that have no nontax purposes.” Along the same line, it described the Supreme Court’s decision in Gitlitz v. Commissioner, 531 U.S. 206 (2001), as approving the proposition that “courts apply the language of the Code even when taxpayers discover that two sections interact to provide benefits Congress likely didn’t intend, or even foresee.” Because “[s]ubstance-over-form principles don’t give courts free rein to choose results that fit their view of good policy,” the dissent concluded that the Tax Court should have respected the Mazzei transaction because the taxpayers complied with the statutory formalities and the entities were what they purported to be—Roth IRAs and an FSC.

The First and Second Circuits Contradict Mazzei’s Shareholder-Level Distinction. After the Tax Court decided Mazzei, both the First and Second Circuits issued decisions addressing the shareholder-level issues presented in Summa I and, like the Sixth Circuit, they reversed the Tax Court. See Benenson v. Commissioner, 887 F.3d 511 (1st Cir. 2018); Benenson v. Commissioner, 910 F.3d 690 (2d Cir. 2018). Both courts agreed with the Sixth Circuit that the IRS could not recharacterize the Summa transactions using the substance-over-form doctrine and that the taxpayers were not liable for excise taxes on excess contributions to the Roth IRAs. The First Circuit stated that the substance-over-form doctrine was not just a “smell test” and that the court could not recharacterize the Summa transactions because they “violate[d] neither the letter nor the spirit of the relevant statutory provisions.” 887 F.3d at 523. The Second Circuit stated that “[l]ike the Sixth Circuit, and for much the same reasons, we conclude that Summa’s payment of deductible DISC commissions was grounded in economic reality and not distortive of the tax code provisions establishing the DISC program.” 910 F.3d at 700.

Thus, the appeal in Mazzei comes to the Ninth Circuit in a posture where it will be difficult for the court to affirm the Tax Court without creating considerable tension or outright disagreement with its sister circuits. The Tax Court distinguished the Sixth Circuit’s Summa II opinion on two grounds. One of those has now essentially been rejected by two other courts of appeals. And even the government did not agree that the second ground was a material distinction.

The taxpayers’ opening brief is due on January 25, 2019.

Mazzei – Tax Court opinion

Sixth Circuit opinion in Summa Holdings

First Circuit opinion in Benenson

Second Circuit opinion in Benenson

Supreme Court to Reconsider Important Administrative Law Precedent

The Supreme Court granted certiorari this morning in a non-tax case that should be of considerable interest to tax litigators because of the important administrative law principle that will be decided.  In Kisor v. Shulkin, the Federal Circuit applied the government’s interpretation of the governing regulation in ruling against a veteran’s claim for disability benefits.  The court found that the regulation was ambiguous, and therefore it ruled that it should defer to the government’s interpretation under the longstanding Supreme Court precedents of Bowles v. Seminole Rock & Sand Co., 325 U.S. 410 (1945), and Auer v. Robbins, 519 U.S. 452 (1997).  The court denied rehearing en banc, although three judges joined an opinion dissenting from that denial.  The Supreme Court has now granted certiorari specifically to address the question “[w]hether the Court should overrule Auer and Seminole Rock.”

Auer deference has played an increasingly prominent role in tax cases since the Supreme Court’s decision in Mayo Foundation made tax cases subject to general administrative law principles.  Revenue Rulings and other lower level administrative interpretations of Treasury regulations are pervasive in the tax area and are subject to being relied upon by courts under Auer deference principles.  And the government has even argued for Auer deference to interpretations stated in its briefs, with the Second Circuit agreeing with that argument.  See, e.g., our prior coverage of the MassMutual and Union Carbide cases here and here.  If Auer is overruled, taxpayers will likely benefit in future litigation involving conflicting views of the meaning of a Treasury regulation.

In recent years, several individual Justices have expressed concern about the wisdom of Auer or Seminole Rock deference, pointing out that it potentially allows an end run around the notice-and-comment procedure for issuing regulations and arguably violates separation-of-powers principles.  Instead of noticing clear regulations that can reasonably be commented upon, Auer enables agencies to promulgate ambiguous regulations and then later to provide administrative interpretations of those regulations (outside the notice-and-comment framework) that create a rule to which courts must defer.  Justice Scalia (who ironically was the author of Auer) was the first to suggest publicly back in 2011 that the Court should reconsider the Auer deference doctrine.  See Talk Am., Inc. v. Michigan Bell Tel. Co., 564 U.S. 50 (2011) (Scalia, J., concurring). In Decker v. Northwest Envtl. Def. Center, 568 U.S. 597, 615 (2013), Chief Justice Roberts and Justice Alito remarked that Justice Scalia had raised “serious questions” about the doctrine.  More recently, in Perez v. Mortgage Bankers, 135 S. Ct. 1199 (2015), Justice Scalia stated flatly that Auer should be “abandoned,” and Justice Thomas wrote a long concurring opinion explaining his view that Auer deference was “constitutionally suspect.”  Justice Alito added that those two Justices had “offered substantial reasons why the Seminole Rock doctrine may be incorrect.”  And just this past March, Justice Gorsuch joined an opinion of Justice Thomas dissenting from the Court’s denial of certiorari in which the latter again described Auer as “constitutionally suspect.”  Garco Construction, Inc. v. Speer, No. 17-225 (Mar. 19, 2018).  Thus, even with Justice Scalia no longer on the Court, four sitting Justices have indicated great skepticism, to put it mildly, about the continuing vitality of Auer deference.  In addition, in a keynote address at a 2016 conference at the Antonin Scalia (George Mason) Law School, Justice Kavanaugh spoke approvingly of Justice Scalia’s criticism of Auer deference and predicted that Justice Scalia’s view would become the law.  Things can change when cases are fully briefed and argued in the Supreme Court, but for now the future of Auer/Seminole Rock deference looks bleak.

The petitioner’s opening brief is due January 31, and the case should be argued in the spring and decided by June 2019. 

Kisor – Petition for Certiorari

Altera Case Submitted for Decision

The reargument of the Altera case was held on October 16. Chief Judge Thomas, who penned the original majority decision, was quiet during the argument, asking only one question. But both Judge O’Malley, who wrote the original dissent, and Judge Graber, who is the new judge on the panel and who might reasonably be expected to cast the deciding vote, were very active questioners. A video tape of the argument can be viewed at this link.

The oral argument was not quite the last gasp in the parties’ presentations to the panel. At the end of the week, counsel for Altera filed a post-argument letter further addressing some of the points that were raised at the argument. The letter stated that some of the statements made by government counsel at the argument were contrary to the provisions of Treas. Reg. § 1.482-4(f)(2)(ii), and that these departures from the existing regulations underscored why adminstrative law principles “do not permit an abandonment of arm’s-length evidence and the parity principle, even if the statute permitted it, without complying with the rules governing administrative procedure.” The government filed its own letter in response, asserting that its counsel’s statements did “not contradict any Treasury regulations” and did not implicate the administrative law principles referenced by Altera.

These letters are attached below.

The case is now submitted for decision. Ordinarily, one would expect several months to elapse after argument before a decision from the Ninth Circuit would issue in a complex case. (The original opinion in this case was issued more than nine months after the oral argument.) Given that Judges Thomas and O’Malley have already written opinions in the case, however, it is very possible that a decision could come much sooner.

Altera – Altera post-argument letter

Altera – Government post-argument letter

 

Supplemental Briefing Completed in Altera

Attached are the four supplemental briefs filed by the parties in the Altera case.  First, in anticipation of the reargument of the case, with Judge Graber now sitting on the panel in place of the deceased Judge Reinhardt, the court invited the parties to file supplemental briefs limited to half of the length of a normal court of appeals brief.  This briefing opportunity was designed to give the parties the chance to restate or add to their arguments on the issues previously addressed in the case, having now had the opportunity to read the competing opinions of Judges Reinhardt and O’Malley that had been vacated.  Although the court’s order took pains to tell the parties that they were “permitted, but not obligated,” to file “optional” supplemental briefs, it will surprise no one that both parties took advantage of the option and filed supplemental briefs on September 28 that pressed right up against the 6500 word limit.  In addition to the parties’ briefs, four supplemental amicus briefs were filed by:  1) the Chamber of Commerce; 2) a group of trade associations; 3) Cisco; and 4) a group of law school professors, with that last one being in support of the government.

This deluge of paper, however, was not enough for the panel.  On the same day that the supplemental briefs were due, the court issued the following order inviting another set of supplemental briefs on the question whether Altera’s suit was barred by the statute of limitations:

“The parties should be prepared to discuss at oral argument the question as to whether the six-year statute of limitations applicable to procedural challenges under the Administrative Procedure Act, 28 U.S.C. 2401(a), applies to this case and, if it does, what the implications are for this appeal. Perez-Guzman v. Lynch, 835 F.3d 1066, 1077-79 (9th Cir. 2016), cert. denied, 138 S. Ct. 737 (2018). Additionally, the parties are permitted, but not obligated, to file optional simultaneous supplemental briefs on this question on or before October 9, 2018. The briefs should be no longer than 6,500 words [that is, half the length of an ordinary appellate brief].”

The court’s injection of this new issue into the case was potentially a very significant development.  If the court were to conclude that Altera’s APA challenge was barred by the statute of limitations, the Ninth Circuit decision in Altera would not shed any light on any of the important issues thought to be presented involving the APA or the substance of the cost-sharing regulations.

In the end, however, it appears that the court’s latest order will not amount to anything.  Altera filed a full-fledged supplemental brief in response to the court’s order in which it raised several objections to the court’s suggestion, including an argument that the government had waived any possible statute of limitations claim.

More significantly, the government did not embrace the court’s suggestion either.  The government simply filed a short letter brief in which it stated that any prepayment suit filed by Altera within the six-year limitations period would have been barred by the Tax Anti-Injunction Act.  (In this connection, the government cited to its brief in the Chamber of Commerce case; see our coverage of that appeal here.)  Hence, the government acknowledged that it would be “unfair” to Altera if that six-year period were held to bar its later suit because that would have the effect of depriving Altera of any ability to sue in the Tax Court.   Moreover, the government noted that the limitations period is not “jurisdictional” and therefore, even if it would otherwise be applicable, the government had waived its right to invoke a limitations defense just as Altera argued in its brief.  The government concluded by stating its position that the six-year statute of limitations that is generally applicable to  APA challenges “does not apply to this case.”  Thus, there is no realistic possibility that the Ninth Circuit will toss the case on statute of limitations grounds, and it can be expected to address the important issues presented by the Tax Court’s opinion.

The oral argument is scheduled for October 16.

Altera – Altera Supplemental Brief

Altera – Government Supplemental Brief

Altera – Altera Statute of Limitations Supplemental Brief

Altera – Government Statute of Limitations Letter Brief

Altera Set for October 16 Reargument

The Ninth Circuit has announced that the panel (with Judge Graber substituted for the deceased Judge Reinhardt) will hear a new oral argument in the Altera case on the afternoon of October 16.  This announcement eliminates the possibility that Judge Graber would simply review the materials in the case and decide to join the prior majority opinion.  The outcome of the case now appears to be up for grabs, and most likely in the hands of Judge Graber unless either Judge Thomas or Judge O’Malley changes his or her mind in the case.

Altera Opinion Withdrawn

In a surprising move, the Ninth Circuit announced today that it has withdrawn its opinion in Altera “to allow time for the reconstituted panel to confer on this appeal,” even though no petition for rehearing has been filed yet.  See our prior report on the Altera decision here.  The mention of  the “reconstituted panel” refers to an order issued by the court last week that appointed Judge Graber as a replacement judge for Judge Reinhardt, who passed away in March.

At the time, the order appointing Judge Graber seemed to be an exercise in closing the barn door after the horse is gone.  But it now appears that Judge Graber is being asked to review the case and give her independent judgment regarding the issues, notwithstanding the decision issued in July.  If so, that would place the outcome in doubt again, since the two other living judges, Chief Judge Thomas and Judge O’Malley, differed on their views of the case.

In some courts, the death of a judge while a case is under consideration automatically means that the judge’s vote will not count.  Unless the remaining two judges agree, that death would necessitate appointing a third judge to render a decision.  But the Ninth Circuit does not follow that approach.  The now-withdrawn opinion recited that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion prior to his death.”  For whatever reason, the court now seems to have decided on its own that it made a mistake in allowing Judge Reinhardt to cast the decisive vote from the grave in such an important case.

Altera – Ninth Circuit order substituting Judge Graber

Altera – Ninth Circuit order withdrawing opinions

 

Chamber of Commerce Appeal Dismissed

We reported earlier that it was likely the government would dismiss its appeal in the Chamber of Commerce case once final regulations were issued addressing inversion transactions.  Those regulations were issued on July 11.  Yesterday, the government moved to dismiss the appeal with prejudice as moot (without specifying the final regulations as the cause), and the court immediately entered an order dismissing it.  Thus, there will be no appellate review of the novel issues raised by the district court’s decision in this case regarding temporary regulations and the Administrative Procedure Act.  See our prior report here.

It is possible that the government will consider asking the district court to vacate its decision because the appeal became moot.  Vacatur might have been appropriate under the old rule of United States v. Munsingwear, Inc., 340 U.S. 36 (1950).  But because the mootness was caused by the government’s own action of issuing final regulations, a motion to vacate likely will not be granted under the current standard set forth in U.S. Bancorp Mortgage Co. v. Bonner Mall Partnership, 513 U.S. 18 (1994).

Chamber of Commerce – Fifth Circuit Order Dismissing Appeal

Chamber of Commerce – Government Motion to Dismiss

Ninth Circuit Reverses Altera and Revives Cost-Sharing Regulations

The Ninth Circuit today by a 2-1 vote reversed the Tax Court’s Altera decision that had invalidated Treasury regulations requiring taxpayers to include employee stock options in the pool of costs shared under a cost-sharing agreement. See our previous reports here. The court’s decision (authored by Chief Judge Thomas) held that the regulations were a permissible interpretation of Code section 482 in imposing that requirement even in the absence of any evidence that taxpayers operating at arm’s length actually share such costs in similar arrangements. The court also held that Treasury’s rulemaking did not violate the Administrative Procedure Act (APA).

The court’s opinion follows the structure of the government’s brief in first analyzing section 482, even though the Tax Court decision rested on the APA. The court began with a detailed history of the development of section 482 and the related regulations. Quoting a law review article, the court stated that Congress and the IRS gradually realized in the years after 1968 that the arm’s-length standard “did not work in a large number of cases” and therefore they made “a deliberate decision to retreat from the standard while still paying lip service to it.” Relying heavily on legislative history, the court stated that the addition of the “commensurate with income” language in the 1986 Act was intended “to displace a comparability analysis where comparable transactions cannot be found.”

Armed with that conclusion, the court found that there was no violation of the APA. The court explained that the commenters had attacked the regulation as inconsistent with the arm’s-length standard, but Treasury in its notice had “made clear that it was relying on the commensurate with income provision”; therefore, the comments in question were just “disagree[ing] with Treasury’s interpretation of the law,” and there was no reason for Treasury to address those comments in any detail. The taxpayer argued that the notice of rulemaking indicated that Treasury would be applying the arm’s-length standard and therefore the Chenery principle of administrative law did not permit the regulations to be defended on the ground that the arm’s-length standard did not apply. See our prior summary of the parties’ arguments here. The court rejected this argument in cursory fashion, stating that it “twists Chenery . . . into excessive proceduralism.” It maintained that the citation of legislative history in the notice was a sufficient indication that Treasury believed that it could dispense with comparability analysis, and therefore the regulations were not being upheld on a different ground from the one set forth by the agency.

Having concluded that there was no APA violation in issuing the regulations, the court then applied the Chevron standard of deferential review to analyze the regulations, and it concluded that they were a reasonable interpretation of the statute. Pointing to the legislative history, the court ruled that the “commensurate with income” language was intended to create a “purely internal standard . . . to ensure that income follows economic activity.” The court added that “the goal of parity is not served by a constant search for comparable transactions.” Rather, by amending section 482 in 1986, Congress had “intended to hone the definition of the arm’s length standard so that it could work to achieve arm’s length results instead of forcing application of arm’s length methods.”

Finally, the court rejected the argument that the new regulations were inconsistent with treaty obligations. It remarked that “there is no evidence that the unworkable empiricism for which Altera argues is also incorporated into our treaty obligations,” describing the arm’s-length standard as “aspirational, not descriptive.”

Judge O’Malley (of the Federal Circuit, sitting by designation) dissented. She approached the case along the lines of the taxpayer’s argument and concluded that the Tax Court had correctly found an APA violation because “[i]n promulgating the rule we consider here, Treasury repeatedly insisted that it was applying the traditional arm’s length standard and that the resulting rule was consistent with that standard.” And “Treasury never said . . . that the nature of stock compensation in the [cost-sharing] context rendered arm’s length analysis irrelevant.” Accordingly, “Treasury did not provide adequate notice of its intent to change its longstanding practice of employing the arm’s length standard.” Finally, Judge O’Malley also noted her disagreement with the majority’s conclusion on the merits that the regulations are consistent with section 482. She explained that the plain language of the commensurate with income provision restricts its application to a “transfer (or license) of intangible property,” which would not encompass a cost-sharing agreement, even if the agreement relates to joint development of intangibles.

It is likely that the taxpayer will seek rehearing of the decision by the full Ninth Circuit, especially since such a rehearing petition was successful a decade ago in Xilinx. A rehearing petition would be due on September 7. If the taxpayer elects not to seek rehearing, a petition for certiorari would be due October 22.

Altera – Ninth Circuit opinion

 

Supreme Court Overrules Quill

The Supreme Court this morning decided South Dakota v. Wayfair and overruled the longstanding “physical-presence rule” for sales tax collection by out-of-state sellers.  See our previous coverage here.  The vote was 5-4.  The dissenters (Chief Justice Roberts and Justices Kagan, Sotomayor, and Breyer) agreed that the cases establishing the rule were wrongly decided, but took the position that the Court should allow Congress to change the rule.  At oral argument, Justice Alito had indicated that he might share that view, but in the end he voted with the Justices that wanted to put an immediate end to the physical-presence rule.

More analysis of the decision at a future date.

Wayfair – Supreme Court opinion

Briefing Delays in Chamber of Commerce Could Portend Dismissal of Appeal

The government’s appeal in the Chamber of Commerce case raises important issues of administrative law (see our previous report here), but it seems increasingly unlikely that the court of appeals will ever reach those issues.

The government’s opening brief was filed in March. That brief (linked below) addresses several issues—including standing, the Anti-Injunction Act, and the authority of temporary regulations issued without notice-and-comment. At the time, the government had sought to avoid having to file its brief at all, filing a motion shortly before the (already extended) due date that asked the court of appeals to stay the briefing schedule indefinitely to await the “imminent” issuance of final regulations addressing inversions. The motion explained that, “having completed notice and comment, Treasury and IRS plan to finalize the proposed regulation,” and stated that the government would then “reevaluate whether it should proceed with this appeal.” As an alternative to a complete stay of the briefing, the government asked for an additional 45-day extension until April 30 to file its brief, and the plaintiffs consented to that extension request.

The court of appeals, however, did not act on the extension request before the due date, and the government accordingly filed its brief on March 16. It thus appeared for a time that the court of appeals might move forward towards deciding the case without waiting for the issuance of final regulations. That is no longer the case.

The court first granted the plaintiffs a fairly routine 45-day extension until May 31. But today the court granted the plaintiffs an additional 60-day extension until July 30. This extension, to which the government consented, is expressly linked to the issuance of the final regulations. Treasury has announced that those regulations will be issued in June, and the plaintiffs state in their motion that the extension is necessary to “facilitate the parties’ efforts to determine whether the final rule will cause the Government to dismiss its appeal or will otherwise affect the presentation of the issues.”

Although the government’s original motion back in March did not commit it to dismissing the appeal, it strongly signaled that the government is inclined towards that course of action once the final regulations are in place. Under Federal Rule of Appellate Procedure 42, an appellant can voluntarily dismiss its appeal as long as it pays certain costs to the appellee. Thus, even if the plaintiffs would want the appeal to continue in order to obtain an appellate decision on the broad administrative law issues, they cannot prevent the government from dismissing the appeal if it chooses to do so.

Chamber of Commerce – Appellees Request for Extension

Chamber of Commerce – Opening Brief for US

Chamber of Commerce – US motion for stay

Oral Argument in Wayfair Raises the Possibility That a Sharply Divided Court Will Preserve Quill

As noted in our initial report on the Wayfair case, supporters of overruling the physical-presence rule of Quill appeared to begin the vote-counting with a solid head start, given statements already made by several of the Justices. Both Justices Kennedy and Gorsuch were on record as questioning the continuing vitality of Quill, and Justice Thomas has repeatedly expressed his general disdain for the Dormant Commerce Clause and seems most unlikely to provide a decisive vote in favor of a controversial application of that doctrine.

The oral argument yesterday in Wayfair provided no reason to change the expectation that these three Justices will vote to overrule Quill. Justice Thomas, in accordance with his standard practice, said nothing at the oral argument. Justice Gorsuch’s questions were all sympathetic to South Dakota. He asked why it was appropriate to draw a distinction that disfavored brick-and-mortar stores and also questioned the retailers’ claim of burdensome tax collection requirements by suggesting that the Colorado notice-and-reporting scheme upheld in Direct Marketing Ass’n v. Brohl, 814 F.3d 1129 (10th Cir. 2016), appears to be even more burdensome. Justice Kennedy described Quill as wrongly decided and criticized some of the other Justices for their apparent willingness to treat the correctness of Quill as irrelevant in deciding how to move forward.

Justice Ginsburg’s questions strongly indicated that she is prepared to supply a fourth vote to overrule Quill. She interjected several times to suggest that solutions would emerge for the problems that were concerning other Justices—namely, Congress could provide a cure for the potential unfairness of imposing a collection requirement on very small sellers and of retroactive application of a new decision overruling Quill; entrepreneurs could be expected to develop software to minimize the burdens of collection. She described the South Dakota statute as one that is equalizing sellers, not discriminating among them, and also pointed out that small local businesses are suffering under the current law. She also remarked that the Court should overturn its own obsolete precedents, not leave the job to Congress. Interestingly, Justice Ginsburg asked counsel for the United States whether the Court could give prospective effect to a ruling overruling Quill. He did not encourage that approach, however, responding that, at least in this context, a prospective decision would be “inconsistent with the judicial role.”

Four votes, however, do not make a majority, and none of the other Justices revealed a strong inclination to join in voting to overrule Quill. In particular, Justices Sotomayor and Alito seemed opposed to changing the law. Justice Sotomayor began the questioning by pointing to “a whole new set of difficulties” that would be created if Quill were overruled, such as possible retroactivity and a “massive amount of lawsuits” about what minimum level of contact would be necessary to obligate a seller to collect sales taxes. Even if Congress were to act to ameliorate these problems, she noted that there would be an “interim period” in which there would be significant “dislocations and lawsuits.”

Justice Alito emphasized that the competing considerations in play cried out for a resolution by Congress that could balance those considerations and reach a more nuanced outcome than the Court could reach. He added that a win for South Dakota in this case would remove the incentive for states to urge Congressional action and hence might reduce the likelihood of Congress stepping in. In response to the argument that this particular statute did not present concerns about retroactivity or burdening very small sellers, Justice Alito stated that the South Dakota law “is obviously a test case,” but the Court needed to be concerned about how a new rule would apply to laws passed by “states that are tottering on the edge of insolvency” that “have a strong incentive to grab everything they possibly can.”

Justices Kagan and Breyer also seemed fairly sympathetic to retaining Quill. Making more of an economic than a constitutional point, Justice Breyer expressed strong concern about the entry costs for small e-commerce businesses, remarking that overruling Quill would undermine the “hope of preventing oligopoly.” On this point, as well as on the economic issues focused upon by the briefs, Justice Breyer expressed frustration that the Court was in no position to resolve the parties’ conflicting empirical claims. In a similar vein, he noted that the issue in the case was like a statutory issue on which the Court would ordinarily allow Congress to act, rather than overruling its own decision, and he cited the brief filed by three Senators and Congressman Goodlatte that argued that Congress will take action if the Court leaves things alone.

Justice Kagan, who is generally a champion of stare decisis, suggested that instead of treating Congressional inaction as a reason for the Court to step in, the Court should “pay attention” to the fact that Congress has chosen not to overturn Quill. She also observed that, if South Dakota prevailed, small sellers would probably look for help to companies like Amazon, which could take over compliance for small companies on their system. Creating this new business opportunity for the major online retailers would be “ironic” – “saying the problem with Quill is that it benefited all these companies, so now we’re going to overturn Quill so that we can benefit the exact same companies.”

Chief Justice Roberts questioned both sides, but not at length. He pressed both South Dakota’s counsel and counsel for the United States on whether the Constitution requires a minimum level of contact for imposing a sales tax collection obligation. He seemed skeptical that it did, which would mean on the one hand that small sellers might be subjected to serious burdens, but on the other hand would ameliorate the concern of an explosion of litigation over the level of contact required. He also remarked that the problem of uncollected sales and use tax seemed to be diminishing as Amazon and other large sellers are now collecting sales tax in all 50 states, which would tend to support the view that “we should leave Quill in place.” He later added that perhaps Congress has already made a decision to leave things as they have been for the last 25 years. Conversely, the Chief Justice criticized Wayfair’s counsel’s argument that reliance interests pointed towards keeping Quill in place, suggesting that a reliance interest based upon nonpayment of lawful use taxes is not one that should be respected.

Thus, the outcome of this case remains very much in doubt. Given the exchanges at the oral argument, however, it would not be surprising if the physical-presence rule again survives by a whisker, as it did in Quill a quarter of a century ago. With almost all of the largest Internet retailers now collecting sales taxes, it could be that the optimal time for persuading the Court to overrule Quill has passed and that the Court will now decide to stick with the devil that it knows instead of opening a new box of uncertainties. A decision in the case is expected by the end of June.

A copy of the oral argument transcript is linked below.

Wayfair – Oral Argument Transcript

Briefing Complete in Wayfair

The parties have now completed the briefing in the Wayfair case involving sales tax collection by out-of-state sellers, which was discussed in previous posts here and here.  Oral argument is scheduled for April 17, and the Court is expected to issue its decision by the end of June.

The retailers’ response brief argues that the reliance interests and concerns about undue burdens on interstate commerce that motivated the Court’s decision to apply stare decisis principles and adhere to settled law in Quill remain in force today.  The brief focuses heavily on trying to rebut South Dakota’s contention that modern software has largely eliminated the burden for out-of-state sellers to collect taxes on behalf of many jurisdictions.  The brief also argues that the increase in online commerce does not provide a basis for departing from Quill, asserting that the amount of uncollected sales tax is actually diminishing and that there is no workable rule that has been proposed that could substitute for  the physical-presence rule.  Finally, the brief argues that overruling Quill could unfairly expose retailers to retroactive tax liability and urges the Court to leave it to Congress to determine how best to balance the competing considerations surrounding sales tax collection by out-of-state sellers.

The United States has filed an amicus brief supporting South Dakota.  It argues that Quill should be overruled if necessary, but also argues that “Quill‘s precedential effect is less sweeping than the courts below and the parties in this case have supposed” and invites the Court to uphold the South Dakota statute by limiting the reach of Quill to mail-order sales and holding that it does not impose a physical-presence rule for online retailers. Twelve other amicus briefs were filed in support of South Dakota, and 23 amicus briefs were filed in support of the retailers.  In addition, five amicus briefs were filed that were captioned as in support of neither party.

The parties’ briefs and the amicus brief of the United States are linked below.

Wayfair – Brief for Respondents Wayfair, Overstock, and Newegg

Wayfair – Brief for the United States

Wayfair – Reply Brief for South Dakota

 

Fifth Circuit Poised to Consider Validity of Temporary Regulations Aimed at Curbing Inversions

We present here a guest post by our colleague Katherine Zhang.

In Chamber of Commerce v. Internal Revenue Service, the Fifth Circuit will consider whether “tax exceptionalism” exists in the context of temporary regulations. At issue in the case are Treasury regulations that provide special rules for calculating the “ownership fraction” for entities engaged in inversion transactions. The district court set aside the regulations as promulgated in violation of the Administrative Procedure Act (APA), and the government has appealed.

Since the Supreme Court consigned the broad notion of “tax exceptionalism” to the scrap heap in Mayo Foundation, 562 U.S. 44 (2011) (see our prior reports here and here), by applying Chevron deference principles to Treasury regulations, the courts have increasingly grappled with the extent to which the APA constrains the promulgation of Treasury regulations. The Altera case pending in the Ninth Circuit presents another important facet of the general interplay between the APA and Treasury regulations (see our reports on Altera here). In this case, the focus is on APA constraints on the issuance of temporary regulations.

Generally, an “inversion transaction” occurs where a foreign corporation replaces the U.S. parent of a multinational group. If the transaction meets certain criteria, then Code section 7874 applies to impose adverse U.S. tax consequences on the parties involved. One key criterion is that, after the transaction, former shareholders of the U.S. parent hold at least 60 percent of the stock of the new foreign parent. This percentage is commonly referred to as the “ownership fraction,” and it may be measured by either vote or value. If the ownership fraction is at least 60 percent and less than 80 percent, then in the ten-year period after the transaction, U.S. tax is imposed on income or gain recognized in this period from transfers or licenses that are part of the transaction or that are made to foreign related persons after the transaction. The resulting liability cannot be reduced by tax attributes such as net operating losses or foreign tax credits. If the ownership fraction is at least 80 percent, then the new foreign parent is treated as a domestic corporation.

In April 2016, the Treasury Department invoked its broad regulatory authority under section 7874 to adopt special rules for calculating the ownership fraction. Under one of these rules, the denominator of the ownership fraction (by value) disregards stock of the foreign corporation attributable to certain prior domestic entity acquisitions. As a result, the ownership fraction increases, and the 60 percent threshold brings more transactions within the ambit of section 7874. The rule is designed to prevent companies from using a series of transactions to safely achieve an inversion that would fall within section 7874 if done all at once or as part of a single plan. The rule was issued both as a temporary regulation that was effective immediately and as a proposed regulation.

This rule is the central focus of Chamber of Commerce. In August 2016, the U.S. Chamber of Commerce and the Texas Association of Business filed suit in the Western District of Texas, arguing that the rule was invalid for failure to meet the requirements of the APA. The government contested both the plaintiffs’ power to bring suit and the merits of the APA objections.

The district court first rejected the government’s jurisdictional challenges that were raised in a motion to dismiss. A plaintiff generally must establish standing by demonstrating that it suffered an “injury in fact” that was caused by the defendant’s conduct and that likely would be redressed by a favorable decision. But an association has standing to bring suit on behalf of its members if, among other elements, the members would have standing to sue in their own right. The court agreed that both plaintiffs had standing because Allergan plc was a member of each trade association.

Shortly after Treasury and the IRS issued the rule in April 2016, Allergan announced the cancellation of a previously announced merger with Pfizer Inc. According to the plaintiffs, the rule eliminated the tax benefits of the merger—because Allergan’s “corporate composition” included several prior acquisitions of domestic corporations, the rule would have applied to cause the entity resulting from the merger to be treated as a domestic corporation subject to U.S. federal income tax. On this basis, the court found that Allergan would have standing to sue in its own right. Although Allergan did not have a specific transaction pending, there was no need for it to “engage in futile negotiations” for a transaction that the rule has “altogether foreclosed or made economically impracticable.” Instead, it was sufficient that Allergan “identified a specific transaction that was thwarted by the Rule and asserted that it would actively pursue other inversions if this court were to set aside the challenged Rule.” The court went on to conclude that the plaintiffs demonstrated “injury in fact” by showing that Allergan was the “targeted object” of the rule. Therefore, the plaintiffs “have alleged an actual, concrete injury, that is fairly traceable to implementation of the Rule, and that would be redressed by a decision setting aside that Rule.”

The court also determined that the suit was not barred by the Anti-Injunction Act, which prohibits suits “restraining the assessment or collection of any tax.” According to the court, the plaintiffs’ suit did not seek to restrain the assessment or collection of tax. Citing Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2015), which analyzed the analogous Tax Injunction Act applicable to state taxes, the court reasoned that “[a]ssessment and collection of taxes does not include all the activities that may improve the government’s ability to assess and collect taxes.” Here, rather than trying to restrain the assessment or collection of tax, the plaintiffs merely challenged the validity of a rule “so that a reasoned decision can be made about whether to engage in a potential future transaction that would subject them to taxation under the Rule.” The rule itself did not constitute the assessment or collection of tax, but only determined who was subject to tax and facilitated the assessment or collection of tax.

The court then turned to the plaintiffs’ motion for summary judgment, which raised the substantive claims of an APA violation. Broadly speaking, the APA governs agency actions and judicial review of such actions. Provisions of the APA governing agency rulemaking require agencies to publish a notice of proposed rulemaking in the Federal Register and to provide “interested persons” with an opportunity to comment. The proposed rule must be published no less than 30 days before its effective date, to allow for adequate opportunity to comment. The APA also directs a reviewing court to “hold unlawful and set aside” certain types of agency action, including actions that exceed statutory jurisdiction, actions that are arbitrary and capricious, and actions taken without procedure required by law. The plaintiffs challenged the rule on all three of these grounds.

The district court rejected the plaintiffs’ first two arguments, finding that the rule did not exceed Treasury and the IRS’s statutory jurisdiction and did not constitute arbitrary and capricious rulemaking. The court reached a different result, however, with respect to the plaintiffs’ third argument, ruling that issuance of the rule as an immediately effective temporary regulation violated the APA’s notice-and-comment requirements.

The government argued for a form of “tax exceptionalism” based on Code section 7805(e), which states that Treasury can issue temporary regulations (subject to automatic expiration after three years), as long as those temporary regulations are accompanied by proposed regulations that are subject to notice and comment. Although that provision contains no language restricting temporary regulations from becoming effective immediately, the court was not persuaded. The APA specifically contemplates that subsequent statutes might override its notice-and-comment requirements, but it requires that statutes make this change “expressly.” 5 U.S.C. § 559. According to the court, section 7805 did not make any such change “expressly”—it refers to effective dates of regulations in connection with limitations on retroactivity in section 7805(b), but “neither explicitly states nor suggests congressional intent to allow a regulation to become effective earlier in relation to publication than provided for in the APA.” The court also declined to look for any such intent in the legislative history, saying that it “will not disregard explicit directives of the APA in favor of legislative history.”

The court also held that the rule did not qualify for the APA’s exception for “interpretative” rules, which exempts such rules from notice-and-comment requirements. 5 U.S.C § 553(b)(A). As described by the court, an interpretative rule advises the public as to the “agency’s construction of the statutes and rules which it administers,” while a substantive rule “affects individual rights and obligations” and “is issued by an agency pursuant to statutory authority.” The court determined that the rule at issue was a substantive rule—it was promulgated pursuant to subsections of section 7874 that authorized Treasury to issue regulations to provide for “adjustments to the application of this section” and to “treat stock as not stock.” These types of rules are “modifications to the application of the statute,” not mere interpretations.

The impact of the Fifth Circuit’s decision in Chamber of Commerce could extend well beyond its effect on the particular inversion rule that is directly at issue. If the court of appeals agrees with the district court’s approach, its decision could well cast doubt on the validity of all temporary Treasury regulations. Conversely, the court of appeals may decide that, under section 7805, tax still is exceptional in at least one important respect.

The government’s opening brief is due March 16.

Chamber of Commerce – District Court opinion

 

Briefing Underway and Oral Argument Scheduled in Wayfair

South Dakota has now filed its opening brief in the Wayfair case urging the Supreme Court to abandon the physical-presence requirement for the imposition of sales tax.  See our earlier report here.   Among the points stressed by the State are that the existing Quill rule is generally out-of-step with Commerce Clause jurisprudence; that Quill and its predecessor were decided in the context of mail-order businesses, prior to the explosion of online commerce, and therefore the Court does not have to conclude that those cases were wrongly decided at the time; and that current technology has eliminated the practical difficulties of sales tax collection from multiple states that previously concerned the Court.

Amicus briefs in support of South Dakota–and they are expected to be numerous–are due next Monday, March 5.  The companies’ response brief is due March 28, with supporting amicus briefs due a week later.

Oral argument is scheduled for April 17.

Wayfair – Opening Brief for South Dakota

Cert Granted in Wayfair

The Supreme Court announced this afternoon that it will hear the South Dakota v. Wayfair case and consider the continuing viability of the physical-presence requirement for imposing an obligation on out-of-state businesses to collect and remit sales and use taxes.  See our prior report here.

The state’s opening brief is due on February 26.   The taxpayers’ response brief will be due at the end of March.   Oral argument will be scheduled for late April with a decision expected by the end of June.

 

Supreme Court Poised to Reevaluate the Constitutional Framework Governing Collection and Remittance of State Sales and Use Taxes by Out-of-State Sellers

The Supreme Court may soon consider in a case entitled South Dakota v. Wayfair, Inc., No. 17-494, whether to discard the longstanding rule that states can require companies to collect sales and use tax only if they have a physical presence in the state. The rule dates back 50 years to National Bellas Hess v. Illinois Dep’t of Revenue, 386 U.S. 753 (1967), where the Court held that constitutional limitations on states’ jurisdiction found in both the Due Process and Commerce Clauses prevented states from imposing such a collection requirement on companies that lacked a physical presence in the state.

As time passed, however, mail-order businesses became much more prevalent, and this rule began to be seen as creating a serious problem for local businesses that had to collect sales taxes while competing against much larger national mail-order businesses that did not collect such taxes. In 1992, the Court revisited the physical presence rule in Quill Corp. v. North Dakota, 504 U.S. 298. To the surprise of many observers, the Court upheld the physical-presence requirement, relying heavily on the principle of stare decisis – that is, adhering to established precedent because of the reliance interests and expectations that were in place. Importantly, however, the Court departed from National Bellas Hess regarding the exact nature of the constitutional limitation. The Quill Court held that the Due Process Clause did not require the physical presence rule. Rather, the “substantial nexus” requirement, which the Court held required physical presence, was imposed only by the Commerce Clause, which is concerned with “the effects of state regulation on the national economy.” 504 U.S. at 312.

The significance of the Court’s determination to source the requirement in the Commerce Clause is that Commerce Clause restrictions are less absolute than Due Process Clause restrictions. The Commerce Clause is an affirmative grant of power to Congress, and the restrictions on state taxation that the Court has found in the Commerce Clause are justified as protecting that power by striking down state actions that intrude on interstate commerce. (Hence, this body of law is referred to as based on the “negative” or “dormant” Commerce Clause.) In practice, this means that Congress has the power to permit state actions that the Court has found violative of the Commerce Clause (even though Congress cannot permit actions that violate due process). In effect, the Quill decision punted to Congress the question of how states can fairly tax interstate commerce in the modern world—a question that has only grown in significance with the proliferation of the Internet e-commerce. See Quill, 504 U.S. at 318 (“the underlying issue is not only one that Congress may be better qualified to resolve, but also one that Congress has the ultimate power to resolve”); id. at 320 (Scalia, Kennedy, and Thomas, JJ., concurring in part and concurring in the judgment) (“Congress has the final say over regulation of interstate commerce, and it can change the rule of Bellas Hess by simply saying so.”). Congress, however, has not been up to the task and has not passed comprehensive legislation to address the issue.

In the meantime, the states have nibbled around the edges of Quill and largely succeeded in limiting its scope. Beginning with Geoffrey, Inc. v. S.C. Tax Comm’n, 437 S.E. 2d 13 (S.C. 1993), more and more states have used the concept of “economic nexus” to impose state income taxes on companies that lack a physical presence in the state. State courts have increasingly upheld these taxes by distinguishing Quill on its facts, even though the logical justifications proffered for having different rules and constitutional nexus standards for income taxes and sales taxes are not necessarily compelling. Nevertheless, the Supreme Court has repeatedly declined invitations to review these state court decisions and determine whether they are consistent with Quill.

In addition, states have imposed notice and reporting requirements on out-of-state businesses that stop short of imposing an actual collection requirement, but that are designed to assist the state in collecting the sales and use taxes directly from purchasers. These requirements may be more intrusive and burdensome on the sellers than an actual collection requirement, and therefore they can create a disincentive to out-of-state sellers to continue to resist a direct collection requirement. In Direct Marketing Ass’n v. Brohl, 135 S. Ct. 1124 (2015), the Court confronted one such statute from Colorado, but in a context that did not present the Court with the question of the statute’s constitutionality. The issue for the Court was whether the Tax Injunction Act barred the plaintiffs’ challenge to the statute. The Court found that the case could go forward and remanded to the court of appeals to consider the statute’s constitutionality.

Notably, however, Justice Kennedy wrote a concurring opinion in which he criticized Quill (even though he had concurred in the judgment in that case), stating that Quill has resulted in “a startling revenue shortfall in many States, with concomitant unfairness to local retailers and their customers who do pay taxes at the register.” Justice Kennedy concluded that it was time to reconsider the physical-presence rule in a case that properly presented the question, observing that Quill had failed to take into account “the dramatic technological and social changes that had taken place in our increasingly interconnected economy,” which have only increased over time, and that “it is unwise to delay any longer a reconsideration of the Court’s holding in Quill.” Id. at 1135.

South Dakota promptly responded to Justice Kennedy’s invitation by enacting a statute that requires companies to collect and remit use taxes even if they lack physical presence in the state. The statute was challenged and declared unconstitutional by the South Dakota Supreme Court on the authority of Quill, with the court recognizing the criticisms of Quill but noting that only the Supreme Court has the “prerogative of overruling its own decisions.”

A petition for certiorari from that decision is now pending before the Supreme Court, and the Court is expected to rule on the petition this month. Numerous amicus briefs have been filed in support of the petition, urging the Court to abandon Quill, although several others have been filed urging the Court to deny certiorari. The latter include a brief filed by some Senators and Congressmen who have sponsored legislation to address the issues and who urge the Court not “to give up on Congress.” A decision to grant certiorari could be announced as soon as this Friday, January 12, which would mean that the case would be argued in the spring and decided by the end of June.

One interesting brief is the one filed by the Tax Foundation. The Tax Foundation candidly acknowledges that it is “not a partisan for aggressive or expansive state tax power” and that it has consistently urged rulings against the state when addressing this issue in the past. Nevertheless, the brief asks the Court to grant certiorari, overrule Quill, and uphold the South Dakota statute. The brief explores the variety of ways in which states have sought to avoid Quill and asserts that the result is a patchwork of laws ultimately harming interstate commerce. By contrast, the Tax Foundation asserts that the South Dakota statute presents a fairer and more workable way of allowing states to impose sales taxes in the current business environment.

Finally, Justice Kennedy is not the only Justice to have gone on record with the view that Quill should be reconsidered. The Colorado notice-and-reporting statute at issue in Direct Marketing Association was upheld on remand from the Supreme Court by a panel of the Tenth Circuit that included then-Judge, now-Justice, Gorsuch. 814 F.3d 1129 (10th Cir. 2016). Justice Gorsuch wrote his own concurring opinion in that case, suggesting that Quill was intended to have an “expiration date” and remarking that it would be appropriate to allow Quill to “wash away with the tides of time.” Id. at 1151. There is a good chance that Quill will soon be swept away more directly and abruptly than first contemplated by Justice Gorsuch.

Wayfair – Petition for certiorari

Wayfair – Brief in Opposition

Wayfair – Reply Brief in Support of Certiorari Petition

Wayfair – Amicus Brief of Tax Foundation

Wayfair – Amicus Brief of legislators

Ninth Circuit Remands For In Camera Review in Sanmina

The Ninth Circuit has remanded the Sanmina case back to the U.S. District Court for the Northern District of California to conduct an in camera review of two in-house tax attorney memoranda to determine if the contents of those memos were disclosed in a DLA Piper valuation report provided to the IRS to support Sanmina’s $503 million worthless stock deduction. The IRS had previously asked the district court to conduct an in camera review, and the district court had declined to do so.

As noted in our previous coverage, the DLA Piper valuation report cited the in-house memos in a footnote  The district court concluded that there was no waiver, holding that “DLA Piper’s mere mention of the existence of the memoranda did not summarize or disclose the contents of the memoranda.” On appeal, the IRS argued that the valuation report went beyond simply mentioning the in-house memos and, in fact, expressly relied on the memos. According to the IRS, the reliance resulted in a waiver even if the substance of the advice was not disclosed. Alternatively, the IRS argued that at least some of the substance appeared to have been disclosed.

In contrast, Sanmina argued that there is no waiver absent a disclosure of the substance of the advice, which had not occurred. At oral argument, the presiding judge pressed Sanmina’s attorney to identify particular cases supporting that legal position. The panel also struggled with how to resolve the waiver issue without knowing the contents of the in-house memos.

In its brief unpublished memorandum opinion, the court of appeals (Ninth Circuit Judges O’Scannlain and Rawlinson and district court Judge Watters from Montana sitting by designation) stated: “Our resolution of this case would be greatly facilitated by a more informed analysis from the district court. More specifically, we prefer the district court review the documents in camera and reconsider its ruling on the asserted privileges following its review of the pertinent documents.” The court of appeals cited United States v. Richey, 632 F.3d 559 (9th Cir. 2011), an IRS summons enforcement case, which both sides highlighted in briefs and at oral argument, in which a similar remand for in camera review occurred. The remand is framed as a directive that the district court “determine whether the documents requested by the government are privileged to any degree,” but the focus of oral argument was the waiver issue, and the IRS has conceded that one of the two memos is privileged. The in camera review therefore likely will focus on the extent to which the substance of the memos was ultimately disclosed or expressly relied on in the DLA Piper valuation report.

As an unpublished opinion, the decision is not binding circuit precedent.  Even so, one practical takeaway from the decision is that both sides should consider encouraging the trial court to conduct an in camera review where an appeal of the privilege issue is likely and the resolution of the appeal turns on the content of the documents. The parties did not agree to do that here and now, 2-1/2 years after the district court issued its decision in favor of Sanmina, the parties are back to square one.

Sanmina Ninth Circuit opinion

Sanmina – Reply Brief for Appellant

 

Ninth Circuit Panel Ready to Hear Oral Argument in Altera on October 11

As discussed in our prior post, the briefing on the government’s appeal of the Altera decision was completed last January.  The Ninth Circuit is scheduled to hear oral argument in the case in San Francisco this Wednesday afternoon, October 11.

The three-judge panel for the arguments consists of Chief Judge Sidney Thomas, Judge Stephen Reinhardt, and Judge Kathleen O’Malley (of the Federal Circuit, sitting by designation). Judge Thomas was appointed in 1996 by President Clinton, Judge Reinhardt was appointed in 1980 by President Carter, and Judge O’Malley was appointed by President Obama in 2010.  The government is probably particularly happy to see Judge Reinhardt on the panel, as he was the dissenting judge who sided with the government in 2010 in the 2-1 Xilinx decision that set the stage for the new cost-sharing regulations at issue in Altera.  (The Xilinx decision was discussed in this contemporaneous Tax Alert.)  The Ninth Circuit has allocated 20 minutes for each side to present argument, which indicates the court’s recognition of the importance and/or complexity of the case; most cases are set for 10 or 15 minutes per side.

The Ninth Circuit now videotapes its oral arguments, so the argument can be watched on a live stream through a link on the Ninth Circuit’s website. The videotape will also be made available after the fact elsewhere on the court’s website.  The afternoon session begins at 1:30 Pacific time.  Because Altera is the third case scheduled for that session, it is likely that the argument in Altera will not begin before 2:15 Pacific time.

Ninth Circuit Briefing Completed in Altera

The parties have now completed briefing in the Ninth Circuit in the Altera case, in which the Tax Court struck down Treasury regulations that require taxpayers to include employee stock options in the pool of costs shared under a cost-sharing agreement.  As described in our previous reports, the Tax Court’s decision implicated both the specific issue of whether the cost-sharing regulations are a lawful implementation of Code section 482 and the more general administrative law issue of the constraints placed on Treasury by the Administrative Procedure Act (APA) in issuing rules that involve empirical conclusions.

The government’s opening brief focuses only on the specific section 482 issue, maintaining that the Tax Court erred in believing that the challenged regulations involved empirical conclusions. Specifically, the government relies heavily on what it terms the “coordinating amendments” to the regulations promulgated in 2003.  Those amendments, which purport to apply the “commensurate with income” language added to section 482 in 1986 for intangible property, state in part that a “qualified cost sharing arrangement produces results that are consistent with an arm’s length result . . . if, and only if, each controlled participant’s share of the costs . . . of intangible development . . . equals its share of reasonably anticipated benefits attributable to such development.”  Treas. Reg. § 1.482-7(a)(3).  By its terms, this regulation states that determining whether a cost-sharing agreement meets the longstanding section 482 “arm’s length” standard has nothing whatsoever to do with how parties actually deal at “arm’s length” in the real world.  On that basis, the government argues that the APA rules are not implicated because the regulations did not rest on any empirical conclusions.  And for the same reason, the government argues that the Ninth Circuit’s earlier decision under the prior cost-sharing regulations, Xilinx v. Commissioner, 598 F.3d 1191 (9th Cir. 2010), is irrelevant since that decision was premised on the understanding (now allegedly changed by the amended regulations) that how parties actually deal at “arm’s length” was relevant to whether the section 482 “arm’s length” standard was met under those prior regulations, which did not explicitly provide a rule for stock-based compensation.  Finally, the government defends the validity of the regulation’s approach to “arm’s length” in the cost-sharing context as being in line with statements made in the House and Conference Reports on the 1986 amendments to section 482, which noted the general difficulty in finding comparable arm’s-length transfers of licenses of intangible property.

In its response brief, the taxpayer takes the government to task for relying on a “new argument” rather than directly addressing the reasoning of the Tax Court. The taxpayer first observes that Treasury never took the position in the rulemaking that the traditional “arm’s-length” standard in section 482 can be completely divorced from how parties actually operate at arm’s length—a position that assertedly “would have set off a political firestorm.”  Accordingly, the taxpayer argues that the government’s position on appeal violates the bedrock administrative law principle of SEC v. Chenery Corp., 318 U.S. 80 (1943), that courts must evaluate regulations on the basis of the reasoning contemporaneously given by the agency, not justifications later advanced in litigation.  And in any event, the taxpayer argues, this position cannot be sustained because it is an unexplained departure from Treasury’s longstanding position that the 1986 amendments to section 482 “did not change the arm’s-length standard, but rather supplied only a new tool to be used consistently with arm’s-length analysis rooted in evidence.”

The taxpayer describes the government’s reliance on the “coordinating amendments” in the regulations as “circular reasoning” that simply purports to define “arm’s length” to mean something other than “arm’s length.”  Even if that is what the regulations say, the taxpayer continues, the regulations could not be sustained because they depart “from the recognized purpose of Section 482 to place controlled taxpayers at parity with uncontrolled taxpayers” and conflict with “the arm’s-length analysis implicit in the statute’s first sentence.”

The government’s reply brief criticizes the taxpayer for not even arguing that its cost-sharing agreement clearly reflects income, and it therefore characterizes the taxpayer as arguing that “the arm’s-length standard gives related taxpayers carte blanche to mismatch their income and expenses.”  With respect to the correct interpretation of section 482, the government repeats its position from the opening brief, maintaining that the term “arm’s length” does not necessarily connote equivalence with real-world transactions.  Instead, the government argues that it is the taxpayer that departs from the statute by failing to give proper effect to the “commensurate with the income attributable to the intangible” language added in 1986.

The government responds to the Chenery argument by denying that it is arguing a different ground for the regulation than that advanced by Treasury.  Rather, the government states that its brief simply further develops the basis advanced by Treasury because it was clear in the regulations that emerged from the rulemaking that Treasury was rejecting the position that an “arms-length” standard can be applied only by looking at empirical evidence of transactions between uncontrolled taxpayers.

Although the briefs are quite long, the basic dispute can be stated fairly succinctly. The parties purport to agree that an “arm’s-length” standard must govern.  The taxpayer says that application of this standard always depends on analyzing actual transactions between uncontrolled parties, where available.  The government says no; in its view, “arm’s length” does not necessarily require reference to such transactions.  Instead, according to the government, in the cost-sharing context “Treasury prescribed a different means of ascertaining the arm’s-length result,” one that “is determined by reference to an economic assumption rather than by reference to allegedly comparable uncontrolled transactions.”

The intense interest in this case is illustrated by the filing of many amicus briefs. The government, which rarely benefits from amicus support in tax cases, is supported by two different amicus briefs filed by groups of law professors—six tax law professors joining in one of the briefs and 19 other tax and administrative law professors joining the second brief.  The taxpayer’s position is supported by seven amicus briefs—including one from the Chamber of Commerce and one from a large group of trade associations.  Four briefs were filed by individual companies—Cisco, Technet, Amazon, and Xilinx.  The seventh brief was filed by three economists—a business school professor (who testified as an expert witness for the taxpayer in Xilinx), a fellow at the American Enterprise Institute, and a managing director at the Berkeley Research Group.  They profess no financial interest in the outcome but argue, based on their experience in dealing with issues relating to stock-based compensation, that, as a matter of economics, the government’s approach is not consistent with how parties acting at arm’s length would proceed.

Notwithstanding the interest in the case, no decision is expected in the near future. The Ninth Circuit has a backlog of cases awaiting the scheduling of oral argument.  In recent years, oral arguments in tax cases typically have not been scheduled until at least a year after the briefing is concluded, and often closer to 18 months.  Thus, oral argument in this case should not be expected before next winter.  And then it will likely be several months after the argument before the court issues its decision.  So at this point, it would be surprising if there were a decision in Altera before mid-2018.

Altera – Taxpayer brief

Altera- Gov’t Opening Brief

Altera – Gov’t Reply Brief

Supreme Court Denies Certiorari in Clarke

As we have previously reported, after the Clarke case was remanded by the Supreme Court, the Eleventh Circuit ruled for the government and upheld the district court’s order enforcing the summonses.  Yesterday the Supreme Court denied a petition for certiorari filed by the parties who were contesting the summonses.  The gist of the petition asked the Court to consider whether the district court had abused its discretion in handling the dispute after the remand–a request that is more case-specific than the kinds of issues that would normally be reviewed by the Supreme Court.  This order marks the end of the line for the efforts to resist the summonses, and the parties will have to comply.

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

 

Rehearing Denied in Clarke

The Eleventh Circuit today denied the petition for rehearing and rehearing en banc filed by the appellants in the Clarke summons enforcement case.  The petition did not focus on the broader legal issue that we have previously addressed here concerning the standards for allowing an evidentiary hearing on the basis of allegations of improper motive in issuing a summons.  Instead, the petition asked the court of appeals to reconsider whether the trial court erred in refusing to allow the appellants to make new submissions in the wake of the Supreme Court’s remand of the case.

The appellants now have 90 days (until September 20) to file a petition for certiorari asking the Court to consider the case for a second time.

Clarke – petition for rehearing

 

Eleventh Circuit Affirms Enforcement of Summonses in Clarke

The Eleventh Circuit this morning affirmed the district court’s decision in Clarke that had enforced a group of IRS summonses. The court’s legal analysis provides a glimmer of hope for taxpayers who desire to contest future summonses on grounds of bad faith, but there are daunting factual challenges to being able to actually make use of that legal analysis.

As evidenced by our prior reports, this case has a long history that now encompasses a Supreme Court opinion and three decisions by the Eleventh Circuit. To recap, the summoned parties sought an evidentiary hearing at which they could examine the IRS agent who issued the summonses to explore whether the summonses were issued in bad faith. The Eleventh Circuit had originally ordered such a hearing, but the Supreme Court reversed on the ground that the Eleventh Circuit’s standard was too lenient in requiring a hearing on the basis of a “bare allegation” of improper motive. Instead, the Supreme Court held that the correct standard requires the taxpayer to “point to specific facts or circumstances plausibly raising an inference of bad faith.”

On remand from the Supreme Court, the district court accepted all of the government’s arguments. It declined to allow the taxpayers to introduce additional evidence to make their case. And it dismissed all of their bad faith allegations as “improper as a matter of law.” The court of appeals took issue with that statement and explained that two of the taxpayers’ allegations were legally sound, but held that the “facts and circumstances” to which the summoned parties pointed were not sufficient to raise a plausible inference of bad faith in this case.

First, the court of appeals emphasized that “issuing a summons only to retaliate against a taxpayer would be improper as a matter of law.” The court found, however, that the taxpayers had not established a plausible basis for a retaliation accusation simply by pointing out that the IRS did not seek to enforce the summonses until six months after they were issued and the matter was already in the Tax Court. The taxpayer argued that this timeline showed that the investigating agents did not need the information sought in the summonses and therefore must have issued them for a retaliatory motive. The court of appeals responded that this argument “requires substantial conjecture that is both implausible and unsupported by the record.”

Second, the court of appeals stated that issuing a summons as a way of circumventing Tax Court discovery limitations would be an improper purpose. As we noted in our report on the oral argument in the Supreme Court, the taxpayers had arguably made a reasonable case that the IRS’s decision to enforce the summonses was motivated by a desire to obtain evidence that could help with the Tax Court proceedings; six months passed before the IRS sought to enforce the summonses and lead counsel in the Tax Court proceeding—not the examining agent—conducted the examination of an individual who chose to comply with the summons issued to her.

The strength of this argument, however, turned on being able to examine the IRS’s decision to enforce, rather than its decision to issue, the summonses because the summonses were issued well before there was any Tax Court proceeding. The Supreme Court had left that question unanswered, but the Eleventh Circuit determined to adhere to its “well-established” precedent “that the validity of a summons is tested at the date of issuance.” Given that proposition, along with the rule that commencing Tax Court proceedings does not extinguish the IRS’s summons power, the court of appeals acknowledged that it would be difficult for a taxpayer to make out a claim of bad faith based on circumvention of Tax Court limitations on discovery. The court of appeals stated that “the circumstances under which a taxpayer could successfully allege improper circumvention of tax discovery are exceptionally narrow” and described such claims are “rarely tenable.” In this case, the court explained that it was “of no consequence” that the summoned information could assist the IRS in its Tax Court litigation; because the summonses were issued pursuant to a valid investigation and before the Tax Court proceedings commenced, the summoned parties were obligated to provide the information. That obligation did not evaporate just because an FPAA was issued or a Tax Court petition was filed. Indeed, the court of appeals noted its agreement with the government’s argument that “it is the domain of the tax court to control discovery in the pending tax litigation.”

In sum, the Eleventh Circuit’s decision gives some theoretical grounds for taxpayers to get the opportunity to examine IRS agents at an evidentiary hearing, but as a practical matter, the decision is unlikely to lead to many such examinations. The long saga of the Clarke case has apparently ended with a result that the government will likely find satisfactory.

P.S. We hope that our readers enjoy the new, updated look of the blog, which coincides with Miller & Chevalier’s move to new office space.

Clarke – Eleventh Circuit Opinion After Remand

Government Files Notice of Appeal in Altera

We have previously reported on the Tax Court’s important decision in Altera, which has significant implications both for IRS regulation of cost-sharing agreements under the transfer pricing rules and, more broadly, for how the Administrative Procedure Act might operate as a constraint on rulemaking by the Treasury Department in the tax area.  Although there were some tactical considerations that could have made the government hesitant to seek appellate review from its defeat in Altera (see here), the government has now filed a notice of appeal to the Ninth Circuit.

The court of appeals will issue a briefing schedule in due course, and we will keep you posted on the progress of the appeal.

IRS Takes an Aggressive Position on Scope of Privilege and Waiver in Sanmina

Opening briefs have been filed in the Ninth Circuit in United States v. Sanmina, where the IRS is appealing a decision by the U.S. District Court for the Northern District of California holding that the attorney-client privilege and work product doctrine protect two memoranda prepared by Sanmina’s in-house tax attorneys. In its opening brief, the IRS is advancing a narrow view of attorney-client privilege and an expansive view of waiver.

Sanmina claimed a $503 million worthless stock deduction on its return. To support its return position, Sanmina provided the IRS a valuation report prepared by outside counsel DLA Piper. The valuation report included a footnote stating that the authors reviewed the two in-house tax attorney memos. The district court held that both memos were protected by the attorney-client privilege and work product doctrine and that no waiver occurred when Sanmina gave the memos to DLA Piper or when DLA Piper referenced them in the valuation report.

On appeal, the IRS contests the threshold applicability of the attorney-client privilege and work product doctrine as to only one of the memos and argues waiver as to both. The IRS argues that the memo was not privileged because it was “to file” and there is no evidence that (1) the memo was reviewed by anyone else in the company, (2) the company sought legal advice from the in-house attorney; or (3) it contained confidential client communications. According to the IRS: “The attorney-client privilege does not extend to an unsolicited memorandum prepared by Sanmina’s in-house tax counsel for their own records.” The IRS also argues that the work product doctrine does not apply because there was insufficient evidence that the memo was prepared because of anticipated litigation. On the issue of waiver, the IRS claims there was a subject matter waiver when Sanmina disclosed the valuation report to the IRS. The IRS also takes the position that Sanmina waived the privilege earlier when it disclosed the memos to outside counsel. “Because DLA Piper was not acting as a lawyer in preparing the valuation report, Sanmina’s disclosures to DLA Piper were not protected by the attorney-client privilege.” As to work product, the IRS argues Sanmina waived that protection when it produced the memos to outside counsel, knowing they would provide the valuation report to the IRS.

In its answering brief, Sanmina asserts that the IRS waived its arguments about the privileged status of the memo by not raising them at the district court. Below, the IRS argued the memo constituted business not legal advice, but abandoned that argument on appeal. Sanmina also challenges the IRS’s factual characterization of the memo, as well as the IRS’s contention that the tax attorney was not anticipating litigation. On the waiver point, Sanmina argues that the valuation report did not disclose the contents of the privileged memos, nor was disclosure of the memos to outside counsel inconsistent with maintaining their confidentiality as to the IRS.

The IRS’s reply brief is due March 9.

Sanmina – District Court Decision

Sanmina – Appellant Brief in CA9

Sanmina – Appellee Brief in CA9

Reply Brief Filed in Clarke

The summoned parties have filed their reply brief in the Clarke case.  The brief focuses more on the particular facts of the case and less on legal principles of broad applicability.  In particular, the brief criticizes the district court’s decision not to allow introduction of new evidence on remand, arguing that the court made that determination at the initial post-remand status conference, which was earlier than the summoned parties should have been expected to make an offer of proof.test

Oral argument is tentatively scheduled for the last week in February.

Clarke – Appellants Reply Brief in CA11

District Court Orders Microsoft Summonses Enforced, Finding No Legal Obstacle to Involvement of Outside Law Firm

The district court has ordered enforcement of the IRS’s summonses in its high-profile audit of Microsoft.  As we have previously discussed, Microsoft’s objections to the summonses centered on the IRS’s novel decision to bring in an outside law firm (Quinn Emanuel) as a consultant to whom certain tasks would be delegated.  The objections also touched on the issue being litigated in the Clarke case concerning the appropriateness of enforcing a summons that is arguably designed to assist the IRS in Tax Court litigation.  (See prior posts on Clarke here.)  The district court’s decision in Microsoft turns on its analysis of the factual record and does not break any new legal ground.

With respect to the law firm’s involvement, the essence of the court’s holding was its conclusion that nothing in Code section 7602 prohibits the degree of involvement by an outside contractor that had been shown by the evidence.  (Microsoft had argued that, by its terms, section 7602 authorizes only the Secretary of the Treasury (or his specified delegates within Treasury) to “take testimony” or otherwise exercise the summons power.)  The court did not affirmatively endorse the IRS’s involvement of the law firm.  To the contrary, the court remarked that it was “troubled by Quinn Emanuel’s level of involvement in this audit.  The idea that the IRS can ‘farm out’ legal assistance to a private law firm is by no means established by prior practice, and this case may lead to further scrutiny by Congress.”  But the court held that it would take further action by Congress to prohibit such involvement; current law does not impose any bar.  Because it found no statutory problem, the court saw no need to consider Microsoft’s arguments challenging the validity of the recent temporary regulation that explicitly addresses the IRS’s use of outside contractors.

In reaching its conclusion, the court pressed counsel for Microsoft to specify where the law draws the line between permissible and impermissible involvement of an outside contractor, and the court ultimately found Microsoft’s answers unpersuasive.  As summarized by the court, Microsoft admitted at the hearing that the contractor “is permitted under law to examine Microsoft’s books and records, formulate questions to ask witnesses under oath, attend those interviews, and even ask questions via a notepad so long as it is the IRS lawyer who speaks the words.”  In the court’s view, nothing in Code section 7602 “prevents the IRS from taking this a step further and having the contractor ask a question while an IRS lawyer continues to run the interview.”  The court’s statements imply that it could well be prohibited for an outside contractor to “run the interview” and certainly for it to control the audit.  But the court found that the record in this case provided “no factual basis” for Microsoft’s assertion that Quinn Emanuel would be “conducting the audit.”  (This finding is hardly surprising given that the only witness at the evidentiary hearing was an IRS official.)  Rather, the court concluded, the evidence indicated that Quinn Emanuel “will be gathering limited information for the IRS under the direct supervision of the IRS.”

Distinct from the issues directly raised by Quinn Emanuel’s involvement, Microsoft argued that the summons was issued for the illegitimate purpose of preparing for Tax Court litigation, not for conducting an audit.  As we have discussed elsewhere, the legal issue raised by efforts to enforce a summons to aid in Tax Court litigation is more squarely presented in the Clarke case currently pending in the Eleventh Circuit on remand from the Supreme Court.  Here, the district court found that there was no factual predicate for Microsoft’s argument, noting that “the record does not contain any direct evidence that these summonses were issued to circumvent the discovery procedures of tax court.”  The court pointed to the testimony at the evidentiary hearing, where the IRS witness stated that the investigation was still in the audit phase and the summonses were issued to help the IRS “get to the right number.”  Microsoft’s counter to this testimony was to ask the court to draw an inference from the involvement of Quinn Emanuel—namely, that a firm known for trial litigation likely was providing advice on trial preparation and the subsequently issued summonses therefore were an aspect of that trial preparation.  The court characterized this evidence as “entirely speculative” and concluded that “Microsoft has entirely failed to meet its burden of proof necessary to prevent the enforcement of these summonses.”

The district court’s decision appears to end this aspect of the Microsoft litigation, as Microsoft is likely to comply with the summons enforcement order rather than seek to have it stayed so that it could appeal.  The action on the question of the IRS’s ability to use the summons power to aid in Tax Court litigation now shifts to the Eleventh Circuit, where briefing is nearly complete in the Clarke case and the court has indicated that oral argument will likely be scheduled for the last week of February 2016.

Microsoft – Order Enforcing Summons

 

Altera Decision Now Ripe for Appeal

We reported earlier on the Tax Court’s important decision in Altera, which invalidated a transfer-pricing regulation for failure to satisfy the “reasoned decisionmaking” standard for rulemaking under the Administrative Procedure Act.  At the time, there were outstanding issues that prevented the Tax Court from entering a final decision.  The parties have now submitted agreed-upon computations, and on December 1 the Tax Court entered a final decision.  The government has 90 days to file a notice of appeal from that decision.

As we noted previously, the government will be motivated to appeal this decision both because of its specific impact on the regulation of cost-sharing agreements and, more broadly, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules.  On the other hand, the government could make a judgment that this particular case is not an ideal vehicle for litigating the broader APA issue, in part because an appeal would go to the Ninth Circuit where the Xilinx precedent on cost-sharing is on the books (see here for a report on Xilinx).  It might then make the tactical choice to forego appeal in this case and await a stronger setting in which to litigate the APA issue for the first time in an appellate court.  The Department of Justice will be weighing these competing considerations, and its conclusion should be evident when the 90-day period expires next March.

Outcome Uncertain After Federal Circuit Oral Argument in Wells Fargo Interest Netting Case

The Federal Circuit heard argument on November 5 in the government’s appeal in Wells Fargo.  The Court of Federal Claims had upheld the taxpayer’s claim for interest netting based on overlapping periods of interest for companies that later became part of Wells Fargo following statutory mergers.  See our prior report here.

The panel consisted of Judge Lourie and the two most recent appointments to the Federal Circuit, Judges Hughes and Stoll.  Although Judge Lourie was silent during the argument, the latter two judges posed questions of both sides.  Both of those judges expressed skepticism of the government’s position that it is entitled to prevail on the authority of the Federal Circuit’s earlier decision in Energy East Corp. v. United States, 645 F.3d 1358 (Fed. Cir. 2011), and of its position that identity of the taxpayer identification number (TIN) should be the litmus test of “same taxpayer.”  At the same time, the judges expressed concern that the logic of the taxpayer’s position could lead to expanding the scope of interest netting beyond the scope of what Congress intended, and even create an improper incentive for companies to merge in order to obtain interest netting benefits.  Overall, the questioning was evenhanded, and the outcome of the appeal will remain in doubt until a decision is rendered, although Judge Hughes did appear to lean towards the view that Wells Fargo has a strong case for interest netting on its particular facts.

Shortly after government counsel began the argument, Judge Hughes began to question her about whether Energy East is distinguishable because it involved two companies who filed a consolidated return (and hence were still distinct companies), rather than companies that had merged into one new company.  Although she eventually acknowledged that this factual difference could be significant in some cases, government counsel pointed out that the Energy East court did not rely on the fact that the companies were consolidated rather than merged.  Instead, that court relied on the non-consolidated status of the companies at the time of the overpayment and underpayment interest payments.  That approach of focusing on the time of payment, she argued, was fatal to Wells Fargo’s case because the TINs were not the same at the time of the respective interest payments (pre-merger and post-merger respectively).  The court returned to Energy East on the government’s rebuttal, with Judge Stoll observing that the portion of the opinion on which the government sought to rely did not truly address the “same taxpayer” requirement.  Judge Hughes concurred, observing that there never was a “same taxpayer” in Energy East and thus the court there simply did not consider how this requirement applies in the case of a merger.  He suggested that the discussion relied upon by the government was best viewed as dicta and hence could not be viewed as controlling in this case.  On the other hand, when the taxpayer’s counsel embraced the distinction between consolidated and merged taxpayers in his presentation, Judge Hughes echoed the government’s argument and pointed out that the Energy East court had not relied upon this distinction, but in fact had relied on a timing-of-payment rationale that would apply equally to Wells Fargo.

The government argued that a relatively narrower reading of “same taxpayer” is necessary because Congress wanted to ensure that obtaining interest netting benefits would not be an incentive for mergers.  It proffered Code section 381 as an example of this concern in the context of net operating losses.  Judge Hughes remarked that the government’s position made more sense in the case of “retroactive” interest netting for past years (where a merger might make preexisting interest netting claims available to a new company that had no connection to the payments), but made less sense on a going-forward basis.  Government counsel responded that there would still be an incentive for a company to “shop” for a merger partner whose overpayment interest characteristics could be used to net against an underpayment interest liability.

Judge Stoll then questioned why the government argued for different outcomes in Situations 2 and 3, where the only difference is which company is the acquirer.  She characterized the distinction as “arbitrary.”  Government counsel responded that the different outcomes flowed from its position that identity of the TIN should be the dispositive factor.  (In this connection, government counsel stated that it embraced the Court of Federal Claims’ holding in Magma Power Co. v. United States, 101 Fed. Cl. 562 (2011), but did not argue for the stricter rule set forth in the CFC’s Energy East decision that the taxpayers must be “identical.” See our report on Magma Power here.)  The TIN rule is “administrable,” counsel argued, and taxpayers can plan with the rule in mind if interest netting benefits are going to be affected by which company is the acquirer.  Judge Hughes then jumped in to second Judge Stoll’s view that there is no significant difference between Situations 2 and 3.  He also remarked that the government’s proffered policy justification for its position—namely, to prevent interest netting benefits from becoming an incentive for corporate acquisitions—is inapplicable in the Wells Fargo case because the relevant underpayment did not occur until after the particular merger that caused the change in the TIN.

In his argument, taxpayer’s counsel stated that it relies on three points:  (1) the legal effect of a merger under state law; (2) the principles previously applied by the IRS under Code section 6402 to interest offsetting when both the overpayment and underpayment were still outstanding; and 3) the IRS’s administrative practice of looking to the successor corporation in contexts other than interest netting.  He particularly emphasized the legal effect of the merger in explaining why Energy East is distinguishable, stating that once a merger occurs the surviving corporation succeeds to the attributes of the predecessor corporations.

At that point, both Judge Stoll and Judge Hughes pressed taxpayer’s counsel on why interest netting should be allowed in Situation 1, where the companies had no connection at the time of both the underpayment and overpayment.  Judge Hughes sought to illustrate his concern by presenting taxpayer’s counsel with the hypothetical situation where interest had stopped running on both the overpayment and the underpayment before the merger, yet the statute of limitations for seeking interest netting remained open after the merger.  Taxpayer’s counsel maintained that the merged corporation would be able to obtain retroactive interest netting in this situation, stating that merger law establishes that the “history [of the predecessor corporations] passes” to the successor corporation and that this conclusion accords with IRS rulings involving mergers (albeit not in the interest netting context)—specifically, Rev. Rul. 62-60, which involves employment taxes.  Both judges suggested that this result appeared to be a windfall for the taxpayer, but taxpayer’s counsel emphasized that this result accorded with the way that the IRS has consistently treated mergers.  Judge Hughes remarked that there was no unfairness to the taxpayer that needed to be remedied in this situation because at the time of the overlapping interest payments the two companies were completely unrelated.  He also criticized that outcome as running afoul of the policy not to encourage the purchase of tax benefits.  Judge Hughes went on to suggest in this connection that the taxpayer is “asking for more than you need to win your case.”

The other topic raised by the judges during the argument was the extent to which existing law requires that a merger be treated as making two corporations into the same taxpayer.  Judge Stoll asked taxpayer’s counsel whether Libson Stores, Inc. v. Koehler, 353 U.S. 382 (1957), belied this notion, but he replied that nothing in that case disturbed Helvering v. Metropolitan Edison Co., 306 U.S. 522 (1939), which indicated that state merger law would govern this question.  He added that the IRS itself in Rev. Rul. 58-603 recognized that Libson had limited effect in stating that it would not apply Libson in situations covered by section 381.  The government for its part stated that merged corporations do not actually become the same taxpayer in all respects under section 381 and that principle supersedes anything to the contrary in Metropolitan Edison or other cases.

In sum, the questioning of the two judges who participated in the Wells Fargo argument focused on three key points and suggested some predisposition by the panel on those points:  (1) although statements in the Federal Circuit’s Energy East precedent support the government, the case is distinguishable on its facts and does not require a ruling for the government; (2) the court is skeptical of the government’s proposed rule that identity of the TIN should be the dispositive factor; and (3) conversely, the panel is concerned that the taxpayer’s approach of applying traditional merger law to hold that the merged corporation inherits all the interest netting attributes of the predecessor corporations is a bridge too far and would allow more generous interest netting than intended by Congress—at least when applied to completed pre-merger periods of interest overlap.  How the Federal Circuit reconciles all of these predispositions remains to be seen, but there is a good chance that the court’s opinion ultimately will stake out a path somewhat different from that argued by either of the parties.  Keeping in mind Judge Hughes’s comment that the taxpayer is “asking for more than you need to win your case,” the outcome could still leave some uncertainty for other taxpayers with post-merger interest netting claims, even if Wells Fargo prevails, depending on their particular facts.

A decision is likely in early 2016, but there is no firm deadline for the court to issue its opinion.

Government Brief Filed in Clarke Summons Enforcement Case

After obtaining a one-month extension, the government has now filed its response brief in the Eleventh Circuit in the Clarke summons enforcement case. See our prior reports here.  The brief raises three points in response to the appellants’ argument that the IRS had an improper purpose in seeking to enforce the summonses after Tax Court litigation had begun.

First, the government argues that the appellants are essentially arguing for a blanket rule that a summons cannot be enforced once litigation has commenced in the Tax Court. Such a restriction is not found in the statute, and accordingly the government argues that the appellants’ position violates the Supreme Court’s instruction that “restrictions upon the IRS summons power should be avoided absent unambiguous directions from Congress.” Tiffany Fine Arts v. Commissioner, 469 U.S. 310, 318 (1985).  Second, the government argues that, in any event, the appellants are misguided in arguing that the enforcement decision was an improper evasion of the Tax Court’s discovery rules.  The government contends that Ash v. Commissioner, 96 T.C. 459, 472 (1991), establishes to the contrary that “the Tax Court has categorically ruled that summonses issued prior to the commencement of litigation . . . do not threaten the integrity of its discovery rules.”  The government adds that, if summons enforcement is judged to be an evasion of the Tax Court’s discovery rules, the proper remedy would be for the Tax Court itself to issue a protective order limiting the use of evidence obtained through the summons, not for the district court to quash the summons.  Third, the government argues that, as a matter of law, the enforceability of a summons must be judged as of the time it is issued.  If the summons was issued for a valid investigative purpose, that is enough, and it is irrelevant what the motivation may have been for deciding to bring an enforcement action months later.

With respect to the appellants’ objection to the district court’s failure to allow introduction of new evidence on remand, the government argues that the appellants did not make an offer of proof and hence they failed to preserve their objection. In any event, the government continues, the court acted well within its discretion in declining to delay the enforcement action further when there was no apparent need for further evidentiary proceedings.

The appellants’ reply brief is due December 14.

Clarke – U.S. Answering Brief in CA11

 

Divided Ninth Circuit Reverses Tax Court in Sophy on Question of Mortgage Interest Deduction Limits for Unmarried Taxpayers

We previously reported (see here and here) on the Ninth Circuit’s consideration of an appeal involving the mortgage interest deduction – specifically, whether the statutory limits on that deduction apply on a per-taxpayer or per-residence basis. The unmarried taxpayers here (Charles Sophy and Bruce Voss) argued that they were each entitled to take a deduction up to the $1.1 million limit for the residence that they co-owned, and thereby receive double the tax benefit that a similarly situated married couple would receive, but the Tax Court disagreed. The briefing in this case was completed in April 2013, but the Ninth Circuit did not schedule oral argument until almost two years later. The court has finally issued its decision, reversing the Tax Court by a 2-1 vote. (Although we have referred to the case as Sophy based on the Tax Court’s caption, the Ninth Circuit opinion reverses the order of the two taxpayers in its caption, and therefore the case may come to be referred to as Voss in the future.)

The majority opinion (authored by Judge Bybee and joined by 8th Circuit Senior Judge Melloy, sitting by designation) recognized that neither the statute nor the regulations directly address this question and then engaged in a detailed textual analysis of various provisions of Code section 163. The majority found the strongest evidence of the correct answer in the statute’s treatment of married taxpayers who file separately. In order to put them in the same position as married taxpayers who file jointly, the statute provides in a parenthetical that married taxpayers filing separately are each entitled to a $550,000 deduction. Because that approach reflects a per-taxpayer rather than per-residence treatment, the majority concluded that the same per-taxpayer approach should be applied to unmarried taxpayers, even though it arguably gives them a windfall double deduction.

The majority rejected the Tax Court’s argument that other provisions of Code section 163 reveal a “focus” on the residence, and it also rejected the Tax Court’s explanation that the approach to married-filing-separately taxpayers was meant to address only the proper allocation of a deduction that is already limited to $1.1 million per residence. Finally, the majority acknowledged that its holding results in a “marriage penalty,” but surmised that “Congress may very well have good reasons for allowing that result” and added that, even if Congress didn’t, the court was bound by the text of a statute that singles out married taxpayers (who file separately) for specific treatment that is not explicitly provided for unmarried co-owners.

Judge Ikuta dissented, arguing primarily that the court should defer to the IRS’s administrative interpretation of the statute set forth in a 2009 Chief Counsel Advice memorandum. She maintained that this informal guidance is entitled to “Skidmore deference,” which the Supreme Court has described as a measure of deference equivalent to the interpretation’s “power to persuade.” The majority found that this level of deference was negligible because the CCA contained only a fairly cursory analysis of the statute, which carried little power to persuade. Judge Ikuta reasoned, however, that the CCA is “more persuasive” than the taxpayer’s interpretation, “which would result in a windfall to unmarried taxpayers.” As to the majority opinion, Judge Ikuta characterized as “the thinnest of reeds” its reliance on the treatment of married taxpayers filing separately.

The government has until November 3 to seek certiorari, but there is no reason to expect that the government would seriously consider seeking Supreme Court review in this case.

Sophy – Ninth Circuit opinion

 

 

 

Federal Circuit Set to Address Post-Merger Application of “Same Taxpayer” Requirement for Interest Netting

The Federal Circuit is now considering an appeal by the government that seeks to restrict the availability of interest netting following mergers. Section 6621(d) provides for a “net interest rate of zero” on “equivalent underpayments and overpayments by the same taxpayer.” As we previously reported here and here, the government declined to pursue an appeal in Magma Power Co. v. United States, 101 Fed. Cl. 562 (2011), in which the Court of Federal Claims held that the “same taxpayer” requirement did not prevent interest netting where the taxpayer was a member of a consolidated group with respect to the period of overpayment interest but was outside the group in the tax year that triggered the underpayment interest. The court concluded there that since the taxpayer had the same taxpayer identification number (TIN) both before and after it became of member of the consolidated group it was the “same taxpayer.”

In Wells Fargo v. United States, however, the government again invoked this statutory language to oppose interest netting—this time in the context of a large taxpayer that had emerged from a series of mergers. The government contended that the “same taxpayer” requirement barred interest netting because the mergers altered the corporate identity of the taxpayers who incurred the overpayments and underpayments. The facts are complex, but the trial court distilled them into three possible scenarios – whether it is permitted to net interest from underpayments and overpayments between: 1) a pre-merger acquiring corporation and a pre-merger acquired corporation; or 2) a pre-merger acquiring corporation and the post-merger surviving corporation; or 3) a pre-merger acquired corporation and the post-merger surviving corporation.

Seizing on the rationale of Magma Power, the government argued that interest netting was unavailable in situations 1 and 3 because the two taxpayers involved do not have the same TIN. The government also relied upon Energy East Corp. v. United States, 645 F.3d 1358 (Fed. Cir. 2011), where the court of appeals held that a parent corporation and subsidiary that were not affiliated at the time each made tax payments could not later net interest in their consolidated return. By contrast, the taxpayer argued that, under established principles, the legal identities of the pre-merger companies are absorbed into the new, post-merger corporation. The new entity, of course, has a different TIN because the acquired corporation no longer exists, but that should not change the availability of interest netting.

The Court of Federal Claims first found that Energy East and Magma Power were distinguishable because “they involved separate but affiliated corporations,” not merged corporations. The court then examined merger law, noting that the surviving corporation is “liable retroactively for the tax payments of its predecessors.” The court concluded that “following a merger, the law treats the acquired corporation as though it had always been part of the surviving entity,” and therefore “the corporations in the present case became the ‘same taxpayer’ by virtue of the statutory merger.” As a result, the court ruled that Wells Fargo was entitled to interest netting in all three of the described scenarios.

The trial court agreed to certify the issue for interlocutory appeal, and the Federal Circuit accepted the appeal. In its briefs, the government relies primarily on the same arguments it made below. It argues that both Energy East and the TIN rule require that interest netting be denied in scenarios 1 and 3. The brief distinguishes between the two scenarios, however, arguing that even if the court were to adopt “a broader inquiry into corporate identity” that would allow netting for scenario 1, it should still deny netting for scenario 3 because the “relevant essentials” of the two entities involved are too different.

The taxpayer’s brief largely defends the rationale of the Court of Federal Claims, relying on “longstanding principles of state merger law.” The taxpayer also emphasizes, as did the trial court, that prior to Energy East the IRS had generally applied the “corporate continuity principle” in its administrative rulings in areas of federal tax law other than interest netting.

Oral argument is scheduled for November 5.

Wells Fargo – Court of Federal Claims opinion

Wells Fargo – Government Opening Brief

Wells Fargo – Taxpayer brief

Wells Fargo – Government Reply Brief

 

Tax Court Relies on APA to Invalidate the Cost-Sharing Regulation Governing Stock-Based Compensation

We present here a guest post from our colleagues Patricia Sweeney and Andrew Howlett. A longer version of this post is published here.

In Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), the Tax Court put the IRS and Treasury on notice that, when promulgating regulations premised on “an empirical determination,” the factual premises underlying those regulations must be based on evidence or known transactions, not on assumptions or theories. Otherwise, the regulations do not comply with the requirements of the Administrative Procedure Act (“APA”), 5 U.S.C. § 551 et seq. Applying the arm’s-length standard of Code section 482, the Altera decision provides another example of transfer-pricing litigation being decided on the basis of evidence of actual arm’s-length dealings rather than economic theories. Looking more broadly beyond the section 482 context, the decision is an important reminder to the IRS and Treasury that, in the wake of the Supreme Court’s decision in Mayo Foundation (562 U.S. 44 (2011), see our prior reports on the decision and oral argument in that case here and here), tax regulations are subject to the same APA procedures as regulations issued by other federal agencies. As a result, Treasury cannot ignore the evidence and comments submitted during the rulemaking process. If it is to reject that evidence, Treasury must engage in its own factfinding, and it must explain the rationale for its decision based upon the factual evidence.

Because of its specific impact on the regulation of cost-sharing agreements and, more generally, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules, the government will strongly consider an appeal of this decision to the Ninth Circuit. A notice of appeal will be due 90 days after the Tax Court enters its final decision, but there is not yet a final, appealable order in Altera.

The Context for the Dispute. Code section 482 authorizes the Commissioner to allocate income and expenses among related parties to ensure that transactions between them clearly reflect income. Treas. Reg. § 1.482-1(b)(1) provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” In 1986, Congress amended section 482 to provide that, “in 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.” As noted by the Tax Court, Congress enacted this amendment to section 482 in response to concerns regarding the lack of comparable arm’s-length transactions, particularly in the context of high-profit-potential intangibles. Congress did not intend, however, to preclude the use of bona fide cost-sharing arrangements under which related parties that share the cost of developing intangibles in proportion to expected benefits have the right to separately exploit such intangibles free of any royalty obligation. See H.R. Conf. Rep. No. 99-841 (Vol. II), at II-637 to II-638 (1986).

In 1995, Treasury issued detailed new cost-sharing regulations that generally authorized the IRS “to make each controlled participant’s share of the costs . . . of intangible development under the qualified cost sharing arrangement equal to its share of reasonably anticipated benefits attributable to such development.” In Xilinx, Inc. v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010), the Ninth Circuit affirmed the Tax Court’s holding that the regulations did not require the taxpayer to include employee stock options (“ESOs”) granted to employees engaged in development activities in the pool of costs shared under the cost-sharing arrangement. The court reasoned that the term “costs” in the regulation did not include ESOs because that would not comport with the “dominant purpose” of the transfer pricing regulations as a whole, which is to put commonly controlled taxpayers at “tax parity” with uncontrolled taxpayers. Because of the overwhelming evidence that unrelated parties dealing at arm’s length in fact do not share ESOs in similar co-development arrangements, the court concluded that such tax parity is best furthered by a holding that the ESOs need not be shared. (For a more detailed examination of Xilinx, see our contemporaneous analysis here.)

In 2003 (prior to the Xilinx decision), Treasury had amended the transfer pricing regulations that were applicable to the years at issue in Xilinx. The amended regulations explicitly address the interaction between the arm’s-length standard and the cost-sharing rules, as well as the treatment of ESOs. Treas. Reg. § 1.482-1(b)(2)(i) now states that “Treas. Reg. § 1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement . . . produces results consistent with an arm’s length result.” Contrary to Xilinx, Treas. Reg. § 1.482-7(d)(2), as amended, specifically identifies stock-based compensation as a cost that must be shared.

Altera did not include ESOs or other stock-based compensation in the cost pool under the cost-sharing agreement it entered into with a Cayman Islands subsidiary. In accordance with the 2003 regulations, the IRS asserted that those costs should be included in the pool, and that, as a result, Altera’s income should be increased by approximately $80 million in the aggregate.

The Tax Court’s Analysis. Ruling on cross motions for summary judgment, the Tax Court, in a 14-0 decision reviewed by the full court, agreed with the taxpayer that the 2003 amendments to the cost-sharing regulations were invalid under the APA because Treasury did not adequately consider the evidence presented by commentators during the rulemaking process that stock-based compensation costs are not shared in actual third-party transactions.

The Tax Court first addressed the threshold issue of whether the 2003 regulations were governed by the rulemaking requirements of section 553 of the APA. To that end, it analyzed whether the regulations were “legislative” (regulations that have the force of law promulgated by an administrative agency as the result of statutory delegation) or “interpretive” (mere explanations of preexisting law). (This legislative/interpretive distinction under the APA is different from the distinction between legislative and interpretive Treasury regulations that was applied for many years in tax cases, but rendered largely obsolete by the Supreme Court’s Mayo decision.) Relying on Hemp Indus. Ass’n v. DEA, 333 F.3d 1082 (9th Cir. 2003), the Tax Court found that the 2003 cost-sharing regulations were legislative because there would be no basis for the IRS’s position that the cost of stock-based compensation must be shared under section 482 absent the regulation and because Treasury invoked its general legislative rulemaking authority under Code section 7805(a) with respect to the regulation.

APA section 553 generally requires the administrative agency to publish a notice of proposed rulemaking in the Federal Register, to provide interested persons an opportunity to participate in the rulemaking through written comments, and to incorporate in the adopted rules a concise general statement of their basis and purpose. APA section 706(2)(A) empowers courts to invalidate regulations if they are “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” The Tax Court cited Motor Vehicles Mfrs. Ass’n v. State Farm, 463 U.S. 29 (1983), as holding that this standard requires “reasoned decisionmaking” and that a regulation may be invalidated as arbitrary or capricious if it is not based on consideration of the relevant factors and involves a clear error of judgment.

The Tax Court found that the stock-based compensation rule did not comply with the reasoned decisionmaking standard because the rule lacked a factual basis and was contrary to evidence presented to Treasury during the rulemaking process. The Tax Court stated that, although the preamble to the 2003 rule stated that unrelated parties entering into cost-sharing agreements typically would share ESO costs (thereby relating the regulation to the arm’s-length requirement of section 482), Treasury had no factual basis for this assertion. Commentators had provided substantial evidence that stock-based compensation costs were not shared in actual third-party agreements, which the Tax Court itself had found (and which the government conceded) in Xilinx. Treasury could draw no support from any of the submitted comments nor did it engage in any of its own factfinding to support its position. Absent such factfinding or other evidence, the Tax Court concluded that “Treasury’s conclusion that the final rule is consistent with the arm’s-length standard is contrary to all of the evidence before it.”

The Tax Court also stated that Treasury’s failure to respond to any of the comments submitted was evidence that the regulation did not satisfy the State Farm standard, stating “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is [because m]eaningful judicial review and fair treatment of affected persons require an exchange of views, information and criticism between interested persons and the agencies.” As a result, the final rule failed to satisfy State Farm’s reasoned decisionmaking standard.

Challenges for Treasury. The Altera decision highlights the limitations of the Treasury Department’s rulemaking authority when the regulation is based on a factual determination. In that situation, the deference normally given to Treasury because of its expertise as an administrative agency carries little weight unless it is supported by specific factfinding Treasury has done with respect to the rule at issue. In other words, Treasury cannot expect tax regulations that seek to implement a fact-based standard to be upheld simply because Treasury believes that they reach the right theoretical result. Instead, Treasury must explicitly cite the evidence and explain how that evidence provides a rational basis for the regulation.

The Altera decision should motivate Treasury to incorporate responses to submitted comments in its descriptions of final regulations. By specifically citing Treasury’s failure (1) to respond to comments or (2) to engage in independent factfinding as being important components of judicial review under the APA, the Tax Court’s decision effectively directs Treasury to spend more resources during the rulemaking process.

More broadly, the Altera decision underscores the constraints placed on Treasury and other administrative agencies under the APA. Although Mayo announced that Chevron deference principles would apply to Treasury regulations in the future, that was not a radical shift in the law because Treasury regulations had always been subjected to a deference analysis that bore considerable similarity to Chevron. By contrast, as the Tax Court noted, Treasury regulations have not traditionally been measured by APA standards, and Treasury’s notice-and-comment procedures have not been analyzed under State Farm. The Tax Court’s unanimous decision in Altera shows that judicial review under the State Farm standard is more than a mere paper tiger; where Treasury does not demonstrate that it adequately considered the relevant factors, including submitted comments, its regulation is at risk of being overturned. Although Altera as of now is binding authority only in Tax Court cases, challenges to Treasury regulations in other forums likely will cite its reasoning with respect to what constitutes reasoned decisionmaking for purposes of judicial review under the APA.

Considerations for Taxpayers. Absent reversal on appeal, Altera will have an impact on all related-party cost-sharing agreements. Although cost-sharing agreements governed by the 2003 regulations typically have provided for a sharing of stock-based compensation, they often have provided for a retroactive adjustment back to the start of the agreement if there is any relevant change in law. Taxpayers with cost-sharing agreements should carefully review their agreements and tax positions to determine whether their agreement provides for an adjustment mechanism or whether if claims for refund for open years are appropriate based on the Altera holding.

In addition, taxpayers should consider whether Altera has opened the door for additional regulatory challenges, both in the transfer pricing arena and elsewhere, in contexts where the regulations were premised on factual or theoretical assumptions by Treasury that lack sufficient evidentiary support. The Altera case already has been brought to the attention of the district court handling the Microsoft summons litigation in the Western District of Washington as relevant to determining whether the Treasury regulations at issue there are valid, and the case will likely also be cited in cases involving the validity of other transfer pricing regulations, such as the regulations currently under review by the Tax Court in 3M Co. et al. v. Commissioner; No. 005816-13. In addition, the transfer pricing regulations governing services transactions, which were developed following the regulations at issue in Altera, also define the term “cost” to include stock-based compensation and therefore may be vulnerable to reasoning similar to that in Altera.

Finally, taxpayers and other commentators should consider the Tax Court’s reasoning in Altera in developing comments to proposed regulations. Altera demonstrates that such comments can be important in laying a foundation for future judicial challenge even if the commentators are not successful in persuading Treasury to adopt their position.

Altera – Tax Court opinion

Summons Enforcement Update — Opening Brief Filed in Clarke and Briefing Ordered in Microsoft

The government has filed its opening brief in the Eleventh Circuit in the Clarke case. The case is now back in that court for the second time after a remand from the Supreme Court that did not persuade the district court to retreat from its prior denial of an evidentiary hearing. See our previous report here.

On the merits, the appellants’ primary argument is that they are entitled to a hearing to explore their allegation that the government is misusing the summons enforcement process to obtain discovery for pending Tax Court proceedings. To that end, the appellants ask the court not to restrict its consideration of the validity of the summons to the situation existing on the date it was issued, but instead to look at the later decision to enforce the summons – well after the statute of limitations had expired. Secondarily, the appellants argue that the district court erred in refusing to allow them to make supplemental submissions in the wake of the Supreme Court’s remand, which arguably changed the legal standard to be applied to appellants’ contentions.

The government’s response brief is due in late September.

In the Microsoft case, the district court held an evidentiary hearing on August 25 and has ordered the parties to submit supplemental briefs on September 2.

Clarke – Appellants Opening Brief in CA11

Update on Microsoft Hearing

For those who have been wondering why they have seen no reports on the evidentiary hearing in the Microsoft summons enforcement case (see our previous report here), the hearing was postponed at the request of both parties.  It has been rescheduled for August 25.

Summons Enforcement Hearing in Microsoft Set for July 21

While the Eleventh Circuit begins the process of reconsidering the Clarke summons enforcement case following the Supreme Court’s remand (see our prior reports here), a federal district court is poised to address similar issues much sooner in a case that has garnered extensive publicity.  (Incidentally, briefing is now underway in Clarke, with the respondents’ opening brief on appeal due on August 14.).

As most readers probably know, the government is engaged in a major transfer pricing audit of Microsoft in connection with its cost-sharing arrangements with affiliates in Puerto Rico and Asia.  The IRS has hired the law firm of Quinn Emanuel as a consultant to assist in the audit, including participating in interviews.  That unusual course of action by the IRS has attracted much attention, including from the Senate Finance Committee, which sent a letter to the IRS demanding an explanation and requesting that the IRS halt the use of such private contractors “for both the examination of records and the taking of sworn testimony.”

Microsoft has vigorously challenged the legality of the IRS’s engagement of Quinn Emanuel.  The IRS contends that its action is authorized by a temporary regulation promulgated without notice-and-comment on June 9, 2014, which provides that third-party contractors “may receive books, papers, records, or other data summoned by the IRS and take testimony of a person who the IRS has summoned.”  26 C.F.R. § 301.7602-IT(b)(3).  The IRS contends that Quinn Emanuel did not commence work under the contract until approximately a month after the regulation was issued, although technically it was retained earlier.

Microsoft has pursued its challenge on multiple fronts.  It submitted several FOIA requests to the IRS, and its FOIA requests for documents relating to promulgation of the temporary regulation and its contacts with the private law firms are the subject of pending lawsuits in federal district court in Seattle (Western District of Washington).  (An earlier FOIA suit was dismissed after the IRS capitulated and turned over its contract with Quinn Emanuel.)  The immediate action, however, lies in a summons enforcement suit pending before the same judge as the FOIA cases (Judge Ricardo Martinez).

After issuing more than 200 IDRs, the IRS issued several designated summonses seeking additional information.  Microsoft forced the IRS to go to court to seek enforcement of the summonses and then argued that it was entitled to an evidentiary hearing (and discovery of the documents being sought in the FOIA litigation) before being required to comply.  Microsoft’s objections centered on the Quinn Emanuel engagement, with Microsoft contending that the IRS had improperly delegated key aspects of the tax audit and that it was entitled to a hearing to explore exactly what was the firm’s role.

On June 17, the district court granted Microsoft’s motion to conduct an evidentiary hearing.  Citing repeatedly to Clarke, the court remarked that Microsoft needed to carry only a “fairly slight burden to trigger an evidentiary hearing.”  The court found the hearing appropriate because Microsoft had made a “plausible” showing that the regulation is invalid.  The court first observed that the statutory provisions establishing the summons authority do not appear to leave room for delegation to non-government officials.  In particular, the term “delegate” of the Secretary of the Treasury is defined as “any officer, employee, or agency of the Treasury Department duly authorized by the Secretary” to perform the delegated task.  I.R.C. § 7701(a)(12)(A)(i).  Although the court acknowledged that this argument based on the plain language of the statute raised a question of law, the court added that there were “factual questions” raised as well.  In support, it pointed to Microsoft’s contention that the IRS had not satisfied the requirements for an exception from notice-and-comment procedures and that the regulation is fatally flawed for being “issued without reasoned analysis.”  The court also stated that the timing of the regulation in close proximity to the Quinn Emanuel contract “plausibly raises an inference of improper motive.”

With respect to Microsoft’s specific objection to Quinn Emanuel’s participation, the court made a more convincing case for a hearing to explore factual issues.  The court found that the language of the contract suggested that the firm “may be participating in components of the audit examination for which delegation is statutorily proscribed, such as inspecting books and taking testimony.”  The court also found that, given the timing of the firm’s retention, Microsoft had plausibly raised an inference that the firm had “played an unauthorized role in the issuance of several IDRs” and might have been provided taxpayer information in violation of section 6103.

The court, however, stated that it was not prepared to accede to Microsoft’s request for document discovery regarding the issuance of the summons.  Asserting that a “more stringent” showing of wrongdoing is required to warrant discovery, the court ruled that it would consider the discovery request after the evidentiary hearing, which it scheduled for July 21.

The parties have been skirmishing in advance about how the hearing should be conducted, and those disputes give concrete expression to the concerns the government expressed in Clarke about burdensomeness if evidentiary hearings are too readily allowed in summons enforcement proceedings.  The IRS has put forth an official to testify at the hearing who it asserts has the most knowledge of the circumstances surrounding the issuance of the summons.  Microsoft, however, wants to examine a more senior official about the bigger picture and has urged the court to require the IRS to make available at the hearing or for deposition Heather Maloy, the soon-to-be ex-Commissioner of LB&I.  (Ms. Maloy’s last scheduled day at the IRS is tomorrow, July 10.)  Microsoft has also asked the court to order the IRS to provide, 10 days in advance, summaries of the substance of the testimony it intends to introduce at the hearing.  The government, for its part, has asked the court to clarify several evidentiary and procedural matters surrounding the hearing.  The court heard argument on these various pre-hearing requests at a telephone conference on July 7.

Thus, in addition to the remand decision in Clarke itself, the high-profile Microsoft case promises to shed further light on how the lower courts will approach evidentiary hearings in summons enforcement actions in the wake of Clarke.

Microsoft – Order re Evidentiary Hearing

Microsoft – Letter from Sen. Hatch

Eleventh Circuit Set to Consider Whether IRS Impermissibly Used Summons Power to Obtain “Discovery” in the Tax Court

As we previously reported, the Supreme Court’s decision in the Clarke summons enforcement case was not a complete victory for the government.  The Court set forth a standard that appeared to leave a little more room than before for summoned parties to obtain an evidentiary hearing in resisting summons enforcement actions.  The Court left open the possibility that the lower courts on remand could require a hearing in Clarke itself at which IRS officials would have to testify.

The Eleventh Circuit elected not to address this question in the first instance after the Supreme Court remand.  Instead, it sent the case straight back to the district court with instructions to reconsider its original enforcement order in light of the Eleventh Circuit and Supreme Court opinions.  But the district court saw no reason to change its tune on remand.  First, it refused the private respondents’ request to introduce additional evidence in opposition to the summons enforcement request.  The district court then issued a six-page opinion rejecting point-by-point—in some instances for lack of evidence—the arguments made by the respondents for why the summons might be thought to be improperly motivated.  The respondents have now appealed that latest decision back up to the Eleventh Circuit.

As noted in our previous report, an important aspect of the Supreme Court’s decision was how it dealt with the respondents’ objection that the government sought summons enforcement in order to obtain “discovery” in a Tax Court case that was filed soon after issuance of the summons.  The government had argued that this objection carried no weight because the validity of a summons must be judged as of the time of its issuance, and therefore a later action to seek enforcement to aid litigation in the Tax Court could not be invoked as a ground for challenging the summons.  The district court had endorsed this argument, but the Supreme Court declined to do so.  Instead, the Supreme Court remarked that it was expressing “no view on the issue” and left this question open for the court of appeals to decide on remand.  The Court emphasized that, in deciding this issue, the court of appeals would not be confined by the deference ordinarily owed to the district court’s decision on whether or not to order the questioning of IRS agents in a summons enforcement action.  Rather, the Supreme Court ruled that this argument implicated a “legal issue about what counts as an illicit motive” on which the court of appeals would have “no cause to defer to the district court.”

That legal issue is now teed up for the court of appeals.  The district court’s new opinion on remand essentially repeated the brief analysis of this point from its first opinion, stating that “events occurring after the date of issuance but prior to enforcement should not affect enforceability.”  The court of appeals will review that ruling de novo.  Having reversed the district court and ordered an evidentiary hearing when it last considered the case, it would not be surprising to see the court of appeals reach the same outcome as before and hold that the government’s conduct in the Tax Court proceedings provides enough justification for the court to hold an evidentiary hearing to explore the IRS’s motivation for issuing the summons.

The Eleventh Circuit has not yet issued a briefing schedule.

Clarke – District Court decision on remand

Denial of Rehearing in MassMutual Tees Up Government Decision on Seeking Supreme Court Review of All-Events Test Issue

Let me just begin with a brief apology to the regular readers of this blog for the infrequency of postings over the past several months.  A variety of factors and the press of other matters have interfered with blogging, but we are resolved to get back up to speed in the upcoming months by providing some analysis of intervening developments and posts on some new pending cases.

As we previously reported here, the Second Circuit and the Court of Federal Claims reached different results in considering the application of the all-events test to annual policyholder dividends paid by mutual insurance companies.  The Federal Circuit’s recent affirmance of the Court of Federal Claims in the MassMutual case, allowing the taxpayer to accrue those dividend payments in the year before the dividends were actually paid, thus raises the possibility that the Supreme Court will be asked to wade into this controversy.  The Federal Circuit’s decision does not necessarily establish a square conflict in the circuits, because the respective courts of appeals viewed the dividend programs of New York Life and MassMutual, though similar, as having differences that warranted the disparate results.  But there is sufficient tension between the two circuit court decisions to provide a basis for a credible petition for certiorari to resolve this issue should the government decide to seek Supreme Court review.

The Federal Circuit (Judges O’Malley, Lourie, and Moore) sided with the taxpayer on all issues.  With respect to the threshold issue of the existence of an obligation, the court rejected the government’s argument that the facts were indistinguishable from those in the Second Circuit’s New York Life case.  The Federal Circuit stated that, “[u]nlike New York Life, however, the policies at issue here stated that MassMutual . . . would pay dividends to eligible policyholders,” thus giving those policyholders “a contractual obligation . . . that they would receive a policyholder dividend.”

The court then distinguished the Second Circuit case again in addressing the key issue of whether the taxpayer’s liability was fixed by the close of the taxable year.  The court held that MassMutual had “promised an entire class of policyholders that they would be entitled to the guarantee payments on a pro rata basis,” whereas “New York Life made such guarantees on an individual basis.”  The court viewed this difference as a “significant” one that called for a different result.  The court explained that an individual’s decision to terminate a MassMutual policy would affect only the amount of that company’s obligation to pay a dividend to the remaining members of the class, but the liability to the class would remain.  Thus, the court concluded that “the only uncertainty at the end of the year in which the guarantees were determined was who would ultimately make up the group of policyholders—there was no question that MassMutual had passed an absolute resolution to pay the guaranteed dividend and that at least some policyholders were already qualified recipients of that guarantee.”

Finally, the court held that the dividend payments were “rebates” within the meaning of Treas. Reg. § 1.461-4(g)(3), thereby satisfying the recurring item exception of Code section 461(h).

The government’s response to the opinion was consistent with the approach it has previously taken of minimizing the factual differences between the two cases and presenting them as directly in conflict.  The government sought rehearing by the panel, not rehearing en banc, limited to the question whether the liability was fixed at the close of the taxable year.  It argued that the Federal Circuit had failed to appreciate that MassMutual would have no liability to pay dividends if the policyholder surrendered his or her policy before the dividend payment date.  Accordingly, the government argued, the court erred in finding that “the insurance policies at issue here differed from those at issue in New York Life.”  In neither case, the government maintained, did the payment of premiums necessarily entitle the policyholder to a dividend, and therefore the liability was not fixed until the following year when it became apparent that the policyholder was not surrendering the policy before the dividend payment date.  The Federal Circuit, however, denied the rehearing petition without comment and without modifying its opinion, thus leaving in place the court’s distinction of its facts from those before the Second Circuit in New York Life.

The question remains whether the government will seek Supreme Court review.  The government has preserved its ability to argue that the Federal Circuit and Second Circuit decisions are irreconcilable, which would be a key element in persuading the Supreme Court to hear the case.  Specifically, in the petition for certiorari filed by New York Life, the taxpayer had pointed to a conflict between the Second Circuit’s decision and that of the Court of Federal Claims.  Ordinarily, when opposing a petition for certiorari that raises a claim of conflicting circuit decisions, the Solicitor General will try to defuse the conflict contention by pointing to distinctions between the two cases if at all possible.  In its New York Life brief, however, the SG did not embrace the Second Circuit’s suggested distinction of the two cases, but simply argued that it was premature for the Supreme Court to worry about the alleged conflict because the Court of Federal Claims decision might be reversed on appeal.  Now that the Court of Federal Claims has been affirmed on appeal, the government is in a position to file its own petition for certiorari alleging a conflict.  The Supreme Court, of course, may not be persuaded by that claim when both the Second Circuit (somewhat diffidently) and the Federal Circuit (more definitively) have stated that they do not see a conflict.

The government’s decision ultimately comes down to its assessment of the importance of this issue, weighed against the importance of other cases that it might choose to bring to the Court.  (The Court decided fewer than 70 cases this past year, and not all of those are cases involving the federal government.)  That MassMutual was decided by the Federal Circuit heightens the importance of Supreme Court review to some extent because any taxpayer can arrange to file a refund suit and have its case go to the Federal Circuit.  Thus, in the future, mutual insurance companies could tweak their policyholder dividend programs to be indistinguishable from MassMutual’s and be guaranteed victory on this issue by bringing a refund suit in the Court of Federal Claims.  And by the same token, the government will not be able to get much benefit from its victory in New York Life because savvy taxpayers will not risk litigating this issue in the Second Circuit (or any other circuit, for that matter).  Despite these concerns, there is a good chance that the government will simply decide that the policyholder-dividend issue is not of sufficient moment to bring to the Court, and the government will learn to live with its defeat in MassMutual.

A petition for certiorari would be due on September 15.

MassMutual – Federal Circuit opinion

MassMutual – Petition for Rehearing

New York Life – Petition for Certiorari

New York Life – Brief in Opposition

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

Second Circuit Summarily Affirms in Barnes

The Second Circuit did not make the parties wait very long to learn the outcome of the Barnes Group’s appeal from the Tax Court’s imposition of dividend treatment on its multi-step transaction that enabled it to use in the United States cash that was located in Singapore.  See our prior reports here and here.  Little more than a month after oral argument, the court of appeals today issued a summary order affirming the Tax Court in all respects.  The first page of such unpublished orders recites that they “do not have precedential effect,” but they can be cited in future cases pursuant to Fed. R. App. P. 32.1 (albeit only in limited circumstances in the Second Circuit, see 2d Cir. Local Rule 32.1.1).  In any event, the court issued a nine-page opinion briefly touching on the issues.

First, the court of appeals quickly agreed with the Tax Court that the IRS had not run afoul of the principle that it should not argue against its own revenue rulings.  Even though Barnes had relied on Rev. Rul. 74-503 in determining the tax consequences of a key step in the transaction, the court of appeals accepted the Tax Court’s explanation that Rev. Rul. 74-503 could be disregarded because it “addressed the tax treatment of an isolated exchange of stock, and therefore provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction doctrine.”

The court then upheld the application of the step-transaction doctrine, agreeing with the Tax Court that the intermediate steps would have been fruitless unless they were part of a single integrated plan.  The court rejected the taxpayer’s argument that the doctrine should not apply because the steps had a valid business purpose, finding that the Tax Court’s contrary finding of no valid business purpose was not clearly erroneous.  Specifically, the court of appeals stated that “any non-tax benefit of including the financing subsidiaries was, at best, a mere afterthought.”  Similarly, the court held that the Tax Court did not clearly err in premising its constructive dividend conclusion on a finding that Barnes failed to show that certain interest or preferred dividend payments were ever made.

Finally, the court of appeals upheld the imposition of the 20% accuracy-related penalty.  It ruled that its previous distinction of Rev. Rul. 74-503 as not applying to a situation involving multiple steps also made that ruling unavailable as “substantial authority” that could eliminate the penalty.  And it ruled that Barnes had no “reasonable cause and good faith” defense because the PwC opinion on which it had relied “does not advise as to the tax consequences of the entire series of transactions transferring funds from ASA to Barnes.”

Barnes – Second Circuit opinion

Oral Arguments Scheduled in Barnes and MassMutual

As you may have noticed, the blog has been on summer vacation for a variety of reasons.  I hope our readers managed some vacation as well and are now eagerly awaiting updates on appellate tax matters.  In any case, here are updates on two cases that have now been scheduled for oral argument in the fall.  The identity of the judges who will hear these appeals has not yet been revealed.

Oral argument in the MassMutual case in the Federal Circuit is scheduled for Tuesday morning, October 14.

Oral argument in Barnes in the Second Circuit is scheduled for Wednesday morning, October 1.

 

Supreme Court’s Clarke Decision Sets Forth General Guidelines for When Evidentiary Hearings Should Be Required in Summons Enforcement Proceedings

As expected, the Court this morning reversed the Eleventh Circuit’s decision in Clarke based on the Court’s agreement with the government’s position that the Eleventh Circuit erroneously had required an evidentiary summons enforcement hearing based on nothing more than the bare allegation of an improper purpose. See our previous report here.  But the Court’s unanimous opinion, authored by Justice Kagan, went on to attempt to provide guidance for future disputes over the availability of such hearings, including the resolution of this case on remand, and that guidance could perhaps lead courts to allow such hearings more often than in the past.

The Court summarized the standard to be applied by a court in considering the summoned party’s request for a hearing as follows: “whether the [summoned party has] pointed to specific facts or circumstances plausibly raising an inference of improper motive.”  It elaborated on that standard to some extent elsewhere in the opinion, although the general language still leaves considerable room for interpretation by the lower courts:

“[T]he taxpayer is entitled to examine an IRS agent when he can point to specific facts and circumstances plausibly raising an inference of bad faith.  Naked allegations of improper purpose are not enough:  The taxpayer must offer some credible evidence supporting his charge.  But circumstantial evidence can suffice to meet that burden; after all, direct evidence of another person’s bad faith, at this threshold stage, will rarely if ever be available.  And although bare assertion or conjecture is not enough, neither is a fleshed out case demanded:  The taxpayer need only make a showing of facts that give rise to a plausible inference of improper motive.  That standard will ensure inquiry where the facts and circumstances make inquiry appropriate, without turning every summons dispute into a fishing expedition for official wrongdoing.”

The immediate result of the decision is a remand to the Eleventh Circuit to determine whether the district court’s refusal to order an evidentiary hearing comported with this standard.  The Court did not express a view on whether the evidence that the private parties had put forth (alleging retaliation for failure to agree to a statute of limitations extension and an ulterior motive to conduct the equivalent of discovery for the Tax Court case) met the standard, stating that whether those purposes would be improper was not within the question presented to the Court.  But the Court did set forth some principles for how the Eleventh Circuit should go about reviewing the district court’s decision.

At the outset, the district court’s decision is entitled to deference and is reviewed for abuse of discretion.  But the Court emphasized “two caveats” to that discretion. First, no deference is owed if the district court did not apply the correct standard. Second, no deference is owed to the district court’s decision on “legal issues about what counts as an illicit motive.”

In that connection, the Court proceeded to state that this second caveat encompassed the issue to which the private parties have attached considerable importance – namely, the contention that the IRS was seeking to enforce the summons only in order to obtain discovery for the Tax Court proceedings.  The district court had agreed with the government that this would not constitute an improper purpose because the validity of a summons should be judged as of the time of issuance (which was before the Tax Court proceedings were initiated), not as of the time the IRS moves to enforce the summonses. The Supreme Court declined to endorse that argument, inviting the Eleventh Circuit to consider it as a legal issue on which it owes no deference to the Tax Court.

Thus, the government has dodged a bullet in Clarke, with the Supreme Court reversing the Eleventh Circuit and rejecting the proposition that IRS agents can be hauled into an evidentiary hearing on the basis of a bare allegation of improper purpose.  But the government could well find itself facing a loss again on remand when the Eleventh Circuit applies the standard set forth in Clarke to the evidence in this case.  There is nothing in the Supreme Court’s opinion to discourage the Eleventh Circuit (presumably the same judges who already voted once to afford an evidentiary hearing in this case) from concluding that the private parties here did make a sufficient showing because, as a matter of law, it is improper for the IRS to move to enforce a summons for the purpose of obtaining information to be used in pending Tax Court proceedings.  It will be worth following the remand proceedings in the court of appeals to see how the Eleventh Circuit deals with this issue.

Clarke – Supreme Court decision

Supreme Court to Rule Soon in Summons Enforcement Dispute

It is now six weeks since the Supreme Court heard argument in Clarke regarding the circumstances under which a court must convene an evidentiary hearing in a summons enforcement proceeding to allow IRS officials to be questioned regarded their reasons for issuing the summons. Based on the way the case was litigated and the questions at oral argument, the government is likely rooting for a relatively narrower opinion, whereas taxpayers who might someday be disputing a summons hope that the Court will take this opportunity to elaborate and provide new guidance on summons enforcement proceedings.

The dichotomy between a broad approach and a narrow approach has been reflected all through this case, beginning with the divergent ways in which the two parties framed the summons dispute in their questions presented. See our prior coverage here.  The government has sought to focus narrowly on the precise holding of the court of appeals, while the private parties have asked the Court to look more broadly at all the circumstances of the case and to take a fresh look at how summons enforcement proceedings are generally conducted.

Specifically, the government contended from the start that the Eleventh Circuit had laid down an indefensible blanket rule that a party is entitled to an evidentiary hearing to challenge a summons so long as it alleges an improper purpose. That rule, according to the government, would dramatically increase the extent to which IRS agents are hauled into court for evidentiary hearings and is inconsistent with longstanding summons enforcement law. The parties challenging the summons enforcement proceeding, conversely, have argued that the Eleventh Circuit decision was narrower, pointing to the facts in this case that supported their allegations, albeit facts that for the most part were not relied upon by the court of appeals. Notably, the government has acknowledged that a district court has considerable discretion in deciding when an evidentiary hearing should be held and conceded that a district court appropriately could have scheduled a hearing here. The government objects only to the court of appeals ordering the district court to hold an evidentiary hearing when the district court had already exercised its discretion to deny the private parties’ hearing request.

The Justices inquired into both approaches to the case during the oral argument. It appeared that the Court was in harmony with the government’s narrow view of the Eleventh Circuit’s holding and thus of the bare minimum that has to be decided in the case. In fact, when government counsel began the argument by attacking the court of appeals’ specific statements, Justice Scalia quickly interjected to say that the other side “concedes all that” and that “nobody defends what the lower court said here.”

But the questioning also suggested that the Court might not be content to write an opinion that does the bare minimum – that is, one that just reverses the court of appeals for requiring an evidentiary hearing based on no more than a bare allegation of an improper purpose. Rather, the Court expressed plenty of interest in other aspects of the summons enforcement procedure and raised the possibility that it would use this decision as a way of giving more guidance to trial courts on when hearings would be appropriate in handling these proceedings. Indeed, Justice Alito criticized one of government counsel’s suggestions as not being “very helpful to a district judge” and the Chief Justice noted a desire to give “clearer guidance.” Thus, there appears to be a good possibility of a decision reversing the Eleventh Circuit, and thus ruling for the government, but containing language to guide district courts in the future that the government could find problematic.

In particular, the Justices showed interest in the point on which the private parties laid the most stress in arguing that they had evidence of an improper purpose – namely, the circumstances strongly indicating that the IRS was seeking to enforce the summonses as a way of developing evidence for the Tax Court proceeding rather than for the audit. The government had argued that this issue was not before the Court since the Eleventh Circuit did not rely on it, and also contended that there was no caselaw holding that this was an improper purpose. It also argued that the improper purpose determination relates to the issuance of the summonses and therefore is not to be based on the situation at the time of the enforcement proceedings. It is not apparent, however, that these arguments will carry the day. At least four Justices (Kennedy, Alito, Breyer, Ginsburg) showed interest in this point and evinced some degree of concern whether it would be proper for the IRS to enforce the summonses to aid its position in the Tax Court proceedings. Justice Breyer did question whether, given the posture of the case, the Court could decide the legal question whether aiding the Tax Court proceedings would be an improper purpose. Thus, there is a good chance that the Court’s opinion will leave this issue to be resolved on remand.

At the end of the argument, Justice Kagan asked government counsel to elaborate on what kind of evidence the government would agree would overcome the presumption that a summons was issued for a proper purpose. Counsel pointed to the two improper purposes identified in Powell – harassment and an attempt to pressure the taxpayer into settlement in a collateral matter – asserting that the taxpayer ought to have some evidence in its possession if the latter purpose existed. The Court may be tempted in Clarke to crack open the door a bit more for allegations of improper purpose, but it is unlikely to throw the door open as wide as the Eleventh Circuit appears to have done.

In any event, the answer will come soon. The Court could issue its decision as early as Thursday, and will almost certainly act by the end of June.

Clarke – Government Reply Brief 

Briefing Completed in Barnes

All of the briefs have now been filed in the Barnes case.  The government’s response brief defends the Tax Court’s decision as a run-of-the-mill application of substance over form principles.  Quoting from True v. Commissioner, 190 F.3d 1165 (10th Cir. 1999), it argues that the step-transaction doctrine applies because the “Bermuda/Delaware exchanges did not ‘make[ ] any objective sense standing alone’ without contemplation of the other steps.”  In arguing that these steps served no business purpose, the government relies heavily on evidence that the “reinvestment plan” was based on tax planning that the taxpayer’s accountants had previously done for another client.  The government asserts that “Barnes and PwC went to great lengths to create out of whole cloth a business purpose for a tax-avoidance plan that originated in PwC’s database.”  Rather than a legitimate business plan, the government alleges that “the entire repatriation scheme consists of essentially nothing more than a circular flow of funds among Barnes and its wholly owned subsidiaries.”

The government’s brief also notes that, if the court of appeals is unpersauded by the Tax Court’s opinion, it should remand for additional factual determinations to resolve two alternative government arguments that were not reached by the Tax Court:  1) that the transaction had the principal purpose of tax evasion and therefore deductions could be disallowed under Code section 269; and (2) that the Delaware preferred stock was held under the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4).

With respect to the issue discussed in our previous post regarding the taxpayer’s argument that the government was prohibited from disavowing Rev. Rul. 74-503, the brief largely tracks the Tax Court’s discussion.  In other words, the government does not question the soundness of the principle stated in Rauenhorst that the IRS cannot argue against its Revenue Rulings.  Rather, the brief simply doubles down on the step-transaction point and argues that the taxpayer could not reasonably rely on that ruling here because this case does not involve “bona fide § 351 exchanges.”

With respect to the penalty issue, the government again criticizes PwC’s role, arguing that PwC had a “conflict of interest” in issuing an opinion regarding the transaction because it had an interest in a favorable tax result that would allow PwC to “market [the tax plan] to other corporations seeking to repatriate funds from a controlled foreign corporation.”  Accordingly, the government argues that the taxpayer could not reasonably rely on the PwC letter for “objective advice.”  The government also argues that the taxpayer could not reasonably rely on the opinion because “PwC did not opine on the integrated repatriation scheme as a whole.”

The taxpayer’s reply brief argues that the government’s brief “mischaracterizes the substance of the plan” because the Bermuda and Delaware subsidiaries did not operate as conduits for a dividend payment.  Instead, it accuses the government of making a policy-based argument that would “impermissibly convert Section 956 into an anti-abuse rule.”  The brief then disputes in detail the government’s description of the transaction and underlying facts.

With respect to the penalty issue, the reply brief states that the government “essentially rewrites the Tax Court’s factual findings” in criticizing reliance on the PwC opinion.  The brief notes that PwC was Barnes’ long-time tax advisor and did not market the transaction to Barnes.  It also states that the Tax Court held that the PwC advisor “was a competent professional who had sufficient expertise to justify reliance” and that Barnes “provided necessary and accurate information to the advisor.”  In particular, the reply brief responds to the government’s “conflict of interest” accusation against PwC by noting that the Tax Court specifically observed that there was nothing “nefarious” about PwC keeping tax planning ideas in a database and by asserting that “the government’s unfounded assertions that PwC did not provide an adverse opinion in order to sell the transaction to others is ludicrous and without any factual basis.”  The reply brief also argues that the government is incorrect in stating that the PwC opinion did not address the entire transaction, quoting the PwC opinion itself as stating that it “is premised on all steps of the proposed transaction.”

Oral argument has not yet been scheduled.

Barnes – Government’s Response Brief

Barnes – Taxpayer’s Reply Brief

Briefing Complete in MassMutual

The government has now filed its reply brief in MassMutual.  The brief begins by asserting that the taxpayer has abandoned on appeal an argument that had persuaded the trial court — namely, “reliance on its annual-dividend obligation to individual policyholders to establish the fact of its liability under the dividend guarantees.”  In the government’s view, that “about-face is fatal to its case.”  The reply brief then addresses the taxpayer’s reliance on the Washington Post case.  See our previous report here.  It argues that, “unlike the group obligations in Washington Post, the alleged group obligations in this case were not otherwise fixed as to liability in the years in which the dividend guarantees were adopted” for reasons unconnected to the indeterminate membership of the group.  The rest of the brief hews more closely to the topics discussed in the government’s opening brief, including the Supreme Court’s decision in Hughes Properties and the Second Circuit’s decision in New York Life.  See our previous report here.  The reply brief also argues again that its economic performance regulation is entitled to Auer deference.

The Federal Circuit has not yet announced a date for oral argument.

Mass Mutual – Government Reply Brief

Taxpayer Brief Filed in MassMutual

The taxpayer has filed its response brief in the Federal Circuit in the MassMutual case. See our previous coverage here. With respect to the primary issue of whether its policyholder dividend guarantee was a “fixed liability” within the meaning of the “all events test,” the taxpayer relies heavily on Washington Post Co. v. United States, 405 F.2d 1279 (Ct. Cl. 1969). (The Court of Claims was the predecessor court to the Federal Circuit and its pre-1982 decisions are binding precedent in the Federal Circuit.) According to the taxpayer, Washington Post establishes that “a company can fix a liability to an existing class of beneficiaries, even though the class composition may change before the liability is ultimately satisfied.” In contrast to the government’s brief, the taxpayer does not dwell at length on the Supreme Court’s decisions in Hughes Properties and General Dynamics, but argues that both of those cases are fully consistent with the more-directly-on-point decision in Washington Post.

The brief also addresses the Second Circuit’s decision in New York Life, arguing that the cases are distinguishable. (The Second Circuit had suggested a distinction, but without great conviction, suggesting that it believed the Court of Federal Claims was wrong in MassMutual.) The critical difference, according to the taxpayer, is that “New York Life addressed thousands of separate liabilities to individual policyholders, any one of which could cease to be a policyholder at any time,” whereas MassMutual involves a guarantee to “a class of policyholders” that “does not depend on identifying individual policyholder liability.”  Finally, the taxpayer rejects the government’s argument that the dividend guarantees were “illusory,” stating that the trial court correctly ruled that “Board resolutions can fix liability.”

With respect to the second issue of whether the liability fell within the “recurring item exception,” the taxpayer argues that its position comports with “the only sound interpretation of the regulation.” It further argues that the government’s administrative deference argument is waived for failure to raise it below and, in any event, fails because the government is seeking deference to what is no more “than a convenient litigating position” that has not been shown to have been approved at any level by IRS or Treasury.

The taxpayer’s brief is linked below. Also linked below is the government’s brief in opposition to the petition for certiorari filed by the taxpayer in New York Life. That petition was denied by the Supreme Court on April 28.

MassMutual – Taxpayer Response Brief

New York Life – Brief in Opposition

 

 

 

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

Answering Brief Filed in Clarke

The parties resisting summons enforcement have filed their brief in the Supreme Court in Clarke responding to the government’s opening brief.  Underlying the two sets of briefs is a fundamentally different perspective on the significance of holding an evidentiary hearing at which the agent issuing the summons can be questioned about his motives.  For the government, such a hearing is a big deal, and the courts should not impose that burden on the IRS on the basis of a mere allegation of an improper purpose.  For the summoned parties, such a hearing is a very limited intrusion that must be allowed upon a plausible allegation of bad faith if the notion of judicial oversight of summonses is to have any teeth at all.  They argue that, “[f]or the judiciary to fulfill its function of safeguarding against abusive summonses, it cannot be entirely dependent on one-sided submissions by the government attesting in conclusory fashion that its summons is being pursued for a proper purpose.”

Thus, the summoned parties argue that the government’s position would “transform summons enforcement into an ex parte affair” because there would be no effective way to challenge the “pro forma showing” of government good faith made by an agent’s affidavit.  The summoned party in most cases cannot realistically meet the government’s requirement that it show independent evidence of bad faith before having a hearing because that knowledge “is peculiarly within the knowledge or files of the Service”; the government’s proposed rule thus imposes a “circular burden” because the point of the hearing is give the summoned party the opportunity to develop that evidence.  The brief rejects the government’s accusation that the Fifth Circuit has created a presumption of government irregularity.  Rather, the brief argues that the presumption of regularity is intact, but the Fifth Circuit’s approach “simply allows the taxpayer an opportunity to overcome that presumption.”  As the summoned parties see it, the government’s “position is not merely that it should receive the benefit of the doubt, but that in practice it should be immune from questioning.”

The brief then addresses why the Court should agree that the summoned parties have made a sufficiently plausible showing of bad faith to justify a hearing.  As with its brief at the petition stage, this argument focuses primarily on the evidence showing that the government was interested in getting information that would assist with the Tax Court litigation, not in conducting an administrative investigation into tax liability.  As noted in our first report on this case, the court of appeals did not rely on that evidence, and the courts thus far have not held that a motivation to assist with Tax Court litigation is an improper purpose that justifies denying enforcement of a summons.  Perhaps recognizing that it may be tough to win in the Supreme Court on the present state of the record, the summoned parties specifically request an opportunity to litigate that issue, stating “if this Court vacates the judgment below, it should remand so that the court of appeals can consider whether evidence that the IRS is using a summons only to circumvent Tax Court discovery rules provides grounds for denying enforcement of the summons.”

Oral argument is set for April 23.

Clarke – Brief for Respondents

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

Government Prevails in Quality Stores

The Supreme Court today ruled 8-0 in favor of the government in the long-running Quality Stores litigation, holding that severance payments are taxable FICA wages, even if they fall within the category of “supplemental unemployment compensation benefits” that are subject to income tax withholding under Code section 3402(o).  See our prior coverage here.  The Court’s opinion closely tracks the arguments made by the government in its brief.

The Court began by analyzing the definition of “wages” in the FICA statute, which it repeatedly characterizes as “broad.”  That definition — “remuneration for employment” — appears to encompass the payments at issue because “common sense dictates that the employees receive the payments ‘for employment.'”  Specifically, they are paid only to employees and often vary according to the function and seniority of the particular employee who is terminated.  The Court buttressed this statutory interpretation by pointing both to other aspects of the statutory definition and to its history.  In particular, the Court noted that Code section 3121(a)(13(A) exempts severance payments made because of “retirement for disability” and that exception would appear superfluous if “wages” did not generally encompass severance payments.  The Court also observed that in 1950 Congress had repealed a statutory exception for “dismissal payments,” thus suggesting that severance payments are not meant to be excepted from FICA “wages.”

The Court then turned to responding to the taxpayer’s argument that a contrary inference must be drawn from the treatment of SUB payments in the income tax withholding statute — specifically, that section 3402(o) directs that income tax should be withheld from such payments “as if” they were wages, which indicates that they are not in fact “wages.”  The Court found this provision “in all respects consistent with the proposition that at least some severance payments are wages,” citing to the Federal Circuit’s analysis of the textual issue in the CSX case.  The Court did not reject out-of-hand the taxpayer’s reliance on the heading of section 3402(o), which refers to “certain payments other than wages,” but said that the heading “falls short of a declaration that all the payments listed in section 3402(o) are not wages.”

The Court then embarked on a detailed discussion of the regulatory background against which section 3402(o) was enacted in order to demonstrate why it should not be understood as reflecting a Congressional determination that SUB payments are not FICA “wages,” despite the contrary inference that might logically be drawn from its text standing alone.  Briefly, the Court explained that Congress was solely focused on solving a withholding conundrum created by the regulatory treatment of SUB payments when SUB plans proliferated in the 1950s.  The IRS sought to impose income tax on these payments, but it did not want to characterize them as “wages” because that would have caused state unemployment benefit payments to stop in some cases (because some states would not pay unemployment compensation to people receiving “wages”).  As a result, some individuals were being hit with big tax bills at the end of the year.  Congress wanted to implement withholding for such payments and crafted section 3402(o) broadly so as to cover a spectrum of payments without regard to whether they qualified as FICA “wages.”  Accordingly, the Court concluded that section 3402(o) sheds no light on the definition of FICA “wages.”

The Court added that its approach is consistent with its 1981 decision in Rowan, which had been invoked to support the taxpayer’s position.  The Court stated that the government’s position, not the taxpayer’s, best advanced “the major principle recognized in Rowan:  that simplicity of administration and consistency of statutory interpretation instruct that the meaning of ‘wages’ should be in general the same for income-tax withholding and for FICA calculations.”

Finally, the Court stated that it would not address the validity of the IRS’s currently applicable revenue rulings that exempt from both income-tax withholding and FICA taxation severance payments that are tied to the receipt of state unemployment benefits.  As discussed in our report on the oral argument in this case, the government was questioned repeatedly about these rulings because they are hard to square with the broad reading of the FICA “wages” definition advanced by the government here and now adopted by the Court.  Those rulings are more generous to taxpayers than would appear to be required under the broad FICA definition.  It remains to be seen whether the IRS will revoke those rulings and try to collect FICA taxes on such payments and, if they do, whether that will have an effect on the payment of state unemployment benefits.  With the Court having refrained from invalidating, or even directly criticizing, those rulings, it is possible that the IRS will let sleeping dogs lie and continue to abide by the rulings.

Quality Stores – Supreme Court opinion

Opening Brief Filed in Clarke Summons Enforcement Case

The government has filed its opening brief in Clarke.  The brief, which is quite short for a Supreme Court brief, hews closely to the arguments made in the petition for certiorari.  As we noted in our previous report, the government and the parties resisting summons enforcement took a very different view at the petition stage of the quantum of evidence that formed the basis for requiring the evidentiary hearing in this case.  The private parties contended that they had made “substantial allegations” that the summonses were for an improper purpose, while the government referred to those allegations as “unsupported.”

The brief begins by emphasizing that, however the private parties choose to describe the evidence supporting their allegations, the holding of the Fifth Circuit was that a party is entitled to an evidentiary hearing at which it can question IRS officials about their motives in issuing a summons “whenever a taxpayer makes an ‘allegation of an improper purpose.’”  Indeed, the government argues, the court of appeals specifically rejected the idea that the taxpayer’s allegations must be “substantial” or supported by evidence, pointing to the court’s statement that “requiring the taxpayer to provide factual support for an allegation of an improper purpose, without giving the taxpayer a meaningful opportunity to obtain such facts, saddles the taxpayer with an unreasonable circular burden.”

Thus, the government is willing to concede that, “if an objector presents evidence to support an inference of improper motive—or if a district court otherwise believes that such an opportunity for examination is appropriate—the district court may hold a hearing and require IRS agents to justify their actions.”  But here, the government maintains, the court of appeals “erroneously reduced to zero the amount of evidence that is required to rebut a showing of good faith.”

With the question framed in this way, the government presents its arguments concisely.  It argues that requiring an evidentiary hearing based on a mere allegation of improper purpose undermines Congress’s intent that summons enforcement proceedings be summary and expeditious.  Instead, it would afford summoned parties the opportunity to “delay the resolution of summons-enforcement proceedings merely by alleging that the summons was issued for an improper purpose.”  In addition, the government argues that the court of appeals’ approach infers wrongdoing on the part of a government official without evidence, which violates the “presumption of regularity” that public officials are presumed to have properly discharged their duties.

The response brief of the parties resisting the summons is due in mid-March.  Oral argument has been scheduled for April 23.

Clarke – Opening Brief for the Government

Government Brief Filed in MassMutual

The government has filed its opening brief in MassMutual contesting the Court of Federal Claims’ conclusion that the taxpayer could accrue the amount of certain policyholder dividends in the year before they were paid.  See our prior post on this case and the New York Life case here.  The government’s brief raises three distinct objections to the decision.

The primary argument is that the liability to pay the dividends was not “fixed” under the all-events test.  The government contends that no individual obligation was fixed at the close of the year, even if all the premiums had been paid, because the dividend would not be paid unless the policy remained in force on the anniversary date.  This is the same argument that was accepted by the Second Circuit in New York Life, and the government’s brief here argues that the cases are indistinguishable (asserting that the Second Circuit’s effort to distinguish them was based on a misperception of the facts in MassMutual).

The brief argues that the case “clearly fits the General Dynamics fact pattern,” which it describes as one where the “potential obligee has taken some action that renders him preliminarily eligible to receive the payment, subject only to some other condition that is within his exclusive control” – here, “forgoing the right to surrender the policy for its cash value prior to the next anniversary date.”  It rejects the proposition argued by the taxpayer that this alleged final condition is not a genuine “event,” but rather just a continuation of the status quo.  The government points to a comment in the Restatement (Second) of Contracts stating that “a duty may be conditioned upon the failure of something to happen . . ., and in that case its failure to happen is the event” that constitutes a condition precedent.  And it rejects the contrary suggestion in Burnham Corp. v. Commissioner, 878 F.2d 86 (2d Cir. 1989), as misguided.  Finally, the brief argues that the taxpayer’s all-events-test interpretation proves too much because its logical implication is that the amount of the dividend could be accrued even if the company had not passed a board resolution in the taxable year guaranteeing an aggregate dividend – a position that the taxpayer has not argued.

Second, the government argues that the dividend guarantees did not even give rise to an obligation, fixed or otherwise, because they were not communicated to the persons who were to benefit from them.  Thus, the government argues, the taxpayer could have walked away from the guarantees at any time.  In addition, the government argues, the guarantees were not a meaningful “substantive undertaking” because, based on the historical data, the guaranteed payments were “already virtually certain to occur in the ordinary course of the companies’ business operations, independent of any ‘guarantee’ to that effect.”  There is some degree of irony in this argument; on its face, certainty that the amounts will be paid would appear to be an argument in favor of accrual, not against it.  But the certainty of which the government speaks refers to the aggregate amount of payment; it is not a concession with respect to an individual obligation being fixed.

Third, the government contests the Court of Federal Claims’ holding that the dividends fell within the “recurring item” exception.  The government’s primary point here is that this determination turns on the meaning of “rebate, refund, or similar payment” in Treas. Reg. § 1.461-4(g)(3), and therefore the court should have deferred to the IRS’s interpretation of that regulation – even if that interpretation did not conclusively emerge until this litigation and is at odds with some earlier internal guidance on the regulation’s meaning.  The general principle of so-called Auer or Seminole Rock deference to an agency’s interpretation of its own regulations has come under fire recently, with Justice Scalia stating that it should be abandoned and Chief Justice Roberts and Justice Alito indicating that they are at least open to reconsidering it.  See Decker v. Northwest Environmental Defense Center, No. 11-338 (Mar. 20, 2013).  So it will be interesting to see how the Federal Circuit responds to this argument, which presents a relatively weak case for deference because the claimed agency interpretation is just based on its litigation position.

The taxpayer’s brief is due April 4.

MassMutual – Gov’t Opening Brief

Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash

In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates.  As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions.  For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt.  Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.

The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware.  The Delaware subsidiary then loaned the cash to Barnes.  Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received.  (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.)  Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.

The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes.  The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons.  First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant.  Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case.  The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation.  In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations.  The court, however, devoted  little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here.  Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.

The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such.  According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.”  The court stated that the doctrine applies if any of three tests are satisfied:  (1) the binding commitment test; (2) the end result test; and (3) the interdependence test.  Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.”  The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.”  This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.

The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.

Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.

The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty.  The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter.  The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight.  In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.”  Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.

With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends.  In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”

The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous.  The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes.  In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.”  For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend.  Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.

Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503.  The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings.  It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.

It will be interesting, and instructive for other cases, to see how the government deals with this point.  If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling.  There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503.  Will the government question the premise of the taxpayer’s argument in any way?  Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of  Rev. Rul. 74-503 cannot reasonably be applied here?  Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?

Third, the taxpayer contests the court’s penalty determination.  With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling.  With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction.  It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion.  Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”

The government’s brief is due May 15.

Barnes – Tax Court opinion

Barnes – Taxpayer Opening Brief

 

Federal Circuit to Consider Accrual of Policyholder Dividends

The Federal Circuit is preparing to consider a government appeal in Massachusetts Mutual Life Ins. Co. v. United States, on an issue involving accrual of annual dividends paid by a mutual insurance company to its policyholders.  This issue was also recently addressed by the Second Circuit, and it turns on an application of the “all events test.”

First, a quick refresher course.  The “all events test” is described as the “touchstone” for determining when a liability has been incurred and a deduction can be accrued.  Dating back to United States v. Anderson, 269 U.S. 422, 441 (1926), and now codified at I.R.C. § 461(h)(4), it originally provided for accrual when “all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.”  In the mid-1980s, litigation over the application of this two-pronged test yielded two Supreme Court decisions in rapid succession, with the taxpayer prevailing in the first one and the government prevailing in the second.

In United States v. Hughes Properties, Inc., 476 U.S. 593 (1986), the Court held that a casino could treat as a fixed liability the amounts shown on the jackpot meters of its progressive slot machines at the close of the taxable year.  In United States v. General Dynamics Corp., 481 U.S. 239 (1987), the Court held that a self-insuring employer could not accrue amounts that it had reserved for payment of employee medical claims not yet filed for services already performed, even assuming that the amount of the liability had been determined with reasonable accuracy.  The Court held that the fact of liability was not established until the employee filed a claim for reimbursement, which it termed a “condition precedent” to the establishment of liability that was not “a mere technicality” or a mere “ministerial” act.  Id. at 242-45 & nn.4-5.  Three dissenters argued that the case was essentially indistinguishable from Hughes Properties, where the Court had rejected the government’s argument that the fact of liability did not arise until the winning patron pulled the handle because until then it was possible that the jackpot would never be paid – for example, if the casino went out of business or declared bankruptcy.  Id. at 248-49.  The majority, by contrast, held that failing to file a claim was not “the type of ‘extremely remote and speculative possibility’” that was found in Hughes Properties not to “render an otherwise fixed liability contingent.”  Id. at 244-45.

In 1984, Congress codified the traditional all events test in Code section 461(h)(4) and added a third prong for future years by enacting section 461(h)(1), which provides that generally “the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.”  The Code, however, contains an exception from the economic performance requirement for “certain recurring items” if economic performance occurs within a reasonable period after the close of the taxable year and certain other conditions are met.  I.R.C. § 461(h)(3).  In the case of policyholder dividends issued by mutual insurance companies, the taxpayers have contended that the section 461(h)(3) exception is satisfied and therefore that their right to accrue those dividend payments turns on whether the original two-pronged all events test has been satisfied.

The insurer in MassMutual adopted Board Resolutions before the close of the taxable year guaranteeing an aggregate amount of policyholder dividends that would be paid in the upcoming year on each individual policyholder’s anniversary date.  The government argued that the all events test was not satisfied until the year in which the dividends were paid because the Board Resolution could be revoked (though government counsel apparently characterized this as a “weak argument” at oral argument) and also because no precise dividend amounts could be allocated at the time of the resolution to an identifiable policyholder, since any individual policy might not still be in force on the anniversary date.

After a trial, the Court of Federal Claims rejected these arguments and allowed the taxpayer to accrue the amount of the dividends in the year before they were paid.  Citing to Hughes Properties, the court said that it was not necessary that the identity of the individual recipients be known at the time of accrual.  The court also stated that, “[a]lthough a condition precedent can prevent a liability from being fixed, if the only event(s) still to occur are the passage of time and/or the payment, the liability is considered fixed.”  The court added that “the group of policyholders with paid-up policies were not at risk for their policies lapsing,” so the company “had an unconditional obligation” to those policyholders “to pay the guaranteed amounts of policyholder dividends.”  The court then ruled that the dividends were “rebates” or “refunds” falling within the “recurring item” exception of section 461(h)(3), and therefore “economic performance” was not required before the expenses could be accrued.

After the Court of Federal Claims decision issued, but before it was ripe for appeal, the Second Circuit came to the opposite conclusion in a case involving policyholder dividends accrued by New York Life.  That mutual insurance company also paid annual dividends on the anniversary date, but only if the policy was still in force and fully paid up (payment was required a month in advance).  The taxpayer sought to accrue dividend payments due in January of the following year, since those policies had been fully paid up in December.  The Second Circuit, however, ruled that the all events test was not satisfied for the January anniversary date policies, because of the possibility that the policyholder might choose to cash in the policy in January before the anniversary date and thus the policy would no longer be in force when the dividend came due.

The Second Circuit reasoned that the case was analogous to General Dynamics, stating that “‘the last link in the chain of events creating liability’—the policyholder’s decision to keep his or her policy in force through the policy’s anniversary date—did not occur until January of the following year.”  The taxpayer argued that an “event” that would defeat accrual must be something that marks a change in the status quo, rather than a non-event like the policyholder’s failure to cash in a policy.  The court, however, rejected this position, stating that the fact of liability “depend[ed] upon an actual choice by the third-party policyholder:  her decision not to redeem her policy for cash, for example, and invest her money elsewhere.”

The court suggested that the MassMutual decision was distinguishable on its facts because there “the policy was considered ‘in force’ simply ‘if the premiums for the policy [had been] paid through its anniversary date,’” whereas in New York Life the company defined eligibility as “requiring both that the policyholder have paid all premiums and that she not have surrendered her policy for cash prior to the policy’s anniversary date.”  Recognizing that this distinction might be viewed as less than compelling, the Second Circuit added that, “to the extent the reasoning of the MassMutual court is at odds with ours . . ., we respectfully disagree with that court’s approach.”

New York Life has filed a petition for certiorari seeking review of the Second Circuit’s decision.  The petition focuses on the court of appeals’ reliance on the possibility that the policyholder might not receive a dividend because she chose to cash in her policy before the January anniversary date.  The question presented in the petition is whether the court erred in holding that “the continuation of the status quo is a required event, and thus a ‘condition precedent,’ needed to establish the fact of liability under the all-events test.”

The petition’s main contention is that the Second Circuit’s decision cannot be squared with Hughes Properties.  Because MassMutual is just a trial court decision, the cert petition rests its claim of a circuit conflict primarily on older cases that predate General Dynamics, arguing that the Second Circuit’s decision “recreates a multi-circuit conflict resolved by this Court in Hughes Properties.”  The timing of the respective decisions is such that MassMutual is not likely to provide much help in this regard; the Supreme Court can be expected to act on the cert petition by the end of May at the latest, well before a Federal Circuit decision is likely in MassMutual.

The government’s opening brief in MassMutual is due February 20.  Its opposition to the petition for certiorari in New York Life is due, after one extension, on March 20.

MassMutual – Court of Federal Claims opinion

New York Life – Second Circuit opinion

New York Life – Petition for Certiorari

D.C. Circuit Holds in Loving that IRS Lacks Authority to Regulate Tax-Return Preparers

Yesterday, the D.C. Circuit unanimously held in Loving v. IRS, that the IRS lacks statutory authority to regulate tax-return preparers.  See our previous coverage here.  In its February 11 decision, the court characterized the IRS’s interpretation as “atextual and ahistorical,” and, more humorously, as a large elephant trying to emerge from a small mousehole.

In 2011, the IRS for the first time attempted to regulate tax-return preparers, issuing regulations requiring that paid tax-return preparers pass an initial certification, pay annual fees, and complete at least 15 hours of continuing education courses each year.  The IRS estimated that the regulations would apply to between 600,000 and 700,000 tax-return preparers.  Before 2011, the IRS had never taken the position that it had the authority to regulate tax-return preparers.  According to the D.C. Circuit panel (Kavanaugh, Sentelle, and Williams): “In light of the text, history, structure, and context of the statute, it becomes apparent that the IRS never before adopted its current interpretation for a reason:  It is incorrect.”

The IRS claimed that 31 U.S.C. § 330 provided statutory authority for the regulations.  That statute authorizes the IRS to “regulate the practice of representatives of persons before the Department of Treasury.”  31 U.S.C. § 330(a)(1).  The D.C. Circuit cited the familiar two-step Chevron standard of review:  (1) is the statute ambiguous, and (2) if so, is the agency’s interpretation reasonable.   The court of appeals concluded that the “IRS’s interpretation fails at Chevron step 1 because it is foreclosed by the statute,” and, in any event, “would also fail at Chevron step 2 because it is unreasonable in light of the statute’s text, history, structure, and context.”  The court of appeals cited six reasons foreclosing the IRS’s interpretation of the statute:

First, the D.C. Circuit concluded that the term “representative” generally is understood to refer to an agent with authority to bind others.  “Put simply, tax-return preparers are not agents.  They do not possess legal authority to act on the taxpayer’s behalf.”  Second, the preparation of a tax return does not constitute “practice . . . before the Department of the Treasury.”  “Practice before” an agency generally implies an investigation, adversarial hearing, or other adjudicative proceeding.  Moreover, a related section of the statute allows the Secretary of the Treasury to require that a representative admitted to practice before the agency demonstrate four qualities, one of which is “competency to advise and assist persons in presenting their cases.”  31 U.S.C. § 330(a)(2).   Filing a tax return is not understood in ordinary usage to be “presenting a case.”  Third, the original version of the statute, enacted in 1884, referred to “agents, attorneys, or other persons representing claimants before [the] Department.”  The court of appeals concluded that this original language clearly would not encompass tax return preparers.  When the statute was recodified in 1982, the phrase, “agents, attorneys, or other persons representing claimants” was simplified to “representatives of persons,” but the language change expressly was not intended to effect a substantive change.  Fourth, the IRS’s interpretation is inconsistent with the “broader statutory framework,” in which Congress has enacted a number of statutes specifically directed at tax-return preparers and imposing civil penalties.  Those statutes would not have been necessary, the court reasoned, if the IRS had authority to regulate tax-return prepares.  Fifth, if Congress had intended to confer such broad regulatory authority upon the IRS, allowing it to regulate “hundreds of thousands of individuals in the multi-billion dollar tax-preparation industry,” the statute would have been clearer.  Referring to the statutory language, the court of appeals concluded:  “we are confident that the enacting Congress did not intend to grow such a large elephant in such a small mousehole.”  Sixth, the court noted that the IRS in the past had made statements and issued guidance indicating that it did not believe it had authority to regulate tax-return preparers.  The court found it “rather telling that the IRS had never before maintained that it possessed this authority.”

The decision ends with the court of appeals noting that new legislation would be needed to allow the IRS to regulate tax-return preparers.

Given that the membership of the D.C. Circuit has recently expanded to include three additional judges, the government might believe that it is worthwhile to seek rehearing en banc before the full court.  A petition for rehearing would be due on March 28.  If the government does not seek rehearing, a petition for certiorari would be due on May 12.  Whether it pursues the litigation further or not, the government can be expected to seek new legislation that would give the IRS the regulatory authority that the court of appeals refused to find.

Loving – Court of Appeals Opinion

Supreme Court to Address the Right to an Evidentiary Hearing in Summons Enforcement Proceedings

The Supreme Court has granted certiorari in United States v. Clarke, No. 13-301, to explore the circumstances under which an entity is entitled to an evidentiary hearing before an IRS summons is enforced, so that it can question IRS officials about their motives for issuing the summons.  The parties’ different views of the case are aptly captured by the dueling questions presented.  The government says the case presents the question “whether an unsupported allegation” that the IRS issued a summons for an improper purpose entitles an opponent to examine IRS officials at an evidentiary hearing.  The entities contesting the summons say the case presents the question whether the court erred in ordering such an evidentiary hearing “in light of [their] substantial allegations that the IRS had issued summonses to them for an improper purpose.”

The basic summons enforcement rules are long established, but the devil can be in the details.  Under United States v. Powell, 379 U.S. 48 (1964), a summons is to be enforced if the IRS demonstrates that:  (1) “the investigation will be conducted pursuant to a legitimate purpose”; (2) “the inquiry may be relevant to the purpose”; (3) the IRS does not already have the information; and (4) the IRS followed the proper administrative steps.  The IRS generally carries its initial burden simply by producing an affidavit from the investigating agent, which then shifts the burden to the party contesting the summons.  At that point, it gets a little murkier.  If the party contesting the summons raises a “substantial question” as to whether the summons is an abuse of process, then it is entitled to an “adversary hearing” at which it “may challenge the summons on any appropriate ground.”  Id. at 58.

What happened here is that the IRS wanted to look more carefully into a partnership’s tax returns, particularly its claim of $34 million in interest expenses over two years.  Although the partnership agreed to two extensions of the statute of limitations, it declined to extend the period a third time.  Shortly thereafter, the IRS issued six summonses to third parties connected to the partnership, but those parties did not comply with the summonses.  Just before the limitations period closed, the IRS issued a notice of Final Partnership Administrative Adjustment (FPAA) to the partnership, and the partnership challenged the FPAA by filing a petition in the Tax Court.  A couple of months later, the IRS filed summons enforcement actions.

The summoned parties, who are the respondents in the Supreme Court, responded by contending that the summonses were not issued for a legitimate purpose and requesting an evidentiary hearing and discovery.  They basically made two arguments.  First, they contended that the summons was issued in retaliation for the partnership’s refusal to extend the statute of limitations, pointing to the fact that the summonses were issued very soon after that refusal was communicated.  Second, they contended that the summonses were designed to circumvent the Tax Court’s restrictions on discovery.  They advanced some evidence to support this contention, including the IRS’s request for a continuance in the Tax Court on the ground that the summonses were outstanding.

The district court (for the Southern District of Florida) ordered the summonses enforced, stating that a hearing is not required based on a “mere allegation of improper purpose” to retaliate.  With respect to respondents’ second contention, the district court said that a finding that the IRS was using the summons process to avoid discovery limitations in the Tax Court would not be a valid ground for quashing a summons.

The Eleventh Circuit reversed in an unpublished opinion.  It ordered the district court to hold an evidentiary hearing at which respondents could question the IRS examining agent about his motives for issuing the summonses (though the court declined to authorize discovery).  The court explained that the district court had abused its discretion because the respondents were entitled to a hearing “to explore their allegation” that the summonses were issued “solely in retribution for [the partnership’s] refusal to extend a statute of limitations deadline.”

The difference in the way the two parties have phrased the question presented reflects the two different grounds on which the respondents challenged the summonses.  The allegation that the summonses were a form of retaliation or punishment, instead of for a legitimate investigative purpose, is pretty close to an “unsupported allegation.”  That the summons followed closely on the heels of the decision not to extend the statute of limitations is weak evidence of an improper retaliatory purpose, though, as the respondents point out, it is hard to have strong evidence of a retaliatory purpose without having discovery or a hearing.  Thus, the respondents may have a hard time defending the court of appeals decision on its own terms.

On the other hand, the respondents will be able to advance their second basis for challenging the summonses as an alternate ground for affirmance, even though the court of appeals did not rely upon it.  On that ground, the respondents have more than an “unsupported allegation” – they are more like “substantial allegations” – that the summonses were designed to obtain evidence for use in the Tax Court proceedings that could not have been obtained through discovery.  The government’s response on this point is the same as that of the district court – namely, that these allegations, if true, would not demonstrate an illegitimate purpose and would not be grounds for quashing the summons.  Two courts of appeals have reached this issue and have agreed with the government.  On the other hand, respondents have a logical argument that a summons is an investigative tool and the investigation phase is over by the time the FPAA has issued and the case has been docketed in the Tax Court.  Respondents note in this connection that the IRS’s own Summons Handbook states that, “[i]n all but extraordinarily rare cases, the Service must not issue a summons” after a notice of deficiency is mailed because at that point “the Service should no longer be in the process of gathering the data to support a determination because the [notice of deficiency] represents the Service’s presumptively correct determination and indicates the examination has been concluded.”  This second ground not reached by the court of appeals thus may prove to be the more interesting and closely contested aspect of this case.

To add a little more spice to this case, the Court’s determination to revisit summons enforcement comes at a time when the IRS may significantly increase its use of its summons power.  On January 2, 2014, a new policy went into effect for audits of the largest taxpayers that threatens the issuance of a summons when a taxpayer fails to timely respond to requests for documents and/or information.  The new policy sets out a mandatory timeline for warning letters and a drop-dead due date, after which the examining agent will initiate procedures for the issuance of a summons.  This policy could well lead to many more summons enforcement proceedings.  For more information on the IRS’s new IDR enforcement policy, please contact George A. Hani (ghani@milchev.com) or Mary W. Prosser (mprosser@milchev.com).

The government’s opening brief is due February 24.  The case will be argued in late April and a decision is expected by the end of June.

Clarke – petition for certiorari

Clarke – brief in opposition

Clarke – reply brief in support of certiorari petition

Clarke – court of appeals opinion

Fifth Circuit Upholds Penalties in NPR

The Fifth Circuit has finally issued its opinion in NPR (as reflected in our prior coverage, this case was argued almost two years ago), a case involving a Son-of-BOSS tax shelter in which the district court absolved the taxpayers of penalties.  The taxpayers were not as fortunate on appeal, as the Fifth Circuit handed the government a complete victory.

The court’s consideration of the two issues before the court of broadest applicability were overtaken by events — specifically, the Supreme Court’s December 2013 decision in United States v. Woods.  See our report here.  In line with that decision, the NPR court held that the penalty issue could be determined at the partnership level and that the 40% penalty was applicable because the economic substance holding meant that the basis in the partnership was overstated.  This latter holding reversed the district court, which had relied on the Fifth Circuit precedents that were rejected in Woods.

The other issues resolved by the Court were mostly of lesser precedential value.  First, the court affirmed the district court’s conclusion that a second FPAA issued by the IRS was valid because NPR had made a “misrepresentation of a material fact” on its partnership return.

Second, the court rejected the district court’s holding that the taxpayers could avoid penalties on the ground that there was “substantial authority” for their position.  It criticized the district court for basing its “substantial authority” finding in part on the existence of a favorable tax opinion from a law firm (authored by R.J. Ruble who eventually went to prison as a result of his activities in promoting tax shelters).  The court explained that a legal opinion cannot provide “substantial authority”; that can be found only in the legal authorities cited in the opinion.  Here, the legal opinion had relied on the “Helmer line of cases,” which establish that contingent obligations generally do not effect a change in a partner’s basis.  The court of appeals held that Helmer did not constitute substantial authority in a situation in which the transactions lack economic substance and in which the partnership lacked a profit motive.  The court also observed that the IRS was correct in arguing that its Notice 2000-44 should be considered as adverse “authority” for purposes of the “substantial authority” analysis — albeit entitled to less weight than a statute or regulation.

Finally, the court overturned the district court’s finding that the taxpayers had demonstrated “reasonable cause” for the underpayment of tax.  With respect to the partnership, the court stated flatly that “the evidence is conclusive that NPR did not have reasonable cause.”  With respect to the individual partners, the court left a glimmer of hope, ruling that an individual partner’s reasonable cause can be determined only in a partner-level proceeding.  Thus, the court merely vacated the district court’s finding of reasonable cause and left the individual partners the option of raising their own individual reasonable cause defenses (whatever those might be) in a partner-level proceeding.

NPR Investments – Fifth Circuit Opinion

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

Ninth Circuit Sides with Government’s Interpretation of QAR Regulations in Bergmann

That didn’t take long.  Less than two weeks after learning that the parties would not be mediating their dispute (see our previous report here), the Ninth Circuit issued a brief five-page unpublished opinion affirming the Bergmann case in favor of the government.  The court held that the time for filing a qualified amended return for an undisclosed listed transaction terminates when the promoter (here, KPMG) is first contacted by the IRS about examining the transaction, not when the IRS later determines the transaction is a tax shelter.

To recap the issue (see our original report here), under Treas. Reg. § 1.6664-2(c)(3)(ii), as in effect when the Bergmanns filed their amended return, the time to file a qualified amended return terminates when the IRS first contacts a “person” concerning liability under 26 U.S.C. § 6700 (a promoter investigation) for an activity with respect to which the taxpayer claimed a tax benefit.  The Bergmanns claimed tax benefits from a Short Option Strategy promoted by KPMG on their 2001 tax return.  The IRS served summonses on KPMG in March 2002 for its role in promoting the Short Option Strategy transactions.  The Bergmanns did not file their qualified amended return until March 2004, shortly after KPMG identified the Bergmanns as among those taxpayers who participated in the transaction.  The Bergmanns argued that “person” as used in the regulation meant only those persons liable for a promoter penalty under 26 U.S.C. § 6700.

The Ninth Circuit quickly dispatched the taxpayers’ argument, characterizing their interpretation of the regulation as “impermissibly rendering its text and purpose nonsensical.”  Under the express language of the regulation, it applies when the promoter is “first contacted,” not found liable.  The court of appeals concluded by observing that the purpose of qualified amended returns is to encourage and reward taxpayers who “voluntarily disclose abusive tax practices, thereby saving IRS resources.”  Here, the taxpayers did not amend their return until after KPMG gave their names to the IRS.

Bergmann – Ninth Circuit Opinion

 

Supreme Court Hears Oral Argument in Quality Stores

The Supreme Court heard oral argument on January 14 in Quality Stores.  Whether it was because of a lack of interest in the subject matter or because it was the third argument of the day at the unusually late hour of 1:00 (the Court’s usual schedule in recent years calls for two (sometimes only one) arguments in the morning that finish before lunch), the Court was less active than usual in its questioning.  Indeed, the government’s counsel began to sit down after using only five of his allotted 30 minutes for his opening argument (though he was then persuaded to remain at the podium by some additional questions).  By the end, all of the Justices except Justice Thomas participated, and the advocates for each side had to deal with some hostile questions.  The questioning was not so one-sided as to make the outcome a foregone conclusion, but the Court seemed to be leaning more towards the government’s position than the taxpayer’s.  On the other hand, the Court seemed to be learning some of the nuances of the case as the argument proceeded, so there is the possibility that the views of some Justices could yet shift from where they appeared to be at oral argument.

Eric Feigin began the argument for the government, and he was allowed to make his basic presentation without interruption – namely, that the severance pay here comes within the broad definition of FICA wages and the Court should not have to worry about the text of section 3402(o), the income tax withholding statute on which the taxpayer relies.  On the latter point, Justice Ginsburg interrupted to ask about the statement in Rowan indicating that wages should be interpreted the same way for FICA and income tax withholding.  Mr. Feigin gave two responses:  1) Rowan does not say that the income tax statute should govern the substance of the FICA statute; and 2) the basic principle of Rowan is to establish congruence between FICA “wages” and income tax withholding “wages” for purposes of administrability, and that goal would be advanced by adopting the government’s position.

After Mr. Feigin described the background of the 1969 income tax withholding legislation, Justice Kennedy asked about the history of FICA withholding of supplemental unemployment benefits.  Mr. Feigin responded that there is no FICA withholding of SUB payments, apparently referring to the government’s narrow definition of SUB payments that the revenue rulings exempt from FICA wages, rather than the broader concept of SUB payments as defined in section 3402(o).  The Chief Justice then asked him to clarify the reason for the enactment of section 3402(o), and Mr. Feigin explained that the benefits were considered to be taxable income even if not subject to withholding.  At that point, Mr. Feigin stated that he was prepared to sit down unless there were further questions.  That suggestion proved to be premature, as it turned out that there were several Justices who still had questions.

Justice Ginsburg began by asking about the effect on state unemployment compensation.  That question arises from the fact that some states will not pay unemployment compensation if the employee is receiving “wages,” even if the employee is out of work.  To avoid having individuals in those states lose their state unemployment benefits as a result of receiving SUB payments from their employer, the IRS has drawn a strange distinction in its revenue rulings, currently providing that SUB payments must be “linked to state unemployment compensation in order to be excluded from the definition” of FICA wages.  Rev. Rul. 90-72.  That distinction is policy-driven, but makes no logical sense as an interpretation of the statutory text.  Mr. Feigin sought at first to steer away from this problem by saying that the government was arguing for the status quo, so nothing would change.  He added, however, that “if the court were to reach some other conclusion in this case than the one the government is urging” (which appears to be a reference to the possibility that the Court’s decision would wipe out the distinction in the revenue ruling), then that might have an effect on state unemployment benefits.  The states, he argued, could then cure any problems by amending state law.

After a short response to Justice Kennedy’s question about whether some employees might prefer to have these payments treated as FICA wages, Mr. Feigin again began to sit down.  This time Justice Alito asked whether it would make a difference if the payments were not keyed to length of service.  Mr. Feigin responded that the government’s position would be the same.  Justice Alito then followed up by citing the Coffy case and asking why the distinction drawn there “between compensation for services and payments that are contingent on the employee’s being thrown out of work” was not applicable.  Mr. Feigin replied that the cases involved different issues and different definitions.  He went on to argue that FICA does not distinguish “between payments that are part of the continuing employment and payments that occur at the end of the employment relationship,” stating that FICA wages include retirement pay and dismissal payments.  At that point, Mr. Feigin again offered to end his presentation and was permitted to sit down after 12 minutes of argument.

Robert Hertzberg argued for the taxpayer and began by arguing that the SUB payments were not “remuneration for services” – and hence not FICA wages – because, as stated in Coffy, they were contingent on losing one’s job.  Justice Sotomayor asked the first question, inquiring whether the taxpayer could prevail if the Court invalidated the government’s “regulation” (likely a reference to the applicable IRS revenue rulings).  This question appears to have been prompted by the heavy criticism of the IRS rulings, particularly in the amicus briefs, with Justice Sotomayor wanting to put aside the rulings and focus on the statute.  Mr. Hertzberg replied that the taxpayer should prevail because the statutory language is clear, and the FICA and income tax withholding statutes should have the same meaning under Rowan.  Both Justices Sotomayor and Ginsburg then suggested that it would be simpler and more appropriate to have the SUB payments treated the same way under the two statutes.  Mr. Hertzberg replied that they were not “wages” under the statute.  He added that different treatment made sense because the SUB payments are provided as a “safety net” and logically ought not to be reduced by FICA taxation in order to fund Medicare and Social Security.

Justice Scalia pointed out that the payments are “for faithful and good past services” because they are paid only to employees, and this comment led to a bevy of questions from all sides.  Justice Ginsburg remarked that there “are some severance payments that do count for FICA purposes,” even under the taxpayer’s position.  Justice Alito asked what would happen if section 3402(o) did not exist.  Mr. Hertzberg replied that the term “supplemental unemployment benefits” has its own definition, going back to 1960 legislation dealing with trusts, and those benefits have not been regarded as FICA wages, even in the 1977 revenue ruling.  He then emphasized that Congress reenacted the FICA statute in 1986 against that backdrop, and therefore that payments falling within the existing definition of SUB payments should not be within FICA wages.

Justice Breyer then objected that the FICA definition is very broad.  With respect to income tax withholding, he questioned whether section 3402(o) shouldn’t be viewed as just being enacted to be on the safe side, but not necessarily indicating that Congress had concluded that SUB payments were not FICA wages.  Mr. Hertzberg responded that it was clear from the text, the title of the section, and the legislative history that Congress did not understand SUB payments to fall within FICA wages.  This triggered Justice Ginsburg to ask again what is the distinction between “dismissal payments” that are subject to FICA and those that are not.  After Mr. Hertzberg described that distinction (that SUB payments must come from a plan and follow a mass layoff or plant closing), Justice Breyer came back to his question.  Acknowledging now that Congress in 1969 probably did not view the SUB payments as FICA wages when it passed section 3402(o), he asked why that should be given weight in construing the FICA statute passed earlier by a different Congress.  Mr. Hertzberg replied that the statutes were reenacted together in 1986, and therefore it was not just a matter of a later Congress commenting on what an earlier Congress had passed.  Justice Breyer’s followup comment, however, indicated that he either did not understand or was not persuaded by this answer, as he noted that the statute was passed because there was “authority saying it wasn’t wages,” but the authority was not necessarily correct.

Justice Alito then asked about the government’s argument that the “treated as” language in section 3402(o) was necessary because the IRS had ruled that some SUB payments are not wages, but it did not mean that all such payments were not wages.  Mr. Hertzberg replied that the language of 3402(o) was clear, particularly the title, which addresses payments “other than wages.”  The argument closed with Justice Scalia promising to ask the government on rebuttal about Mr. Hertzberg’s point that, given the reenactment of both statutes at the same time, it appeared that section 3402(o) is superfluous under the government’s position.

Mr. Feigin begin his rebuttal by addressing Justice Sotomayor’s question about how the Court should approach the case if the IRS revenue rulings are invalid.  He said that this would not affect the outcome of this case because the defect in the rulings would be that they exclude some SUB payments from wages, when in fact all such payments should be included.  That is, any problem would be cured by making even more SUB payments subject to FICA taxation.  Justice Sotomayor replied that this answer was “touching at what I was thinking,” and then asked Mr. Feigin to address Justice Scalia’s point about 3402(o) being superfluous.  Mr. Feigin began by acknowledging that “the revenue rulings are not consistent with the statutory text of FICA.”  He attributed this defect to the fact that the rulings trace back to a “more freewheeling time in the history of statutory interpretation.”

Justice Scalia then jumped in to bring the discussion back to whether section 3402(o) was unnecessary, stating that the statute “contradicted itself” if the government’s position were correct.  Mr. Feigin responded by making the same point that Justice Alito had made earlier (also reflected in the Federal Circuit’s CSX decision) that there was no contradiction if section 3402(o) was drafted as it was because there were some SUB payments that were not wages under the revenue ruling.  Justice Scalia found that response unsatisfying since the title clearly refers to payments “other than wages.”  Mr. Feigin answered by saying that the title refers to “certain payments” and the statute provides that they should be “treated as wages for a payroll period.”  He then went on to reiterate his prior points about the history of the development of section 3402(o) and argued that it was drafted as it was to cover the possibility that the IRS would draw different distinctions in the future regarding which SUB payments constitute “wages.”

Finally, this discussion prompted Justice Ginsburg and Chief Justice Roberts to revisit the IRS revenue rulings, which the Chief Justice characterized as taking a narrower view of the FICA definition than the government was arguing for.  Mr. Feigin responded that the rulings were not directly at issue here, but if the Court thought it had to rule on them, it should follow the government’s current arguments regarding the statutory text “notwithstanding the revenue rulings.”  He then again assured Justice Ginsburg that the states could fix any bad results related to their own unemployment compensation schemes that might ensue from invalidating the revenue rulings.

It is always tricky to forecast a Supreme Court decision based on the oral argument.  Still, it cannot have been encouraging for the taxpayer that its counsel was the recipient of most of the difficult questioning, with Justices Sotomayor and Breyer in particular seeming to exhibit agreement with the government’s position.  On the other hand, as noted above, the Court appeared still to be digesting some of the complexities of this case, so the positions reflected at oral argument are not set in stone.  For example, Justice Scalia showed more skepticism of the government’s position during rebuttal than he did during Mr. Feigin’s opening argument.  Time will tell.  A decision is expected this spring, likely issuing sometime between late March and early June.  If the vote on the Court is 4-4, however (with Justice Kagan being recused), then the Court will announce that outcome as early as next week.  That is because there will be no need to write an opinion; the result will just be a one-line announcement that the decision has been affirmed by an equally divided Court.

Ninth Circuit Consideration of Bergmann Is Back On

A court can lead the parties to mediation, but can’t make them drink.  We reported last month that, after oral argument, the Ninth Circuit had suspended its consideration of the Bergmann case so that the parties could pursue court-sponsored mediation.  Apparently, that effort never got off the ground.  Yesterday, the Ninth Circuit entered a new order:  “We previously withdrew submission pending an opportunity for mediation.  Because mediation has not resolved this appeal, the case is ordered resubmitted as of the date of this order.”  The Court will now proceed to write an opinion and issue its decision in due course.  When that happens, one of the parties likely will be sorry that it wasn’t more flexible with the mediation process and the other will feel vindicated.

Briefing Complete in Quality Stores

The government’s reply brief has now been filed in Quality Stores, completing the briefing.  The Court will hear oral argument on January 14.

Also linked below are three amicus briefs that have been filed in support of the taxpayer.  The brief filed by the ERISA Industry Committee comprehensively addresses the question presented, examining the relevant statutes, legislative history, administrative pronouncements, and judicial precedents.  The brief filed by the American Payroll Association engages in a statutory analysis and examines the administrative pronouncements, concluding that the government’s position “would replace the straightforward definition provided by Congress with a cumbersome and essentially unadministrable definition.”  The brief filed by the American Benefits Council focuses almost exclusively on the IRS’s Revenue Rulings.  Admittedly “derived from an article” previously published by the brief’s author, the amicus brief argues that the regime established by the Revenue Rulings is “incoherent and unsupported” and should be rejected by the Court in favor of the taxpayer’s position, which is “coherent, sensible, and easily understood.”

Quality Stores – Government Supreme Court Reply Brief

Quality Stores – Amicus Brief of ERISA Industry Committee

Quality Stores – Amicus Brief of American Benefits Council

Quality Stores – Amicus Brief of American Payroll Association

Taxpayer Brief Filed in Quality Stores

The taxpayer has filed its responsive brief in Quality Stores, setting forth both its basic position that SUB payments are not FICA “wages” and responding in detail to the government’s contrary arguments.  The taxpayer’s affirmative case begins with the income tax withholding provisions that the government has argued are irrelevant.  The taxpayer argues that the payments are not “remuneration . . . for services” within the meaning of Code section 3401(a) and, in particular, cannot be “wages” because they fall within the category of payments that section 3402(o) describes in its title as “certain payments other than wages” and in the text provides that they “shall be treated as if [they] were a payment of wages.”  That statutory argument is supplemented by examination of the legislative history of the passage of section 3402(o) and by a detailed parsing of other statutory provisions suggesting that Congress did not regard these payments as “wages.”  The taxpayer also points to statements made by the Court about SUB benefits in another context in Coffy v. Republic Steel Corp., 447 U.S. 191 (1980), to the effect that such payments are not “compensation for work performed” because “they are contingent on the employees being thrown out of work.”

The brief also responds to the arguments made by the government.  It dismisses the broad definition of FICA wages in Social Security Bd. v. Nierotko, 327 U.S. 358 (1946) — made in the context of back pay to a current employee — as not probative here where the recipient is not in a current employment relationship with the employer.  The taxpayer also takes issue with the government’s reliance on the historical treatment of “dismissal payments,” arguing that these payments are not synonymous with SUB payments.

The taxpayer invokes the Court’s Rowan decision in support of its basic position that “wages” must be construed the same for both FICA purposes and income tax withholding purposes.  As noted in our previous report, the government has chosen to oppose this argument without relying on the so-called “decoupling amendment” that Congress enacted in the wake of Rowan.  The taxpayer disputes the government’s argument that the consistency rationale of Rowan is best served by treating SUB payments as “wages” for both purposes.  To the contrary, the taxpayer argues, there is a sound policy reason for treating such payments as “wages” for income tax withholding (preventing a heavy year-end tax burden), but no corresponding policy reason to do so in the FICA context.

The taxpayer’s brief devotes considerable attention to arguing that no deference should be paid to the IRS’s Revenue Rulings defining what kind of severance payments constitute “wages.”  This topic is also the focus of an amicus brief filed by Professor Kristin Hickman, which asks the Court to hold that such rulings are not entitled to Chevron deference because they are not promulgated in compliance with the Administrative Procedure Act.  This focus is a bit surprising since the government’s brief does not argue for deference to its Revenue Rulings, and government officials have previously publicly stated that the Justice Department will no longer argue in court that Revenue Rulings are entitled to Chevron deference.   The government’s brief, however, does discuss its relevant Revenue Rulings in some detail, in the nature of background for why it believes Congress addressed income tax withholding in the way that it did.  The taxpayer treats this discussion as reflecting an “implicit (and incorrect) presumption” that the Court must defer to the Revenue Rulings and, taking no chances, the taxpayer tackles that presumption head-on.

Oral argument is scheduled for January 14.

Quality Stores – Taxpayer’s Response Brief

Quality Stores – Amicus Brief of Prof. Hickman

 

Ninth Circuit Refers Bergmann Case to Mediation After Oral Argument

In a somewhat unusual move, the Ninth Circuit issued an order last week suggesting that the parties pursue mediation in the Bergmann case.  The order came two days after the court heard oral argument.  The order states that “the court believes this case may be appropriate for mediation” and therefore it is being referred to the Ninth Circuit’s Mediation Office.  A mediator will then contact the parties to determine their interest, but the parties are not required to elect mediation.  The Circuit Mediator is directed to report back to the panel by January 4.  In the meantime, the court will not act on the appeal.

The oral argument in this case was held on December 3 before Ninth Circuit Judges Gould, Paez, and District Court Judge Marilyn Huff, sitting by designation.  As we have previously reported, the issue in this case is whether the taxpayer was insulated from penalties for participating in a tax shelter because he filed a qualified amended return.  The outcome turns on the applicability of Treasury regulations that delineate when it is, in effect, too late for a taxpayer to save himself by filing an amended return because it is understood that he is doing so only because IRS actions have tipped him off that the shelter is being audited.  As the parties framed the issue at oral argument, the dispute boils down to whether the current Treasury regulation (which describes what IRS actions are to be understood as tipping off the taxpayer) was merely a clarification of the previous regulation that was in effect at the time that the taxpayer filed his amended return.  The taxpayer’s counsel conceded that applying the terms of the current regulation would have terminated the right to avoid penalties by filing an amended return; government counsel conceded that it is the older regulation, not the current one, that applies.

A couple of questions were asked at oral argument of each side, but nothing unexpected arose that obviously should have prompted the panel to suggest mediation.  Towards the end of the argument, however, after the panel had established that few, if any, taxpayers remain governed by the terms of the older regulation, District Judge Huff asked government counsel whether the parties had considered mediation (noting that she did not even know if the Ninth Circuit had a mediation program).  Not surprisingly, both government counsel and later taxpayer counsel said that they would not rule anything out and would be willing to entertain mediation.

The Ninth Circuit, of course, has an established mediation program — to which this case is now being referred — but that program ordinarily kicks in at the outset of the appeal, not after briefing and oral argument.  In fact, in this case the parties participated in the first stage of that process, a telephone settlement assessment conference, back in March 2012.  Thereafter, on March 15, 2012, the Court issued an order stating that the case was not selected for the mediation program, and it then proceeded to briefing.

The panel is now suggesting that the parties take a fresh look and decide whether they can reach a middle ground.  There is no middle ground if the appeal proceeds to a decision:  either the qualified amended return was timely and effective to protect against penalties or the taxpayer’s ability to achieve that protection was terminated before he filed the amended return.  The panel perhaps decided that a fairer result lies somewhere in the middle — given that the text of the older regulation appears to lean towards the taxpayer but resolving the case on that basis might be regarded as allowing the taxpayer to benefit from a poorly drafted regulation when it should have been too late, as a policy matter, to avoid penalties by filing an amended return.  Whatever the court was thinking, the oral argument and this order have given each side reason for concern that it might lose if the appeal proceeds to judgment.  On the one hand, the judges did not question the government’s assertions that its interpretation of the regulation was entitled to deference and that it would be a bad policy result to allow the taxpayer to escape penalties here.  On the other hand, the court — particularly Judge Gould who questioned government counsel on this point — did not appear entirely convinced that the current regulation can be viewed as a “clarification” because the text of the older regulation is not easily read to support the government’s position.  It is entirely possible that both sides will seize this opportunity to split the baby and will reach a settlement through the mediation process.

Supreme Court Rules for Government on Both Issues in Woods

The Supreme Court this morning ruled 9-0 in favor of the government on both issues in Woods, holding that:  (1) there is partnership-level TEFRA jurisdiction to consider the appropriateness of a penalty when the partnership is invalidated for lack of economic substance; and (2) the 40% valuation overstatement penalty can apply in that setting on the theory that the basis of a sham partnership is zero and therefore the taxpayers overstated their basis.  See our prior coverage here.  The opinion, authored by Justice Scalia, is concise and appears to resolve definitively both issues that had previously divided the lower courts.

On the jurisdictional issue, the Court began by pointing to Code section 6226(f), which establishes partnership-level jurisdiction for “the applicability of any penalty . . . which relates to an adjustment to a partnership item.”  Accordingly, the Court found, the question “boils down to whether the valuation-misstatement penalty ‘relates to’ the determination” that the partnerships were shams.  On that point, the Court agreed with the government’s “straightforward” argument that “the penalty flows logically and inevitably from the economic-substance determination” because the trigger for the valuation overstatement calculation is the conclusion that a sham partnership has zero basis.

The Court rejected the taxpayer’s argument (previous adopted by the Federal and D.C. Circuits) that there can be no partnership-level determination regarding “outside basis” because some partner-level determinations are necessarily required to conclude that outside basis has been overstated.  The Court found that this approach is inconsistent with TEFRA’s provision that the applicability of some penalties must be determined at the partnership level.  If the taxpayer’s position were correct, the Court stated, it “would render TEFRA’s authorization to consider some penalties at the partnership level meaningless.”  The Court stressed that the partnership-level applicability determination is “provisional,” meaning that individual partners can still raise partner-level defenses, but the partnership-level proceeding can determine an overarching issue such as whether the economic-substance determination was categorically incapable of triggering the penalty.  In the Court’s view, “deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy:  duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.”

With respect to the merits issue of the applicability of the 40% penalty, the Court relied on what it regarded as the “plain meaning” of the statute.  The text applies the penalty to tax underpayments attributable to overstatements of “value . . . (or the adjusted basis)” of property.  Finding that the parentheses did not diminish or narrow the import of the latter phrase, the Court concluded that a substantial overstatement of basis must trigger the 40% penalty and that such an overstatement occurred in this case.  Because the term “adjusted basis” “plainly incorporates legal inquiries,” the Court was unpersuaded by the taxpayer’s argument that the penalty applies only to factual misrepresentations of an asset’s value or basis.  As we have previously noted (see here and here), both the taxpayer and an amicus brief filed by Prof. David Shakow set forth considerable evidence that the intent of Congress in enacting the 40% penalty was to address factual overstatements, not overstatements that flow from legal errors.  The Court, however, stated that it would not consider this evidence, which is found in legislative history and in the IRS’s prior administrative practice, because “the statutory text is unambiguous.”

In addition, the Court rejected the reasoning of the Fifth Circuit that the underpayment of tax was “attributable to” a holding that the partnership was a sham, not to an overstatement of basis.  The Court instead adopted the reasoning of Judge Prado’s opinion in the Fifth Circuit (which had questioned the correctness of binding circuit precedent) that, “in this type of tax shelter, ‘the basis understatement and the transaction’s lack of economic substance are inextricably intertwined.'”

At the end of the opinion, the Court addressed an issue of statutory interpretation that has broader implications beyond the specific context of Woods.  The taxpayer had relied on language in the Blue Book, and the Court stated in no uncertain terms that the Blue Book is not a relevant source for determining Congressional intent.  Rather, it is “post-enactment legislative history (a contradiction in terms)” that “is not a legitimate tool of statutory interpretation.”  The Court acknowledged that it had relied on similar documents in the past, but suggested that such reliance was a mistake, stating that more recent precedents disapprove of that practice.  Instead, the Blue Book should be treated “like a law review article”— relevant only if it is persuasive, but carrying no special authority because it is a product of the Joint Committee on Taxation.

Woods – Supreme Court Opinion

 

Supreme Court Briefing Underway in Quality Stores

The government has filed its opening brief in the Quality Stores case, which involves the question whether severance payments made pursuant to an involuntary reduction in force are subject to FICA taxation.  See our prior coverage here. The brief is considerably shorter than the page limit, as the government has sought to take a relatively simple approach to an issue that in the past has generated complex and detailed briefs and opinions.

The government’s primary submission is that the Court needs to focus its attention on the FICA statute and not be distracted by the income tax withholding statute that formed the basis for the Sixth Circuit’s opinion.  The FICA statute broadly defines “wages” for FICA purposes as “remuneration for employment,” and that language assertedly encompasses the severance payments at issue here.  To support the argument that this language should be read broadly, the government points to current Treasury regulations and to the Supreme Court’s decision in Social Security Board v. Nierotko, 327 U.S. 358 (1946).  The government also relies on the history of the FICA definition of wages, pointing out that it originally contained an exception for discretionary “dismissal payments” like those at issue here, but that exception was repealed in 1950.

The brief then moves on to respond directly to the Sixth Circuit’s reliance on 26 U.S.C. 3402(o), the income tax withholding provision stating that severance payments should be “treated as . . . wages” (and therefore, according to the taxpayer, must be something different from “wages.”)  The government states that, by its terms, this provision applies only to income tax withholding and can provide no inference for determining whether the severance payments are subject to FICA taxation.  Even if that basic point does not prevail, however, the government argues that the inference drawn by the Sixth Circuit is incorrect.  Adopting the analysis of the Federal Circuit in CSX, the government argues that the term “wages” and the class of payments included in section 3402(o) are not mutually exclusive; the latter section is broadly drafted and can encompass payments that also fall within the category of “wages.”  The brief then embarks on a fairly detailed account of the history of the IRS’s administrative rulings on the scope of “wages,” seeking to explain why Congress was motivated to enact section 3402(o) as it did and, correspondingly, why that action should not carry any logical inference for the definition of FICA wages.  In particular, the government argues that Congress was concerned that the IRS had determined that certain payments were includible in gross income, but not subject to income tax withholding, thus leaving taxpayers with an unexpectedly high tax bill when it came time to file their return.  In acting to solve that problem, the government maintains, Congress was not saying anything about FICA nor was it defining “wages” even for income tax withholding purposes.

For those that have followed this issue over the years, we note one subissue that has receded in importance under the government’s current approach — namely, the relevance of legislation enacted by Congress in the wake of the Court’s decision in Rowan Cos. v. United States, 452 U.S. 247 (1981).  Taxpayers have pointed to Rowan as indicating that terms in the FICA statute and income tax withholding statute generally ought to be interpreted harmoniously.  In the Sixth Circuit and in other litigation, the government has defended against the citation of Rowan by pointing to later legislation in which Congress codified the specific result in Rowan but also enacted a “decoupling amendment” establishing that nothing in the income tax withholding regulations providing an exclusion from “wages” “shall be construed to require a similar exclusion from ‘wages'” in the FICA regulations.  31 U.S.C. § 3121(a).  The legislative history described this provision as broadly decoupling the FICA definition of wages from the income tax withholding definition.   See our reports on the Sixth Circuit briefing here and here.  The Sixth Circuit, however, was unpersuaded by the “decoupling amendment” argument because applying decoupling to statutory definitions of “wages” is based entirely on the legislative history; the decoupling amendment itself expressly addresses only regulations.  The Federal Circuit in CSX similarly rejected the government’s position on the decoupling amendment, even though it agreed with the government on the ultimate issue of including severance pay in FICA wages.

The government apparently has concluded that the “decoupling” argument will fare no better in the Supreme Court.  Instead, it makes other arguments to defend against the taxpayer’s reliance on Rowan.  First, it argues simply that Rowan is irrelevant because it was addressing a different issue — the validity of a Treasury regulation providing that the value of meals and lodging should be included in FICA wages.  More substantively, the government argues that its position is consistent with the rationale of Rowan.  The Court stated there that Congress intended to coordinate the FICA and income tax withholding systems to advance Congress’s interest in “simplicity and ease of administration” (452 U.S. at 257).  According to the government, that interest is disserved by the Sixth Circuit’s decision because Congress has provided that the supplemental benefits included in the section 3402(o) definition are to be treated as wages for income tax withholding purposes.

The taxpayer’s response brief is due in mid-December, and oral argument is scheduled for January 14.

Quality Stores – Opening Brief for the Government

Oral Argument Scheduled in Quality Stores

The Supreme Court has scheduled oral argument in the Quality Stores case for the afternoon of Tuesday, January 14.  Two other cases will be argued in the morning session, and the Court will then break for lunch and reconvene at 1:00 for the Quality Stores argument, in which each side is given 30 minutes for argument.  A decision is expected no later than the end of June.

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

Government Submits Supplemental Authority in Loving

We recently reported on the oral argument before the D.C. Circuit in Loving, in which the court considered the validity of the recently promulgated Treasury regulations addressing registration of tax return preparers.  Subsequent to that argument, former IRS Commissioner Lawrence Gibbs published an article defending the IRS’s authority to promulgate those regulations and discussing their importance to tax administration.  The government has now filed a FRAP Rule 28(j) letter bringing the article to the attention of the court and highlighting some points made in the article.  The plaintiffs have responded to that letter, arguing that the article is not the kind of supplemental authority that is covered by Rule 28(j) and briefly addressing some of the points made in the article.  Copies of the letters are attached below (the article itself is appended to the government’s letter).

[Note:  Lawrence Gibbs is a member of Miller & Chevalier.]

Loving – Government’s Rule 28(j) Letter

Loving – Plaintiffs’ Response to Rule 28(j) Letter

 

Oral Argument Scheduled in Bergmann

We have previously reported on the Ninth Circuit’s consideration of the qualified amended return regulation in the Bergmann case.  Several months after the close of the briefing, the court has now scheduled the case for oral argument on December 3 in San Francisco.  The identity of the three-judge panel will be announced at a future date.

Supreme Court Struggles to Unravel TEFRA Jurisdiction in Woods Oral Argument

The Supreme Court held oral argument in United States v. Woods on October 9.  As we have previously reported, the case presents two distinct questions:  (1) a TEFRA jurisdictional question concerning whether the court could determine the applicability of the valuation overstatement penalty in a partnership-level proceeding; and (2) the merits question whether the 40% penalty applied when the partnership was found not to have economic substance and therefore the basis claimed by the taxpayers in the partnership was not recognized.

Most of the argument time for both advocates was spent on the jurisdictional issue, as the Justices often seemed genuinely confused about how TEFRA is generally supposed to work and about the respective positions of the parties on how the statutory provisions should be interpreted in the circumstances of this case.  [For example, Justice Sotomayor:  “what is this case a fight about?” “Could you give me a concrete example, because I’m not quite sure about what you’re talking about.”  Justice Breyer:  “I am genuinely confused.  I have read this several times.”]  Thus, a higher percentage of the Justices’ questions than usual appeared designed simply to elicit information or alleviate confusion, rather than to test the strength of the advocate’s position.

Justice Sotomayor began the questioning by suggesting to government counsel, Deputy Solicitor General Malcolm Stewart, that there was an “incongruity” in its position in that it was acknowledging that there were partner-level issues that precluded a final determination of penalty liability until the partner-level proceeding, yet it was insisting that the penalty could be imposed without a notice of deficiency prior to the partner-level proceedings.  Mr. Stewart responded that a taxpayer would have an opportunity before the penalty is imposed to make the kinds of broad objections that are at issue in this case.  He would have to file a partner-level refund suit only if he had undeniably partner-specific issues like a good faith reasonable cause defense, and Congress contemplated that there would not be a prepayment forum for those kinds of issues.

Justice Kagan suggested that the government’s position essentially was “what you do at the partnership level is anything that doesn’t require looking at an individual’s tax return”; Mr. Stewart agreed, but he said that he preferred to state the position as “any question that will necessarily have the same answer for all partners should presumptively be resolved at the partnership level.”

Chief Justice Roberts asked Mr. Stewart about the D.C. Circuit’s reasoning in Petaluma that the penalty issue related to outside basis and therefore could not be resolved at the partnership level even if the answer was obvious.  Mr. Stewart began his response by agreeing (as the government has throughout the litigation) with the proposition that “outside basis, in and of itself, is not a partnership item,” but this observation triggered some questions looking for clarification.  Justice Scalia asked why outside basis would vary from partner to partner, and Justice Kennedy suggested that the government was arguing that “outside basis in this case is necessarily related to inside basis” – a formulation that Mr. Stewart rejected.  The result was that the last few minutes of Mr. Stewart’s argument on the jurisdictional point were diverted into explaining that the government was not making certain arguments being suggested by the Court.

When Gregory Garre began his argument for the taxpayers, Justice Kagan zeroed in on the statutory text and asked if the case didn’t just boil down to whether the “related to a partnership item” language in the statute required that the relationship be direct [taxpayers’ view] or could be satisfied if the relationship were indirect [government’s view].  Mr. Garre responded by arguing that the government’s position was more at variance with the statutory text than she had suggested because the statute gives a partnership-level proceeding jurisdiction over “partnership items” and outside basis concededly was not a partnership item.  Justice Scalia, and later Justice Kagan, pushed back against that answer by noting that the statute establishes jurisdiction over more than partnership items.  Justice Kennedy chimed in to note that penalties are always paid by the partners, not the partnership itself, yet TEFRA contemplates that some penalties are determined at the partnership level.

Mr. Garre then emphasized that this penalty could not be determined at the partnership level because “outside basis isn’t reported anywhere at all on the partnership” return.  Justices Scalia and Breyer both blurted out “so what” in response.  There followed a long colloquy in which Mr. Garre argued to Justice Breyer that the difference between overstatements of outside basis and inside basis was of jurisdictional significance.  Justice Breyer appeared unconvinced, suggesting instead that the partnership itself is a partnership item, and therefore the penalty based on shamming the partnership should also be regarded as a partnership item.  Mr. Garre replied that the penalty was for overstating outside basis, which concededly is not a partnership item.

Justice Ginsburg showed great interest in the recently enacted economic substance penalty, asking about it on three different occasions.  Although that new penalty is not applicable to the tax years at issue in this case, the taxpayers had argued that its enactment showed that Congress did not agree with the government’s position – namely, that the valuation overstatement penalty already on the books would apply when partnerships are found to lack economic substance.  With respect to jurisdiction, Mr. Garre confirmed that the new penalty could be imposed at the partnership level because it is based on shamming the transaction, a partnership-level determination.  With respect to the merits, the advocates unsurprisingly responded differently to Justice Ginsburg’s questions.  Mr. Stewart stated that, although there was some overlap between the new penalty and the overstatement penalty at issue in this case, the overlap was not total, and it is not anomalous to have some degree of overlap.  Therefore, enactment of the new penalty was not inconsistent with the government’s position.  Mr. Garre, by contrast, asserted that the new penalty “that Congress passed to cover this situation here solves all the problems,” and thus it would be wrong for the Court “to fit a square peg into a round hole” by applying the valuation overstatement penalty to this situation.  Chief Justice Roberts later asked about how the new penalty operates as well.

Mr. Garre then emphasized the “practical consequences” of resolving the penalty issue at the partnership level – specifically, that it would allow the government to impose the penalty without making a prepayment forum available for the taxpayer to contest it.  Justice Sotomayor had begun the argument by asking Mr. Stewart about this point, and now she switched sides and asked Mr. Garre why that was inappropriate when it was “obvious” that the partner was going to claim a nonzero basis.  Mr. Garre responded that, obvious or not, the court could not create jurisdiction by “assuming a fact necessary to the penalty.”

Justice Scalia had asked Mr. Stewart whether pushing the penalty determination to the partner level would open the door to inconsistent outcomes on the same legal issue.  That was a friendly question, and Mr. Stewart happily agreed.  When Justice Scalia asked Mr. Garre the same question, it led to a more extended discussion with several Justices.  Mr. Garre initially responded that there was no danger of inconsistent outcomes on the merits issue because the Supreme Court’s resolution of that issue would be binding on everyone.  Although different outcomes could occur because different partners have different outside basis, that is what Congress intended and is the reason why TEFRA provides for partner-level proceedings.  Justice Scalia then asked about the possibility of different results on whether the partnership was a sham, but Mr. Garre pointed out that this determination was properly made at the partnership level and would apply equally to all partners.  Chief Justice Roberts, however, questioned whether the asserted need for a partner-level determination of outside basis was mostly theoretical, asking:  “does your case hinge on the perhaps unusual situations where you have one of these partners having a fit of conscience and decides to put down the real number or has some other adjustment to it?”  Mr. Garre responded “largely, yes,” but added that the statute did not allow these determinations to be made at the partnership level even if they are obvious, and that where individual transactions are shammed (instead of the entire partnership), it will not be obvious that the basis is overstated.  Justice Sotomayor remarked that she was confused by the individual transaction point, but she did not press Mr. Garre on the point after he explained it a second time.

The jurisdictional discussions left so little time for the advocates to address the merits that the argument did not shed much light on the Justices’ views on the applicability of the valuation overstatement penalty.  During the government’s argument, Justice Ginsburg finally moved the discussion to the merits by asking the question about the new economic substance penalty discussed above.  One other question followed from Chief Justice Roberts in which he asked Mr. Stewart to respond to one of the taxpayers’ main arguments – namely, that there is not an overvaluation of an amount here but instead a determination wiping out the entire transaction.  Mr. Stewart responded that it was appropriate to apply the valuation overstatement penalty because “the whole point of the avoidance scheme was to create an artificially inflated basis.”

Mr. Garre also moved to the merits issue late in his argument.  He began by emphasizing that Congress clearly aimed this penalty at the fundamentally different situation where the taxpayer misstated the amount of the value.  Justice Kagan interjected to say that he was describing “the prototypical case,” but that didn’t have to be the only case, and the statute was drafted more broadly.  Mr. Garre responded that “context, punctuation, pre-enactment history, post-enactment history and structure” supported the taxpayers’ position, but Justice Kagan rejoined skeptically that “you’re saying they have text, and you have a bunch of other things.”  Mr. Garre then expanded on his answer, stating that the reference to “basis” in the statute “comes in a parenthetical, subordinate way” and thus must be related to an overvaluation, not to a situation where “the thing doesn’t exist at all.”  He then ended his argument by noting that tax penalties are to be strictly construed in favor of the taxpayer and by inviting the Court to review the amicus brief filed by Prof. David Shakow for examples of other situations that would be mistakenly swept into the valuation overstatement penalty if the government were to prevail.

On rebuttal, Justice Breyer quickly interrupted to ask about his theory that the jurisdictional issue must be resolved in the government’s favor because the existence of the partnership is a “partnership item,” noting his concern that this approach might be too “simple” given that three courts had gone the other way and that he did not “want to say that you are right for the wrong reasons.”  Before Mr. Stewart could respond, however, Chief Justice Roberts asked if he could “pose perhaps a less friendly question.”  He then asked Mr. Stewart to comment on an analogy drawn by Mr. Garre to a taxpayer who claims a deduction for donating a $1 million painting when in fact he never donated a painting at all.  That situation would involve a misstatement, but not a valuation misstatement, and Mr. Garre argued that in both situations the valuation misstatement penalty would be inapplicable.  Mr. Stewart, however, sought to distinguish the painting example from this case because the IRS did not determine that the underlying currency transactions did not occur, just that the partnerships were shams.  Chief Justice Roberts appeared unpersuaded by this distinction, commenting that calling the partnerships shams was “like saying that there were no partnerships,” so it seemed that the situations were “pretty closely parallel.”

Given the nature of the questioning, it is harder than usual to draw any conclusions from the oral argument, except perhaps that the Court (or at least the Justice who is assigned to write the opinion) is regretting its decision to add the jurisdictional question to the case.  Justice Scalia appeared solidly on the side of the government on the jurisdictional question.  Justice Breyer appeared to be leaning that way as well, but on a theory not espoused in the briefs that he himself seemed to recognize might not withstand more rigorous analysis.  Conversely, Chief Justice Roberts referred several times to the D.C. Circuit’s Petaluma decision, perhaps indicating that he finds its reasoning persuasive.  In the end, most of the Justices seem still to be figuring the case out, and we will have to wait to see where they come out.

NPR Court Asks Parties for Additional Information on Jurisdictional Questions

It has been almost two years since the Fifth Circuit heard oral argument in the NPR Investments case, which involves a “son-of-BOSS” tax shelter and associated questions regarding penalties and jurisdiction under TEFRA.  See our previous reports on the oral argument and describing the issues.  Last week, the court issued an order directing the parties to file short “letter briefs,” answering some specific questions involving TEFRA jurisdiction over penalties.  In particular, the court asked the parties to address how NPR compares to the Petaluma (D.C. Cir.) and Jade Trading (Fed. Cir.) cases in which the courts found a lack of jurisdiction in partnership-level proceedings to impose a valuation misstatement penalty where a basis-inflating transaction was found to lack economic substance.  As we have reported, the Supreme Court is preparing to hear argument in U.S. v. Woods, which involves the validity of such a penalty and the same jurisdictional issue addressed in Petaluma and Jade Trading.

It is not clear whether the Fifth Circuit panel considering NPR was aware that the Supreme Court is poised to decide these questions in Woods (though Woods is a case that comes from the Fifth Circuit), but it certainly is aware of it now.  The government’s response to the court’s order points the court to the government’s brief in Woods and explicitly states that “the issue whether Petaluma and Jade Trading were correctly decided is at the heart of the jurisdictional issue before the Supreme Court in Woods, scheduled for argument on October 9.”  Given that a Supreme Court decision will be coming down in the next several months that, at a minimum, will bear closely on the issues in NPR Investments and quite possibly resolve them definitively, it is hard to see why the Fifth Circuit would press ahead to decide the NPR case.  Most likely, it will continue to sit on the case until Woods is decided.  But that is not certain.  The responses to the court’s request for supplemental briefs demonstrated some level of agreement between the government and the taxpayer.  If the Fifth Circuit has an opinion almost ready to go, but for a couple of areas of uncertainty that have now been cleared up by the supplemental briefs, it might go ahead and issue its opinion.  If it does, however, the ultimate result in the case likely will still remain in play until the Supreme Court speaks in Woods.

NPR Investments – Court Request for Supplemental Briefs

NPR Investments – Government’s Supplemental Brief

NPR Investments – Taxpayer’s Supplemental Brief

Supreme Court Grants Certiorari in Quality Stores

The Supreme Court, not surprisingly, granted cert this morning in the Quality Stores case.  As we have previously reported (see our prior coverage here), the Court is now poised to resolve a conflict between the Sixth Circuit and the Federal Circuit regarding whether severance payments paid to employees pursuant to an involuntary reduction in force are “wages” subject to FICA taxation.  Notably, Justice Kagan did not participate in the order granting the petition, perhaps because she had some involvement in the case during her tenure as Solicitor General.  Her recusal creates the theoretical possibility that the Court could ultimately divide 4-4 on the case and thus be unable to resolve the conflict.

The government’s opening brief is due November 15.  Oral argument will likely be scheduled for January 2014.

Government Faces Sharp Questioning from D.C. Circuit in Loving

The D.C. Circuit heard oral argument on September 24 in the government’s appeal in Loving from the district court decision enjoining the IRS from enforcing its new registration regime for paid tax return preparers.  The panel consisted of Judges Sentelle, Williams, and Kavanaugh.  The court was active, jumping in with questions in the first minute of the government’s opening presentation.  The court asked several questions of the plaintiffs’ counsel as well, but those questions seemed to evince less skepticism of the advocate’s position.  While it is always hazardous to predict the outcome based on the oral argument, the court of appeals certainly seemed to be leaning towards affirming the district court.

As we have previously discussed, the government’s position relies heavily on Chevron deference to its new tax return preparer regulations.  It argues that the statutory authority to regulate practice before Treasury is sufficiently broad to encompass tax return preparers — specifically, that the term “practice of representatives of persons before the Department of the Treasury” is ambiguous and could reasonably be construed by the regulations to include persons who prepare tax returns.  The relevant language is currently codified at 31 U.S.C. § 330(a)(1), but it dates back to 1884, when Congress responded to complaints about misconduct by claims agents who represented soldiers with claims for lost horses or other military-related compensation from the Treasury.

Just 30 seconds after the argument began, Judge Sentelle stepped in to challenge the premise of government counsel Gil Rothenberg that the Treasury regulations were valid because the statute did not “foreclose” them.  Judge Sentelle maintained that the question instead was whether the statute “empowered” Treasury to regulate in this area, and the case could not be analyzed by assuming that Treasury had unlimited power except to the extent that Congress had explicitly foreclosed it.  Shortly thereafter, Judge Williams questioned the government’s failure, in his view, to provide any support for the notion that the ordinary use of the statutory terms, like “representative” or “practice,” could encompass a tax return preparer who merely helps a taxpayer “fill out a form” that he is obliged to file with the IRS.  Mr. Rothenberg responded that, although there were no cases on point, return preparers do more than “fill out a form” and that the statutory term “representative” cannot be limited to an agency relationship because the term was intended to retain the same meaning as the original 1884 statute, which applied to “agents, attorneys, or other persons representing claimants.”

Judge Sentelle then suggested that the fact that Treasury had not claimed any authority to regulate tax return preparers until now, even though the statute had been on the books for more than a century, cast some doubt on the existence of that authority.  Judge Kavanaugh added that Congress’s enactment of legislation regulating tax return preparers during that period also suggested that Congress did not think that it had delegated that authority to the Treasury Department.  Mr. Rothenberg responded that the administrative process is an “evolving process,” and Treasury was free to “choose” not to regulate for many years and then later to invoke its latent authority to regulate.  Later, he added that the need to regulate the competence of tax return preparers is greater today than it was decades ago when taxpayers could more easily avail themselves of direct assistance from the IRS in filling out their return.  With respect to the legislation, Mr. Rothenberg distinguished laws that impose after-the-fact sanctions on return preparers from the Treasury initiative to impose up-front “admission” requirements.  Judge Sentelle questioned why the regulations are limited to paid return preparers, but do not cover persons who prepare tax returns for free.  Mr. Rothenberg responded that Treasury was tackling the problem one step at a time and reasonably believed that the biggest problem was with unqualified persons marketing their ability to prepare returns.

Judge Kavanaugh then zeroed in on the statutory text, pointing out that section 330 (a)(2)(D) states that Treasury “may . . . require” that “representatives” demonstrate their “competency to advise and assist persons in presenting their cases.”  That language indicates that Congress understood that the “representatives” who could be regulated were persons who would assist in “presenting cases,” not just filling out returns.  Mr. Rothenberg disagreed, arguing that Treasury was not compelled to impose all of the requirements set forth in subsection (a)(2) and that the other three requirements could apply to tax return preparers.  Judge Sentelle expressed some doubt whether that position was consistent with the statutory use of the conjunctive “and” in joining the four subsections of (a)(2).  Judge Williams then suggested that these were four different characteristics of representatives, but that the language of (a)(2)(D) in that case still bore some relevance to interpreting the term “representatives” in (a)(1).  Mr. Rothenberg again disagreed, stating that the discussion was now focused on what he believed to be the fundamental error of the district court — namely, treating all four characteristics of section (a)(2) as mandatory, because that would exclude otherwise able practitioners from representing taxpayers before Treasury simply because they lacked advocacy skills.  He also noted the position taken in the amicus brief of former IRS Commissioners that the “presenting a case” language could encompass preparing a tax return, but Judge Sentelle retorted that this would be an “awfully strange” use of the language.

Mr. Rothenberg then closed his argument by reiterating the government’s position that the district court erred in reading (a)(2) as limiting the language of (a)(1) and that (a)(1) itself did not foreclose Treasury from regulating tax return preparers.  Therefore, Chevron deference is owed to those regulations.

Counsel for the plaintiffs, Dan Alban, began his argument by maintaining that there was no statutory authorization for the regulation.  He described the statute as clearly focused on Treasury’s controversy and adjudicative functions, such as examination of returns and appeals before the agency, and not on what he described as “compliance” functions like filing a tax return.  He also pointed to the “presenting their cases” language in subsection (a)(2), stating that no “case” exists until there is a dispute over the taxpayer’s return.  Judge Williams asked about evidence that the scope of the original 1884 statute was limited to claims that were being resisted by the government — that is, controversies.  Mr. Alban replied that it was clear that the statute was addressing claims that the claimants chose to bring, rather than a mandatory function like filing a tax return.  In addition, he noted, the legislative history indicates that these were “contested” claims and that the representatives were standing in the shoes of the claimants.  Here, by contrast, tax return preparers are not “representatives” before the agency.  Judge Kavanaugh then asked who the preparers are representing.  Mr. Alban replied that they are not representatives of anyone; they are just performing a service in assisting preparation of the return, but the taxpayer himself has to sign it.  He noted in that connection that tax return preparers are not required to obtain a power of attorney, unlike taxpayer representatives in agency proceedings.

The court challenged Mr. Alban when he argued that the “level of policy decision” here warranted caution in allowing an agency, rather than Congress, to implement this new regulatory regime.  Judge Sentelle noted that counsel couldn’t get much “traction” with that argument when the D.C. Circuit frequently deals with “sweeping regulations” that create major changes in the regulatory landscape.  Judge Kavanaugh observed that, even if counsel was merely stating that the significance of the change ought to color the court’s approach to finding ambiguity, the suggestion was unworkable because it is hard for a court to decide what is “major.”

Finally, Judge Sentelle asked about the impact of the Supreme Court’s recent decision in City of Arlington holding that Chevron deference is owed to an agency’s determination of the scope of its jurisdiction.  Mr. Alban stated that the decision was not directly applicable, but in any case the Supreme Court had made clear in that case the importance of seriously applying the limitations on Chevron deference.  Here, because the statute was not ambiguous, Mr. Alban stated, the government’s position fails at Chevron Step 1, and therefore no deference is owed.  Putting aside the discussion of broader administrative law principles, it was not apparent that any of the judges on the panel disagreed with the plaintiffs on that basic point regarding section 330(a).

Mr. Rothenberg began his rebuttal with a general discussion of Chevron principles, stating that all the prior cases in which the D.C. Circuit had invalidated regulations at Chevron Step 1 were situations where the agency action was more clearly foreclosed by a specific Congressional determination found in the statutory text, but he was met with considerable resistance.  The judges observed that his list did not appear to be “exhaustive.”  In particular, Judge Sentelle suggested that this case was perhaps analogous to the American Bar Ass’n case, which he described as invalidating FTC regulations directed at the legal profession on the ground that Congress had not empowered the FTC to regulate that profession.  When Mr. Rothenberg answered in part that Chevron Step 1 sets a “low bar,” Judge Kavanaugh disagreed, stating that a court is to use all the tools of interpretation at Step 1 and that City of Arlington did not reflect a “low bar.”

Finally, Judge Kavanaugh asked Mr. Rothenberg to respond to Mr. Alban’s point that the IRS does not require tax return preparers to obtain a power of attorney.  He replied that the power of attorney is required for “agents,” and tax return preparers are not agents.  Mr. Rothenberg then repeated the point made in his opening remarks that the original 1884 statute covered “agents,” but other persons as well.  Judge Williams interjected that the government appeared to be placing too much weight on the statutory reference to “other persons,” because canons of statutory construction provide that the scope of broad language like that is limited by the specific terms that precede it — here, “agents” and “attorneys.”  Mr. Rothenberg noted that he disagreed, but his time expired before he could elaborate.

The case was heard on an expedited schedule, and therefore it is reasonable to expect that a decision will issue in the next couple of months.

Attached below is the plaintiffs’ response brief and the government’s reply brief, which were not previously posted on the blog.  The government’s opening brief and two amicus briefs in support of the government were previously posted here and here.

Loving – Plaintiffs’ Response Brief

Loving – Government Reply Brief

 

 

Reply Brief Filed in Quality Stores

Linked below is the government’s reply brief in support of its petition for certiorari.  The reply attempts to counter the taxpayer’s argument that the conflict between the Sixth Circuit and the Federal Circuit is unimportant because all taxpayers will choose to avoid the Federal Circuit in the future.  See our previous report here.  The government criticizes this argument for seeking to preserve a “forum shopping” opportunity and also remarks that “there is no reason to assume that other courts of appeals” faced with this issue will follow the Sixth Circuit’s reasoning rather than that of the Federal Circuit.  The government also dismisses the taxpayer’s suggestion that the issue can be resolved by promulgating new regulations, thus obviating the need for Supreme Court review.  The government asserts that the Sixth Circuit’s opinion suggests that the IRS has no authority to treat the severance payments as subject to FICA taxation and therefore the Sixth Circuit likely would not be swayed by new regulations.

As previously noted, the Court is scheduled to consider this petition at its September 30 conference and could announce whether it will grant certiorari as early as that afternoon.

Quality Stores – Government Reply Brief at Petition Stage

 

Briefing Complete in Woods

The government has filed its reply brief in the Supreme Court in Woods.  See our reports on the opening briefs here and here.  The discussion of the jurisdictional issue focuses less on the textual analysis set forth in the government’s opening brief and more on the policy implications of adopting the taxpayers’ position.  The government asserts that the taxpayers’ reading of the statute would effectively “negate Congress’s grant of authority to courts in partnership-level proceedings to determine the applicability of penalties.”

On the merits, the reply brief devotes most of its attention to responding to the taxpayers’ threshold argument that the penalty is inapplicable because there was no valuation misstatement to begin with, which was not the rationale of the court of appeals’ opinion.  The government relies heavily on the statutory reference to “adjusted basis,” noting that it is stated in the disjunctive and therefore should be read to apply to basis overstatements that have nothing to do with “fact-based” valuation misstatements.  The merits discussion also adverts to policy, stating that there is nothing “objectionable about the fact that basis overstatements arising from sham transactions will nearly always trigger the 40% penalty for gross misstatements.”  That is because “the most egregious misconduct–engaging in phony transactions to create an artificial basis–warrants the most severe sanction.”

We also link to an amicus brief inadvertently omitted from our previous report.  This brief, filed by Penn Law School Professor David Shakow because the issue is one “in which he has a special interest and about which he has been engaged for some time in writing,” supports the taxpayers’ primary argument on the merits.  The brief analyzes the statutory language in context, and examines the history of the statute — both the legislative history and its application before tax shelters became rampant — and concludes that the valuation misstatement penalty should not apply in the absence of an actual valuation misstatement.  According to Professor Shakow, the IRS, with the acquiescence of many courts, is improperly “using the valuation misstatement penalty as a surrogate for a ‘tax shelter’ penalty that Congress has not authorized.”

Oral argument is scheduled for October 9.

Woods – Government Reply Brief

Woods – Amicus Brief of Prof. Shakow

Supreme Court Schedules Quality Stores for Conference

The taxpayer has filed its brief in opposition in the Supreme Court in Quality Stores.   (See our earlier report on the certiorari petition here.)  The government has the option of filing a reply brief, which has no specific due date, but likely would be filed no later than early September.

The brief in opposition argues at length that the Sixth Circuit’s decision is correct on the merits.  With respect to the government’s reliance on a circuit conflict, the taxpayer describes this as a “shallow conflict” that does not justify a grant of certiorari.  Specifically, the taxpayer acknowledges a conflict with the Federal Circuit’s decision in CSX, but argues that the other decisions from regional circuits cited by the government do not conflict “because they all involved payments made to employees who had accepted some form of voluntary separation from employment or payments otherwise materially different in character from SUB payments.”  The taxpayer argues that the conflict with the Federal Circuit “may have no practical effect” because taxpayers can always choose to seek a refund in district court and thus avoid the CSX precedent.  The taxpayer also suggests that “it is possible” that the Federal Circuit could reconsider its position in light of information about the IRS’s prior administrative practice that was presented to the Sixth Circuit but not to the CSX court.

The Court has scheduled the certiorari petition for consideration at its September 30 conference.  Although the Court does not formally begin its new Term until the following Monday (the traditional “First Monday in October”), it has adopted the practice in recent years of announcing grants of certiorari in advance of that date, in order to give the lawyers an opportunity to start on the briefing.  Thus, if cert is granted in Quality Stores, an order could issue as early as the afternoon of September 30.

Quality Stores – Taxpayer Brief in Opposition to Certiorari

Taxpayers’ Brief Filed in Woods

The taxpayers have filed their response brief in the Supreme Court in the Woods case, contending first that the courts lacked jurisdiction to impose the penalties requested by the IRS and, second, that, if jurisdiction exists, the Fifth Circuit correctly held that the valuation misstatement penalty could not be imposed.

On the jurisdictional point, the brief emphasizes the same basic point made by the courts that have questioned jurisdiction in similar partnership cases (see our previous report here) – namely, that the statute allows for partnership-level jurisdiction in a TEFRA proceeding only over a penalty that relates to adjustment of a “partnership item.”  It is undisputed that outside basis is not a partnership item, and the taxpayers contend that the “penalty at issue in this case undeniably relates to the adjustment of a nonpartnership item—outside basis—not to a partnership item.” The taxpayers’ brief dismisses the government’s argument on this point as having “an Alice-in-Wonderland feel to it” and, at any rate, as proving too much.  The taxpayers concede that the outside basis determination does relate to the adjustment of a partnership item, specifically, whether the partnership transaction should be disregarded for lack of economic substance.  But the brief maintains that, if that attenuated connection were enough for jurisdictional purposes, then the statute’s jurisdictional limitation “would be rendered essentially meaningless and could be readily circumvented.”  The result would be to “rewrite Section 6226(f) to create precisely the jurisdiction that Congress withheld.”

On the merits of the penalty, the brief begins with a different argument from the one relied upon by the Fifth Circuit – maintaining that “there was no ‘valuation misstatement’ to begin with.”  Pointing to the common meaning of the word “valuation” in the statutory text, and to the legislative history, the taxpayers argue that “Congress meant the penalty to address misstatements about valuation—an inherently factual concept concerning the worth or cost of property.”  Therefore, the penalty should not be “triggered by transactions that are accurately reported but deemed not to exist based on a legal conclusion that they lack economic substance,” even if the result of that legal conclusion is to restate the basis claimed by the taxpayer.

The government argues, of course, that the text of the penalty provision is not limited strictly to classic “valuation” misstatements, because the statute defines those misstatements as occurring when “the value of any property (or the adjusted basis of any property)” is overstated on the return.  The taxpayers argue, however, that the government is overreading the parenthetical “adjusted basis” reference and, read in context, it should apply “only when basis is incorrectly reported due to a factual misrepresentation of a property’s worth or cost.”  For the government to read this language as authorizing application of the valuation overstatement penalty to cases where there is a “basis overstatement that is in no way dependent on a valuation error” – that is, one that is traceable to a legal conclusion that the transaction creating the basis was devoid of economic substance – is in the taxpayers’ view “essentially blowing [the penalty provision] up and transforming it into a penalty scarcely recognizable to the one Congress intended.”

The taxpayers also point to the penalty provision added in Congress’s recent enactment of an economic substance provision.  They argue that the penalty associated with that provision (see Code section 6662(b)(6) and (i)) could impose a 40% penalty for the reporting in this case and therefore its enactment indicates that the existing valuation misstatement penalty should not be construed to cover economic substance cases.

As a fallback argument, the taxpayers argue for adopting the rationale of the Fifth Circuit – namely, that the underpayment of tax is “attributable to” a finding of no economic substance and hence is not attributable to a basis overstatement.  Finally, the taxpayers rely on language from Supreme Court decisions in the 1930s to argue that doubts about the meaning of ambiguous tax statutes should be resolved in favor of the taxpayer.

An amicus brief in support of neither party was filed by Professor Andy Grewal.  That brief discusses the state of the law in the courts of appeals regarding the substance of the economic substance doctrine, but urges the Court to “reserve its opinion on the broader economic substance issues implicated in this case.”  Four amicus briefs were filed in support of the taxpayers, on either one or both issues, by other taxpayers involved in pending litigation that would potentially be affected by the Court’s holding.  See here, here, here, and here.

The government’s reply brief is due August 18.  Oral argument has been scheduled for October 9.

Woods – Taxpayers’ Response Brief

Fifth Circuit Rules for Government in Rodriguez

The Fifth Circuit has issued its opinion in Rodriguez, unanimously affirming the Tax Court in an opinion authored by Judge Prado.  As forecasted in our earlier report on the oral argument (see here), the Court saw no way for the taxpayer to get around the technical obstacle that a section 951 inclusion is neither an actual dividend nor expressly denominated by Congress to be a “deemed dividend.”  On the first point, the court stated that “actual dividends require a distribution by a corporation and receipt by the shareholder; there must be a change in ownership of something of value.”  Hence, “Section 951 inclusions do not qualify as actual dividends because no transfer occurs.”  On the second point, the court stated that the taxpayers’ “deemed dividends” argument was “unpersuasive . . . because, when Congress decides to treat certain inclusions as dividends, it explicitly states as much,” pointing to several provisions where Congress has explicitly stated that certain amounts should be treated as dividends.

The court did not express much angst over the unfairness argument made by the taxpayers — namely, that they could have obtained qualified dividend treatment through the formal declaration of a dividend had they only known that Congress was going to implement a more favorable rate for such dividends.  The court recognized that fact, but did not agree that it led to a “harsh and unjust result.”  To the contrary, the court said that the taxpayers had the opportunity to declare a dividend, or take other steps with the accumulated earnings, and those would have carried different tax implications.  But they could not “now avoid their tax obligation simply because they regret the specific decision they made.”  The court also gave short shrift to the taxpayers’ reliance on language in earlier legislative history and IRS pronouncements that described “a conceptual equivalence” between section 951 inclusions and dividend income.”  The court said that these pronouncements carried little weight because the distinction between these inclusions and formal dividends “was treated loosely at the time because it did not carry tax implications” until 2003 when the preferential rate for qualified dividends was implemented.

The taxpayers have 45 days from the July 5 date of decision to seek rehearing, and 90 days to seek certiorari, though there is no reason to believe that either of those avenues for further review would prove to be fruitful.

Rodriguez – Fifth Circuit 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

Extension Obtained to Respond in Quality Stores

The taxpayer has obtained an extension until July 31 to respond to the government’s petition for certiorari in Quality Stores.

Both Parties Questioned Extensively at Rodriguez Oral Argument

The Fifth Circuit held oral argument in the Rodriguez case before Circuit Judges DeMoss, Dennis, and Prado.  As we have previously reported here and here, the issue in this case is whether the taxpayers can receive qualified dividend income treatment for amounts included in their income under section 951.  Taxpayers’ counsel stated that he had three main arguments:  (1) section 951 is just an anti-deferral statute, not concerned with characterizing the income as dividend or ordinary income; (2) Private Letter Rulings and other Executive Branch announcements had previously characterized section 951 inclusions as “deemed dividends”; and (3) it was unfair, akin to a penalty, to deny dividend treatment to these income inclusions when the taxpayers concededly would have received qualified dividend treatment if they had actually made the distribution that was being imputed.

The court’s questioning at first focused on challenging the taxpayers’ basic point that the section 951 inclusion is essentially indistinguishable from a dividend.  The court pointed out that at best what was involved was something “similar” to a dividend, not an actual dividend, noting that there was no actual distribution.  When taxpayers’ counsel argued that the Code deems other kinds of income to be dividends even in the absence of a distribution, the court rejoined that these examples were distinguishable because they involved explicit statutory language providing that the income should be treated as a dividend.  The taxpayers’ argument appeared to get more traction on the fairness point.  The court observed that the taxpayers probably received legal advice and ought to suffer the consequences if they failed to make a dividend distribution and instead allowed the money to stay in the CFC and be subject to section 951 inclusion.  But this position appeared to soften when taxpayers’ counsel explained that this choice would not have been apparent at the relevant time because it was not until the Bush-era tax cuts were enacted (including the reduced tax rate for qualified dividends) that it made any difference whether the inclusion was treated as a dividend or not.

Government counsel was met with questions as soon as she took the podium and overall had to entertain more questions than did taxpayers’ counsel.  The court initially focused on the fairness point, remarking that the taxpayers had just done what was normally done at the time (before the Bush-era tax cuts) and wondering why they ought not to get the same treatment as if they had actually distributed the dividend.  Government counsel acknowledged that Congress had no specific intent to impose a penalty on people in the taxpayers’ situation, but maintained that there was no basis for giving the taxpayers the relief they seek.  Congress wanted to establish a reduced rate for dividends, but this was not a dividend nor any kind of distribution; it was just imputed income.  Later, government counsel emphasized that there were other respects (apart from the reduced qualified dividend rate) in which the income included under section 951 is not treated as a dividend, such as the effect on earnings and profits.  In response to a question about Congress’s understanding, she argued that Congress did understand that section 951 inclusions were not being treated as dividends and chose not to change that, pointing to a bill that did not get very far that would have explicitly treated them as dividends.  Before the government’s argument concluded, however, the court returned to its starting point, and government counsel conceded that the taxpayers would have received the reduced tax rate if they had just formally distributed the included amount as a dividend.

On rebuttal, the court suggested to taxpayers’ counsel that the taxpayers perhaps ought to live with the consequences of their failure to take advantage of the option of declaring a dividend.  The court also confirmed that the taxpayers could not cite to any binding precedent on point, but instead relied primarily on district court decisions from other jurisdictions.

Given the relative balance in the court’s questioning, neither affirmance nor reversal would be startling.  If I were to hazard a guess, however, the most likely outcome appeared to be the conclusion that the reduced rate applies to “dividends,” and section 951 inclusions, while they may be similar, are not technically “dividends” nor have they been deemed dividends by statute.  If so, the taxpayers may be out of luck.

ExxonMobil Victory in Interest Netting Case Is Final

[Note:  Miller and Chevalier represented the taxpayer Exxon Mobil Corp. in this case.]

We previously reported on the Second Circuit’s consideration of the interest netting issue that had been resolved against the taxpayer by the Federal Circuit in FNMA v. United States, 379 F.3d 1303 (2004).  Although we did not follow up with a timely report on the Second Circuit’s decision in that case in favor of the taxpayer, the decision is now final, with the government having allowed the time to seek certiorari to expire.  To close the loop, we provide here a summary of the decision and a link to the opinion.

As explained in our prior post, the issue concerned a “special rule” enacted when Congress passed the interest netting rule of section 6621(d) in 1998.  The statute operates prospectively, but Congress also allowed taxpayers to file interest netting claims for pre-1998 periods subject to a statute of limitations constraint.  The dispute was over the scope of that constraint, with the taxpayer arguing that interest netting is available so long as the statute of limitations was still open on the 1998 effective date for either of the years used in the interest netting calculation.  The government, by contrast, argued that the statute of limitations must have been open on the relevant date for both the underpayment and overpayment years that are used in the interest netting calculation.  The Federal Circuit in Fannie Mae had ruled for the government, reasoning that the statutory text is ambiguous and should be construed narrowly in favor of the government because the “special rule,” the court concluded, is a waiver of sovereign immunity.  The Tax Court, however, declined to follow Fannie Mae in this case and ruled for the taxpayer.

The Second Circuit affirmed the Tax Court in a comprehensive decision that closely tracked the taxpayer’s brief.  The court rejected the sovereign immunity argument and then concluded “that the structure, context, and evident purpose of section 6621(d) and the special rule indicate that the special rule is to be read broadly, such that global interest netting may be applied when at least one leg of the overpayment/underpayment overlapping period is not barred by the applicable statute of limitations.”

The court did not dwell on the statutory text, finding that “the provision is susceptible to both proffered interpretations and that the intended meaning of the special rule cannot be derived from the text alone.”  Therefore, the court stated that it was necessary “to consult the provision’s structure, historical context, and purpose–as well as applicable canons of statutory construction–in order to determine its meaning.”  The court added that it would be “particularly mindful” of one pro-taxpayer canon of construction that is sometimes mentioned by courts but also often ignored in favor of competing pro-government canons — namely, “where ‘the words [of a tax statute] are doubtful, the doubt must be resolved against the government and in favor of the taxpayer,’ United States v. Merriam, 263 U.S. 179, 188 (1923).”

The court then stated that it agreed with the portion of the Fannie Mae opinion that rejected the government’s requests for deference to the relevant Revenue Procedure or to the “Blue Book” summary of the special rule.  It is a bit surprising that the court addressed these arguments since the government had not made them in its brief in ExxonMobil; the court noted that “it appears . . . that the Commissioner has abandoned these arguments in this appeal.”  Apparently, the court wanted to make sure that its opinion left no room for further litigation of the interest netting issue.

The court then turned to the main bone of contention, the holding in Fannie Mae that the special rule was a waiver of sovereign immunity that must be narrowly construed in favor of the government.  The court’s analysis was succinct, observing that a “waiver of sovereign immunity is a consent on the part of the government to be sued,” and “[t]he special rule at issue here does no such thing.”  Specifically, the special rule “does not create jurisdiction or authorize claims against the United States.  Other provisions of the tax code perform that function.”

If the case was not to be resolved on the basis of sovereign immunity, the court explained, it should be resolved using the basic rules of statutory interpretation, which pointed towards a ruling for the taxpayer.  First, “[t]he structure of § 6621(d) as a whole–and particularly its use of interest equalization–strongly suggests that the special rule is meant to apply whenever the period of limitations for at least one leg of the overlapping period of reciprocal indebtedness remains open.”  Under that approach, it is “not necessary to adjust the computation of interest” for both legs “to achieve the zero net rate,” and therefore “it is not necessary for the limitations period to be open for both legs.”  The court also noted that the government conceded that only one leg needed to be open when the statute was being applied prospectively, and it saw no reason for different treatment for retrospective interest netting claims.  Finally, the court found support for the taxpayer’s position by examining “the historical context from which section 6621(d) emerged.”  Given Congress’s repeated efforts to urge the IRS “to ameliorate the inequitable effects of the interest rate differential,” the court found that section 6621(d) and the special rule are “best understood as remedial provisions, and should therefore be interpreted broadly to effectuate Congress’s remedial goals.”

The Second Circuit’s holding in ExxonMobil is of limited significance to other taxpayers going forward.  This is likely why the government chose not to seek certiorari despite the clearest circuit conflict imaginable.  The holding applies only to the availability of interest netting for periods ending before July 22, 1998, so the number of remaining interest netting claims governed by the special rule at all is not large.  And even within that universe, for many taxpayers the only available jurisdictional route will be through a refund suit in the Court of Federal Claims, where Fannie Mae remains binding precedent.

The court’s reasoning, however, could come into play in other settings, particularly where the government seeks to invoke sovereign immunity principles to support its position in a tax case.  See, e.g., Ford Motor Co. v. United States, 2013-1 U.S. Tax Cas. (CCH) ¶ 50,102 (6th Cir. Dec. 17, 2012).  The Second Circuit’s thoughtful approach to the definition of waivers of sovereign immunity will stand as a strong counterweight to the exceedingly expansive approach taken by the Fannie Mae court.

Exxon Mobil Second Circuit Opinion

Supreme Court Briefing Underway in Woods on Penalty and TEFRA Issues

The government has filed its opening brief in the Supreme Court in the Woods case, which involves whether the 40% gross valuation overstatement penalty applies in the context of a basis-inflating transaction held not to have economic substance.  See our earlier report here.

The government’s arguments on the question whether the penalty can be applied in these circumstances are similar to those discussed here previously and addressed in several court of appeals decisions.  It relies on the “plain text” of the statute, arguing that “[t]he word ‘attributable’ means ‘capable of being attributed’” and therefore a finding of lack of economic substance does not defeat the conclusion that the tax underpayment is “attributable” to a basis overstatement.  And the brief responds at length to the Fifth Circuit’s reliance on the “Blue Book” to justify a narrower interpretation of the statute.  The government characterizes the court’s approach as reflecting “a misinterpretation of the relevant passage” in the Blue Book and goes on to say that, “[i]n any event, the Blue Book, a post-enactment legislative report, could not trump the plain text of Section 6662.”  Finally, the government asserts that a contrary rule “would frustrate the penalty’s purpose of deterring large basis overstatements.”

The brief also addresses a question not presented in the petition for certiorari, but instead added to the case by the Supreme Court – namely, whether the district court had jurisdiction under Code section 6226 to decide the penalty issue.  This issue concerns the two-level structure established by TEFRA for judicial proceedings involving partnerships.  Partnerships are not taxable entities themselves; tax attributes from the partnership flow through to the tax returns of the individual partners.  Accordingly, before 1982, tax issues raised by a partnership tax return could be resolved only through litigation with individual partners, leading to duplicative proceedings and often inconsistent results.  The TEFRA scheme calls for proceedings at the partnership level to address “the treatment of any partnership item,” which would be issues common to all the individual partners.  Adjustments that result from those proceedings flow down to the individual partners, and the IRS can make assessments on the individual partners based on those partnership-level determinations without having to issue a notice of deficiency or otherwise initiate a new proceeding.  Issues that depend on the particular circumstances of individual partners, however, are determined in separate partner-level proceedings.

In this case, the penalty determination was made at the partnership level.  That seems logical in one sense because the conclusion that the transaction lacked economic substance – and therefore did not have the effect on basis claimed by the taxpayer – was a partnership-level determination that would not depend on an individual partner’s circumstances.  The Tax Court agrees with that approach, but the D.C. Circuit and the Federal Circuit have stated that such determinations do not involve “partnership items” within the meaning of TEFRA and hence a penalty determination like the one in this case should  be made at the individual partner level.  See Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010); Petaluma FX Partners, LLC v. Commissioner, 591 F.2d 649 (D.C. Cir. 2010).  The reason is that the basis at issue here is an “outside basis,” that is, the partner’s basis in his or her partnership interest.  A partner’s outside basis is not a tax attribute of the partnership entity (unlike, for example, the basis of an asset held by the partnership).  These courts did not dispute the assertion that outside basis is an “affected item” (that is, an item affected by a partnership item) and that the conclusion underlying the penalties obviously follows from the partnership item determination; it is obvious that there is zero outside basis in a partnership that must be disregarded on economic substance grounds.  But these courts ruled that obviousness is not a good enough reason to get around the jurisdictional limitations of the statutory text; “affected items” must be determined in a partner-level proceeding.

In its brief in Woods, the government argues that the statutory text allows the penalty determination to be made at the partnership level because the text affords jurisdiction over a penalty that “relates to an adjustment to a partnership item.”  I.R.C. § 6226(f) (emphasis added).  According to the government, “[w]hen a partnership item is adjusted in a way that requires an adjustment to an affected item and triggers a penalty, the penalty ‘relates to’ the adjustment to the partnership item.”  The statute thus should be understood as providing that “the court [considering the partnership-level issues] should decide whether an error with respect to a partnership item, if reflected in a partner’s own return, could trigger the penalty.”  The government’s brief then argues forcefully that its interpretation “best effectuates the objectives” of TEFRA because requiring this kind of penalty determination – involving “a pure question of law whose resolution does not depend on factors specific to any individual partner” – to be made at the partner level “would restore the inefficient scheme that Congress intended to do away with.”

The taxpayer’s brief is due July 22.

Woods – Government’s Opening Brief

Petition for Certiorari Filed in Quality Stores

The government has finally filed its long-awaited cert petition in Quality Stores, asking the Supreme Court to review the Sixth Circuit’s ruling that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes.  In our previous coverage, we have noted why this case is a strong candidate for Supreme Court review, and the cert petition sets those forth succinctly:  (1) “the Sixth Circuit’s decision in this case squarely conflicts with the Federal Circuit’s decision in CSX Corp.”; and (2) “the question presented here is both recurring and important.”  The petition elaborates on that latter point by stating that the question presented “is currently pending in eleven cases and more than 2400 administrative refund claims, with a total amount at stake of more than $1 billion.  That figure is expected to grow.”

The petition goes on to address the merits of the underlying issue in some detail, even though there will be another opportunity to brief the merits if certiorari is granted.  In essence, the government argues that the court of appeals went astray by drawing an inference about FICA taxation from Code section 3402(o)(2), which addresses income tax withholding.  The government asserts that the “court of appeals’ chain of reasoning reflects significant misunderstandings of Section 3402(o)’s text, history, and purpose.”  To the government, that section “simply directs that payments encompassed by the statutory definition will be subject to income-tax withholding whether or not they would otherwise be ‘wages.’”  Therefore, it “has no logical bearing on the determination whether particular payments to terminated employees are subject to FICA taxation.”

Instead, according to the government, the FICA taxation issue should be resolved simply by asking whether the severance payments were “wages.”  Looking to Social Security Board v. Nierotko, 327 U.S. 358 (1946), and other authorities, the government concludes that they are “wages” and therefore should be subject to FICA taxation.

The taxpayer’s response is currently due in early July.  Because of the Court’s summer recess, however, a decision on whether to grant certiorari will not be announced before late September.

Quality Stores – Petition.for Certiorari

Supreme Court Denies Review in Historic Boardwalk and Entergy

The Court this week denied the government’s petition for certiorari in the Entergy case.  As explained in our prior post on the PPL decision, this ruling was inevitable in the wake of the Court’s decision for the taxpayer in PPL.  The denial of certiorari now cements Entergy’s victory in the Fifth Circuit.

The Court also denied certiorari in Historic Boardwalk, the historic rehabilitation tax credit case decided in the government’s favor by the Third Circuit.  See our previous reports here.

Supreme Court Rules for Taxpayer in PPL

[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]

The Supreme Court this morning unanimously ruled in favor of PPL in its case involving the creditability of the U.K. Windfall tax.  See our prior coverage here.  The opinion was authored by Justice Thomas, with Justice Sotomayor adding a separate concurring opinion.

The Court’s opinion is fairly succinct.  Viewing the government’s position as more formalistic, the Court stated that it would “apply the predominant character test [of the foreign tax credit regulations] using a commonsense approach that considers the substantive effect of the tax.”  The Court stated that the regulatory test looks to “the normal manner is which a tax applies,” and “the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis.”

Applying this approach, the Court held that “the predominant character of the windfall tax is that of an excess profits tax,” which makes it creditable.  By contrast, the Court found that the government’s attempt to characterize the tax as being imposed on the difference between two values was unrealistic, noting that the U.K. statute’s “conception of ‘profit-making value’ as a backward-looking analysis of historic profits is not a recognized valuation method,” but instead “is a fictitious value.”  The Court agreed with PPL’s argument that the equivalency of the tax with a more typical excess profits tax could be demonstrated through an algebraic reformulation of the formula for computing the tax.  The Court addressed this point in some detail, putting this opinion near or at the top of the rankings in the category of most algebraic formulas found in a single Supreme Court opinion.  Declaring that it must look at “economic realities, not legal abstractions,” the Court concluded that it must “follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.”

Justice Sotomayor’s separate concurring opinion focused on an issue that featured prominently in the oral argument (see our report here) — namely, how the analysis is affected by the way the tax applied to a few “outlier” taxpayers who did not operate for the full four-year period governed by the tax.  Echoing the position taken in an amicus brief filed by a group of law school professors, Justice Sotomayor stated that the treatment of these outliers indicated that “the windfall tax is really a tax on average profits” and ought to be viewed as a tax on a company’s value, not net income.  Justice Sotomayor acknowledged, however, that her position “cannot get off the ground” unless the Tax Court was wrong in stating in Exxon Corp. v. Commissioner, 113 T.C. 338, 352 (1999), that “a tax only needs to be an income tax for ‘a substantial number of taxpayers’ and does not have to ‘satisfy the predominant character test in its application to all taxpayers.'”  Since the government indicated at oral argument that it did not disagree with the Tax Court on that point, Justice Sotomayor concluded that she should not base her analysis of the case on her “outlier” argument and instead would join the Court’s opinion.  Interestingly, Justice Kagan did not join the concurrence even though she was the Justice who appeared at the oral argument to advocate most strongly for the “outlier argument” made in the amicus brief.

For its part, the majority briefly noted this argument in a footnote at the end of its opinion, and stated that it would “express no view on its merits” since the government had not preserved the argument.  Notwithstanding that disclaimer, the body of the Court’s opinion provides ammunition for persons who might wish to oppose Justice Sotomayor’s position in future cases.  The Court stated that the predominant character test means that “a foreign tax that operates as an income, war profits, or excess profits tax in most instances is creditable, even if it may affect a handful of taxpayers differently.”  Another item in the opinion that could find its way into briefs in future foreign tax credit cases is the Court’s observation that the 1983 regulation at issue “codifies longstanding doctrine dating back to Biddle v. Commissioner, 302 U.S. 573, 578-79 (1938).”  In its court of appeals briefing in PPL, the government had denigrated the relevance of pre-regulation case law, stating that the regulations merely “incorporate certain general standards from those cases,” and arguing that PPL “cannot rely on pre-regulation case law—to the exclusion of the specific regulatory test—to make its case.”  The Court’s opinion will lend support to litigants who want to rely on pre-regulation case law in future foreign tax credit cases.

The Court’s opinion in PPL effectively resolves the Entergy case as well.  As we have reported, the government filed a protective petition for certiorari in Entergy, but it has never suggested that PPL and Entergy should be decided differently.  Thus, in the near future, probably next Tuesday, the Court can be expected to issue an order denying that certiorari petition and thereby finalizing Entergy’s victory in the Fifth Circuit.

PPL – Supreme Court opinion

Government Brief in Woods Due on May 30

We previously reported on the Court’s grant of certiorari in Woods, noting that the government’s opening brief would be due on May 9.  If you are looking for the brief, be advised that the Court has extended the filing date until May 30.  The taxpayer’s brief will be due July 22.

Government Response Filed in Historic Boardwalk

The government has filed its brief opposing certiorari in Historic Boardwalk.  The government characterizes the decision as resting “on a fact-bound examination of the agreements between the parties” that presents no legal issue of broad applicability warranting Supreme Court review.  The brief responds at length to the taxpayer’s argument that the court of appeals misapplied Commissioner v. Culbertson, 337 U.S. 733 (1949), maintaining instead that “the court of appeals properly applied the framework set forth in Culbertson.”

As we previously noted, the taxpayer faces an uphill battle because the Court rarely hears technical tax cases over the government’s opposition in the absence of a circuit conflict.  The Court is expected to act on the petition on May 28.

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

Time to Seek Certiorari in Quality Stores Further Extended Until May 31

The Chief Justice has granted the government a second extension of time to file its petition for certiorari in Quality Stores.  See our previous coverage here.  The petition is now due May 31.  By statute, the time to petition for certiorari can be extended for a maximum of 60 days, so the government is now about at the end of its rope, and it will surely fish or cut bait by the current May 31 deadline.

Two Amicus Briefs Filed in Loving, Including One by a Group of Former IRS Commissioners

[Note:  Miller & Chevalier member and former Commissioner of Internal Revenue Lawrence B. Gibbs is among the five former Commissioners who filed an amicus brief in support of the Government in the Loving appeal.]

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

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

Loving – Former Commissioners’ Amicus Brief

Loving- NCLC/NCTC Amicus Brief

 

 

 

Briefing Complete in Sophy on Treatment of Mortgage Interest Deduction for Non-Married Couples

The Government has filed its brief in the taxpayers’ appeal to the Ninth Circuit of the Tax Court’s decision that the mortgage interest deduction applies on a per residence rather than per taxpayer basis.  See our previous coverage here.   Section 163(h)(3) limits deductible mortgage interest to “acquisition indebtedness” of $1,000,000 and “home equity indebtedness” of $100,000.   With their Beverly Hills home and Rancho Mirage secondary residence, domestic partners Bruce Voss and Charles Sophy had considerably more indebtedness, and argued that, together, they should be able to deduct interest paid on up to $2.2 million of acquisition and home equity indebtedness because the limitations should be applied on a per taxpayer rather than per residence basis.  In its opposition brief, the Government argues that the statutory text supports a per residence limitation. The statute refers to acquisition or home equity indebtedness “with respect to any qualified residence of the taxpayer.”  According to the Government, “the word ‘indebtedness’ is used in direct relation to the ‘residence,’ and the word ‘taxpayer’ is used only in connection with the ‘residence,’ not with the ‘indebtedness.’”  The Government also finds support for its position in the Code’s definition of “acquisition indebtedness” as indebtedness incurred in acquiring a residence, not as indebtedness secured in acquiring a taxpayer’s portion of a residence.  Turning to policy arguments, the Government observes that the taxpayers’ interpretation would create an unintended marriage penalty.  Married taxpayers filing separately are limited to acquisition and home equity indebtedness of one-half the otherwise allowable amount, or $500,000 and $50,000 respectively.

In their reply brief, the taxpayers argue that the general rule of section 163(a) (“There shall be allowed as a deduction all interest paid within the taxable year on indebtedness.”) must be read as referring to the taxpayer’s indebtedness.  This “clearly implied” meaning, they argue, should inform the interpretation of the mortgage interest deduction provisions.  The taxpayers also seek support for their interpretation in references in the legislative history to the indebtedness on the qualified residence as being “the taxpayer’s debt.”  With respect to the Government’s marriage penalty argument, the taxpayers note that the Code often treats married couples as a single taxpayer, and married couples enjoy many benefits from that treatment, benefits that are not enjoyed by domestic partners.  The reply brief concludes with the following:  “Once Congress made the decision to treat spouses as a  single taxpayer, the resulting benefits and burdens must be respected equally.  In this case, Taxpayers should not be assigned the burden (or penalty) that results from the Tax Court’s convoluted reading of section 163(h)(3) which treats Taxpayers as a married couple, when they receive none of the marriage benefits.”

Sophy – Government’s Brief

Sophy – Taxpayers’ Reply Brief

 

Cert Petition in Quality Stores Now Due on May 3

The Supreme Court has granted the government’s request for a one-month extension to file its petition for certiorari in Quality Stores, extending the due date from April 4 to May 3.  As we have previously observed, we believe there is a strong likelihood that the government will petition in this case and that the Court will grant certiorari to resolve the circuit conflict on the treatment for FICA purposes of supplemental unemployment compensation benefits.  See our previous coverage here.

With this extension, however, the Court likely will not decide whether to grant certiorari until early October, after the summer recess.  If Quality Stores were to file its response to the cert petition early, however, without taking its full 30 days to respond, then the petition could still be ready for a ruling by the Court before the summer recess.  In either event, if the Court were to grant certiorari, the case would probably be argued in late 2013, with a decision on the merits expected by June 2014.

Government Files Opening Brief in Loving; Seeks Expedited Appeal

Two days after the D.C. Circuit denied its motion for stay pending appeal, the Government moved for an expedited appeal and concurrently filed its opening brief.  The Government seeks an expedited resolution of its appeal of the decision of the U.S. District Court for the District of Columbia (Judge James E. Boasberg) invalidating a licensing regime for paid federal tax return preparers.  Under the Government’s proposed briefing schedule, briefing would be complete by May 31, 2013.  The Appellees have consented to the Government’s proposed briefing schedule.

In its opening brief, the Government argues that the tax return preparer regulations are a reasonable interpretation of an ambiguous statutory grant of authority to regulate the “practice of representatives before the Department of Treasury.”  The district court had held that the Treasury Department was not entitled to any Chevron deference because the statute, 31 U.S.C. 330(a)(1) unambiguously did not authorize the regulation of individuals whose only role is the preparation of the return.  The Government argues that “neither the actual language nor the overall context of 31 U.S.C. 330(a) unambiguously forecloses the Secretary’s interpretation that the term ‘ practice of representatives before the Department of the Treasury’ includes the practice of tax-return preparers.”  The Government pointed to the absence of a definition — either in the Code or in ordinary meaning — of “practice” that would exclude mere return preparation.  The Government also seizes on language in 31 U.S.C. 330(a)(2) authorizing the Secretary of the Treasury to require that representatives who practice before it demonstrate “necessary qualifications to enable the representative to provide to persons valuable service.”  The Government reasons that, because tax return preparers provide a “valuable service,” they should be deemed to “practice” before the Treasury Department.   Acknowledging that the statute authorizes the Treasury Department to require a representative to demonstrate “competency to advise and assist persons in presenting their cases,” the Government contends that Congress did not intend by that language to limit the Treasury Department’s authority to regulate tax-return preparers whose representation ends with preparing the tax return.

Loving – Government’s Opening Brief

Loving- Government’s Motion to Expedite Appeal

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

 

D.C. Circuit Denies Government’s Stay Request in Loving

The D.C. Circuit (Rogers, Tatel, and Brown, JJ.) has denied the government’s request for a stay of the district court’s injunction of the new registration regime for paid tax-return preparers.  The court did not give an elaborate explanation, simply stating that “[a]ppellants have not satisfied the stringent requirements for a stay pending appeal.”  Thus, the court did not indicate whether the government fell short because its motion was not sufficiently convincing that the district court was likely to be reversed on the merits or because it did not make a sufficiently compelling case of irreparable harm.

In any case, it is now likely that the government will not be able to implement the regulatory scheme in full at this time, but will remain bound by the injunction until the D.C. Circuit rules on the merits of its appeal in due course (and, of course, even after that if it is unable to persuade the D.C. Circuit to reverse).  The government does still have the option of asking the Supreme Court to stay the district court’s order pending resolution of the appeal in the court of appeals.  It is unusual for the government to ask the Court for that kind of relief, and for the Court to grant it, but pursuing that route remains a possibility if the government feels strongly enough about the adverse consequences of leaving the injunction in place for the time being.

Loving – Court of Appeals Order Denying Stay

Supreme Court Agrees to Hear Penalty Issue in Woods

The Court this morning granted the government’s petition for certiorari in United States v. Woods, No. 12-562.  As we recently reported, the issue presented in the petition concerns the applicability of the valuation overstatement penalty — specifically, whether tax underpayments are “attributable to” overstatements of basis when the inflated basis claim has been disallowed based on a finding that the underlying transactions lacked economic substance.

The Court also added a second question for the parties to brief — “Whether the district court had jurisdiction in this case under 26 U.S.C. section 6226 to consider the substantial valuation misstatement penalty.”  This issue involves the general question under TEFRA of which issues are to be resolved in a partner-level proceeding and which should be resolved at the partnership level.  See Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 655-56 (D.C. Cir. 2010).

The government’s opening brief is due May 9.  Oral argument will likely be scheduled for late 2013, with a decision expected by June 2014.

Supreme Court Denies Certiorari in Union Carbide

The Court this morning denied Union Carbide’s petition for certiorari that sought review of the Second Circuit’s denial of claimed research and experimentation credits for the costs of certain supplies used in production process experiments.  The petition had also asked the Court to consider the court of appeals’ application of Auer deference principles.  See our prior reports here.

The Court also entered an order denying a motion by the National Association for Manufacturers to file an untimely brief as amicus curiae in support of the petition.  Although the Court routinely grants motions for leave to file timely amicus briefs, it does take its time limits seriously.  In this case, the amicus brief was due January 3 and the brief was actually filed (with an accompanying motion for leave to file out of time) on January 15.

The Court took no action on the government’s petition for certiorari in Woods, a penalty case.  See our prior report here.  It was scheduled to consider the case at last Friday’s conference, but apparently decided that it needed more time to decide what to do.  The case will be rescheduled to be considered again at a future conference, possibly this Friday.  So there could be an order in the case next Monday.

Reply Brief Filed on Stay Motion in Loving

Yesterday, in Loving v. IRS (the subject of a recent post), the Government filed its reply brief in support of its motion to stay the district court’s injunction of the new registration regime for paid tax-return preparers.  With respect to its likelihood of success on the merits, the Government argued the ambiguity of the statute authorizing Treasury to “regulate the practice of representatives of persons before” it.   With respect to the threat of irreparable harm, the Government argued that the injunction risked delaying the implementation of the regulatory regime until the 2015 return-preparation season and that the problem of unregulated return preparers represents a “major public concern.”

Loving – USG Reply Brief re Motion for Stay

Government Seeks Appellate Stay of Order Enjoining Enforcement of New Registration Regime for Paid Tax Return Preparers

The Government has appealed to the D.C. Circuit from the district court decision enjoining the IRS from enforcing its new registration regime for paid tax return preparers.  Loving v. IRS, D.C. Cir. No. 13-5061.  The Government has also asked the court of appeals to stay the decision pending appeal, after the district court declined to grant a stay.  The Government’s stay motion recites that, the appeal has not yet been authorized by the Solicitor General’s office, but that, if the appeal is authorized, the Government intends to file its opening brief in March and to move for an expedited oral argument.

To recap the district court’s decision:  In 2011, the Treasury Department promulgated regulations that extended Circular 230 (the regulations that govern practice before the IRS) to non-attorney, non-CPA tax-return preparers who prepare and file tax returns for compensation.  Under the new regulations, tax-return preparers must register before they can practice before the IRS, and they are deemed to practice before the IRS even if their only function is to prepare and submit tax returns.  In order to register initially, tax return preparers must pass a qualification exam and pay a fee.  To maintain their registration each year, they must pay a fee and take at least fifteen hours of continuing education courses.  The IRS estimated that the new regulation sweeps in 600,000 to 700,000 new tax return preparers who were previously unregulated at the federal level.

Three tax return preparers who were not previously regulated by Circular 230 brought suit challenging the 2011 regulations and seeking declaratory and injunctive relief.  In January 2013, the U.S. District Court for the District of Columbia (Boasberg, J.) granted the plaintiffs’ motion for summary judgment.  The court recognized that, under Mayo Foundation, the two-step analysis of Chevron should be applied to determine the validity of the regulations.  The court explained, however, that “the battle here will be fought and won on Chevron step one” because “Plaintiffs offer no independent argument for why, if the statute is ambiguous, the IRS’s interpretation would be ‘arbitrary or capricious . . .’ under Chevron step two.” Focusing in this way on the unambiguous statutory text, the court held that the Treasury Department lacked statutory authority to issue the regulations.

The court rejected the Government’s argument that the agency had inherent authority to regulate those who practice before it, because a statute (31 U.S.C. § 330) specifically defined the scope of the Treasury Department’s authority.  Under that statute, the Treasury Department is authorized to “regulate the practice of representatives of persons before the Department of Treasury.”  The district court held that, although the statute did not define “the practice of representatives,” the surrounding statutory text made clear that Congress used “practice” to refer to “advising and assisting persons in presenting their case,” not simply preparing returns.  Turning to provisions in the Internal Revenue Code that regulate tax return preparers, the court reasoned that Congress could not have intended § 330 to be the authority for regulating tax return preparers because “statutes scattered across Title 26 of the U.S. Code create a careful, regimented schedule of penalties for misdeeds by tax-return preparers.”  The court rejected the Government’s resort to policy arguments.  “In the land of statutory interpretation, statutory text is king.”  Holding that the new regulations were ultra vires, the court enjoined the IRS from enforcing the registration regime.

In the motion for a stay pending appeal filed with the district court, the Government argued that the injunction substantially disrupted the IRS’s tax administration and that shutting down the program would be costly and complex. The district court was not persuaded, concluding that “[t]hese harms, to the extent they exist are hardly irreparable, and some cannot even be traced to the injunction.”

The Government’s stay motion in the court of appeals, filed February 25, argues that “[f]ailure to grant the stay will work a substantial and irreparable harm to the Government and the taxpaying public, crippling the Government’s efforts to ensure that individuals who prepare tax returns for others are both competent and ethical.”  According to the Government’s brief, the “IRS estimates that fraud, abuse, and errors cost the taxpaying public billions of dollars annually.”  In their March 8 response, the Plaintiffs/Appellees argue that the Government failed to establish any imminent irreparable harm traceable to the injunction, noting that even the Government acknowledged that most of the alleged harms would not occur until 2014.  The tax return preparers also emphasize that the injunction merely preserves the historical status quo.

Loving – District Court Opinion Granting Injunction

Loving – District Court order denying stay and modifying injunction

Loving – Government Motion for Stay

Loving – Appellees’ Response to Motion for Stay

Supreme Court Poised to Consider Penalty Issue in Woods

The government has asked the Supreme Court to resolve a longstanding conflict in the circuits on the applicability of the penalty for valuation misstatements in United States v. Woods, No. 12-562.

The Code contains a variety of civil penalty provisions for conduct connected with underreporting of tax.  The basic penalty is found in section 6662, which imposes an accuracy-related penalty for underpayments of tax “attributable to” different kinds of conduct, including negligence, substantial understatements of tax, and substantial overvaluations.  The penalty is 20% of the portion of the underpayment “attributable to” the misconduct.  I.R.C. § 6662(a), (b).  Section 6662(e) applies the 20% penalty in the case of a “substantial valuation misstatement,” which is defined as occurring when “the value of any property (or the adjusted basis of any property) claimed on any [tax return] is 150 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.”  I.R.C. § 6662(e)(1)(A).  That 20% penalty is doubled, however, to 40% in the case of a “gross valuation misstatement,” which is defined in the same way, except that the overvaluation is 200% or more of the correct amount.  I.R.C. § 6662(h)(2)(A)(i).  (Prior to 2006, the relevant percentages were 200% for a substantial valuation misstatement and 400% for a gross valuation misstatement.)

Congress’s focus in originally enacting this penalty was to address a specific problem of overvaluation.  It found that many taxpayers were severely overvaluing difficult-to-value assets like artwork, anticipating that the dispute would ultimately be resolved by “dividing the difference.”  Thus, the severe penalties were enacted as a deterrent to these overvaluations.  See generally H.R. Rep. No. 97-201, at 243 (1981).

In the last decade or so, however, the government has most frequently invoked this penalty regime in its efforts to combat tax shelters.  Oversimplifying a bit, many tax shelters work by using a series of transactions that have the effect of creating a high basis in some particular asset.  Disposal of that asset then generates a large tax loss.  The IRS often argues in these cases that the high basis is artificially inflated because the transactions lack economic substance.  If that argument succeeds, the high basis and attendant tax loss goes away.  In such cases, the government also frequently argues that the 40% gross valuation overstatement penalty applies on the theory that the taxpayer claimed a high basis in an asset ultimately found to have a much lower basis; hence, the adjusted basis “claimed on” the return exceeded by more than 200% or 400% “the amount determined to be the correct amount of” the adjusted basis.  I.R.C. § 6662(h)(2)(A)(i).  The government has not been able to apply this approach in a uniform way across the country, however, because of a persistent disagreement in the circuits over how to construe the penalty statute.

The crux of the dispute centers on the “attributable to” language in the statute.  More than 25 years ago, the IRS contested certain taxpayers’ deductions and credits claimed as a result of transactions involving the purchase of refrigerated containers.  It argued both that the taxpayers had overstated their bases in the property and that the containers had not been placed in service in the years in which the deductions had been taken.  The court ruled for the IRS based on the latter argument.  The Fifth Circuit held that, in these circumstances, the valuation overstatement penalty did not apply because the tax underpayment was not “attributable to” the valuation overstatement; even if there were such an overstatement, the deductions were completely disallowed for a reason independent of the overstatement.  Todd v. Commissioner, 862 F.2d 540, 541-45 (5th Cir. 1988).  Two years later, the Fifth Circuit applied Todd to a case where the two grounds for disallowance were more closely connected, the IRS having contended that the units were overvalued and that the taxpayers did not have a profit motive for the transactions.  Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990).

The Fifth Circuit has continued to apply Heasley in tax shelter cases, holding that when an asset is found to have an artificially inflated basis because transactions lack economic substance, the tax underpayment is “attributable to” the economic substance conclusion, not to an overvaluation.  Last year, it reaffirmed its adherence to that approach in Bemont Invs. L.L.C. v. United States, 679 F.3d 339 (5th Cir. 2012), although the judges indicated that they thought the Fifth Circuit precedent was probably wrong.  Shortly thereafter, a different panel rejected the government’s position in a one-paragraph per curiam opinion in Woods v. Commissioner, No. 11-50487 (June 6, 2012), that describes Todd, Heasley, and Bemont as “well-settled,” and the court denied a petition for rehearing en banc.  As a result, the 40% penalty is unavailable in the Fifth Circuit in the typical tax shelter case, although a 20% penalty usually will still apply because of negligence or a substantial understatement of tax (I.R.C. §§ 6662(c), (d)(1)).

The government asks the Court to grant certiorari in Woods, contending in its petition that “[t]here is a lopsided but intractable division among the circuits over whether a taxpayer’s underpayment of tax can be ‘attributable to’ a misstatement of basis where the transaction that created an inflated basis is disregarded in its entirety as lacking economic substance.”  Although the Ninth Circuit has followed the Fifth Circuit’s approach, the petition states that eight other circuits have gone the other way.  Several of those decisions have expressly disagreed with the Fifth Circuit precedent.  The petition says the circuit conflict is “ripe for resolution” given that the Fifth and Ninth Circuit have recently denied petitions for rehearing en banc asking them to reconsider their minority view on this issue.

The case is a strong candidate for Supreme Court review, unless the Court concludes that the issue is “overripe.”  In 2010, Congress passed section 6662(i), which imposes a 40% penalty on any underpayment of tax attributable to a “nondisclosed noneconomic substance transaction” entered into after March 30, 2010.  That new section would make the penalty applicable in such economic substance situations even in the Fifth and Ninth Circuits, and thus makes resolution of the conflict less important for future years.  The cert petition addresses this concern, stating that the new statute “has no application to the thousands of taxpayers who engaged in abusive, basis-inflating tax shelters before the provision’s effective date.”  In addition, the government argues that the new provision will not affect cases “where value- or basis-related deductions are disallowed in full on a ground other than lack of economic substance.”

In its brief in opposition, the taxpayer does not deny the existence of the circuit conflict.  He argues, however, that the issue does not warrant the Court’s attention, largely because the 2010 legislation has resolved the issue presented for future years.  In addition, the taxpayer argues that “the imposition of the 40% penalty in cases where the 20% penalty applies is not an important matter” and expresses skepticism about the government’s “sensationalized claim” that “hundreds of millions of dollars” in penalties are riding on this issue.  In response, the government identifies a group of eight cases docketed within the Fifth Circuit that involve aggregate basis misstatements of approximately $4 billion.

The Court is expected to announce whether it will hear the case on March 18.

Woods – Petition for Certiorari

Woods – Brief in Opposition

Woods – Reply Brief in Support of Certiorari

Fifth Circuit decision in Bemont

Oral Argument Scheduled in Rodriguez

The Fifth Circuit has scheduled oral argument in the Rodriguez case for April 3 in New Orleans.  As discussed in our prior posts, the issue in the case is whether section 951 inclusion income should be taxed at the lower rate applicable to qualified dividends.  The identities of the three judges who will hear the case will be announced the week before the argument.

Justices Explore a Variety of Topics in PPL Oral Argument

[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]

Seven Justices (all but Justices Thomas and Alito) asked questions in the oral argument in PPL on February 20, but they did not obviously coalesce around any particular view of the case. Even in cases where the questioning can be more neatly categorized, it is always hazardous to try to predict the outcome based on the questioning at oral argument. At this point, the parties’ work is done, and they are reduced to waiting for a decision, which is likely to come down in May or June — certainly no later than the end of June.

Former Solicitor General Paul Clement argued first on behalf of PPL.  Justice Sotomayor began the questioning of Mr. Clement and asked him the most questions.  She pressed him on why the tax could not be regarded as a tax on value.  She also expressed “fear” over what she saw as the breadth of the taxpayer’s position, characterizing PPL as seeking a rule that a tax is creditable “anytime a tax uses estimates of profits.”  Mr. Clement responded that this “emphatically” was not the taxpayer’s position, explaining that normal valuation is prospective and hence taxes that use future estimates for valuation will always fail the realization requirement for creditability.  In response to Justice Sotomayor’s suggestion that using actual profits was a reasonable way to “find the original flotation value,” Mr. Clement responded that “you would never do that in any normal valuation” because “the first rule of thumb” for those kinds of historical valuations “is to avoid hindsight bias.”

Several other Justices also asked questions of Mr. Clement, focusing on different issues of interest to them.  Justice Kennedy asked a series of questions exploring the significance of the tax being labeled as a tax on value, or reasonably viewed in part as “a tax on low value,” notwithstanding that it is also logically seen as a tax on profits.  Mr. Clement responded that the substance of the tax is “exactly like a U.S. excess profits tax” but did not “look at a normal rubric of value” because “the only measure of value here is by looking at retrospective earnings over a 4-year period.”  Justice Ginsburg asked whether there were other examples of taxes like the U.K. Windfall Tax.  Justice Breyer asked a series of questions exploring the operation and rationale of the tax as it applied to companies that had not been in operation for the full four-year period in which historical profits were measured.  Mr. Clement stated that even these companies did not pay an amount of tax that exceeded their profits and, moreover, that creditability is to be determined by the “normal circumstances in which it applies,” not by the outliers.

One perhaps surprising aspect of the argument was the attention paid to the amicus brief filed by a group of law professors.  Justice Kagan’s extensive questioning of Mr. Clement focused on an argument introduced by that amicus brief – namely, that the tax should not be treated as an income tax because of the way it treats the “short-period” outliers by looking to their average profits, not total profits, in determining the amount of the taxable “windfall” received.  Specifically, the tax rate on those few companies who did not operate for the entire four-year period was higher than for the vast majority of the companies.  Mr. Clement noted that the reason for this was because the taxing authorities “were trying to capture the excess profits during a period in which there is a particular regulatory environment” conducive to excess profits; for the short-period taxpayers the way to do this was to “hit them with a reasonably tough tax in year one but year two, three, and four they were in a favorable regulatory environment and they get no tax at all.”  (Justice Breyer later stated that, “because time periods vary, rates will vary, but I don’t know that that matters for an income tax.”)  Mr. Clement also emphasized here, as he did later to Justice Breyer, that the outlier case does not control creditability, which is determined based on the normal circumstances in which the tax applies.  The amicus brief was also mentioned briefly by Justice Sotomayor.

After Assistant to the Solicitor General Ann O’Connell took the podium, Chief Justice Roberts engaged her on the amicus brief as well, pointing out that the argument discussed by Justice Kagan was “not an argument that you’ve made.”   When Ms. O’Connell agreed, but pointed to the amicus brief, the Chief Justice remarked that “I don’t think we should do a better job of getting money from people than the IRS does.”  In response to Justice Sotomayor, Ms. O’Connell sought to clarify the government’s position by distinguishing between two different points made in the amicus brief.  With respect to the “aspect of the amicus brief that says if it’s bad for one, it’s bad for all,” that is not the government’s position; the government agrees with PPL that outliers do not control credibility.  But with respect to the argument of the amicus that Justice Kagan had discussed in connection with the outliers – namely, that “it taxes average profits, not total profits” – Ms. O’Connell maintained that she was not saying that the argument was wrong, only that the government’s “principal argument” was that the predominant character of the tax “is not an income tax because of the way that it applies to everybody else.”  Justice Kagan took the opportunity to state that she believed the argument developed in the amicus that had formed the basis for her questioning was “the right argument.”

Apart from the amicus brief discussion, Ms. O’Connell was questioned by Justices Scalia and Breyer on whether true valuations are based on historical profits, rather than direct market evidence of value.  She responded that this was a good way to determine the value of the companies at the time of flotation.  In response to questioning from the Chief Justice about how to treat a tax laid on income, Ms. O’Connell stated that a tax just “based on last year’s income” would be an income tax regardless of its label, but if the income were multiplied by a price/earnings ratio, it would be a tax on value.  The topic of deference also made a brief appearance, with Justice Breyer suggesting that deference might be owed to the experts at the Tax Court and Justice Ginsburg wondering whether deference was owed to the government’s interpretation of its own regulations.  The Chief Justice responded to the latter point by remarking that there did not appear to be a major dispute about the meaning of the regulatory language and hence that sort of deference “does not seem to move the ball much.”

Justice Breyer chimed in with a detailed discussion of the mechanics of the tax, suggesting that this indicated that the “heart of the equation in determining this so-called present value is nothing other than taking average income over the four-year period.”  Ms. O’Connell disagreed, and after considerable back-and-forth, Justice Breyer remarked that he had “said enough” and he would go back and study the transcript to decide who was right.

Towards the end of the argument, Justice Ginsburg asked whether the regulation could be changed “so it wouldn’t happen again” if the taxpayer prevailed.  Ms. O’Connell said that perhaps it could be made “even more clear than it already is,” but Justice Breyer wondered why it should be changed to make American companies “in borderline cases have to pay tax on the same income twice.”  Ms. O’Connell disputed that characterization, stating that the taxpayer did get a foreign tax credit for payments it made of the standard British income tax and it would still get a deduction for the U.K. Windfall Tax payments if the government prevailed.  Ms. O’Connell closed her argument by stating that the tax was “written as a valuation formula, and it’s not just written that way, but that’s the substance of what it’s trying to do.”

PPL Oral Argument Transcript

 

 

Briefing Completed on Union Carbide Cert Petition

To close the loop on yesterday’s post on the Union Carbide certiorari petition, the taxpayer has now filed its reply brief in support of the petition.  The reply brief focuses primarily on the Auer deference issue, distinguishing the cases cited by the government in its defense of the application of Auer deference.  The reply brief also vigorously disputes the government’s contention that the Second Circuit would have reached the same result if it had not deferred to the government’s interpretation of the regulation.

Union Carbide – Taxpayer’s Certiorari Stage Reply Brief

Government Opposes Supreme Court Review in Union Carbide

The government has filed a brief in opposition to Union Carbide’s request for review of the Second Circuit’s decision denying its research credit claim.  See our prior reports on the cert petition and the court of appeals’ decision here and here.  With respect to the basic legal issue, the government’s concise analysis tracks that of the Second Circuit, arguing that the taxpayer would get a “windfall” if it received “a credit for the cost of supplies that the taxpayer would have incurred regardless of any qualified research.”  The government emphasizes that there is no circuit conflict on this issue that warrants Supreme Court review, describing this as “the first case since the enactment of the research credit in 1981 that has presented the question of what supply costs are eligible for the credit when a taxpayer simultaneously performs research on a production process and produces products for sale in the ordinary course of its business.”

The government spills more ink addressing Union Carbide’s argument that Supreme Court review is appropriate in order to reject the Second Circuit’s allegedly overbroad application of “Auer deference” to the government’s interpretation of its research credit regulations.  Clearly unenthused about the prospect of the Court re-examining this issue, the government gives a plethora of reasons why it should stay away:  (1) the taxpayer did not raise in the court of appeals its objection that the government should not be entitled to Auer deference when it has a financial interest in the outcome of the case (because the government had not explicitly requested Auer deference in its brief); (2) no other court of appeals has “expressly addressed” this argument; (3) although the Second Circuit invoked Auer deference, that did not affect its decision because it would have interpreted the regulation the same way even without resort to deference principles; (4) Union Carbide’s argument is wrong; and (5) Union Carbide did not claim the credit in question on its tax return and therefore the agency could not apply its interpretation of the regulations until after litigation had commenced.

Given the absence of a conflict and the government’s strong opposition, Union Carbide’s petition faces a steep,a nd likely insurmountable, uphill climb.  The Court is expected to act on the cert petition on March 18.

Union Carbide – Brief in Opposition

Briefing Complete in PPL

[Note:  Miller & Chevalier filed an amicus brief in this case on behalf of American Electric Power Co. in support of PPL.]

PPL has filed its reply brief in the Supreme Court, thus completing the briefing.  The brief responds at length to the government’s contention that the U.K. Windfall Tax should be viewed as a tax on value because it assertedly resembles “familiar” and “well-established” methods of measuring value.  In fact, the reply brief maintains, the tax “is a tax on value in name only.”  The reply brief observes that the tax involves “a backward-looking calculation driven entirely by actual, realized profits” and that it is “imposed on the income-generating companies themselves,” rather than on “the holder of the valuable asset.”  The reply brief then states that the rest of the government’s arguments “all depend on the flawed premise that form trumps substance when it comes to the base of a foreign tax.”  The difficulties with that premise were addressed extensively in PPL’s opening brief and are further addressed in the reply brief.

Oral argument is set for February 20.

PPL – Taxpayer’s Supreme Court Reply Brief

 

Taxpayer Seeks Supreme Court Review in Historic Boardwalk

[Note:  Miller & Chevalier filed an amicus brief in the Third Circuit in this case on behalf of National Trust for Historic Preservation]

We have previously reported extensively (see previous reports here) on the Third Circuit’s decision in Historic Boardwalk denying a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk.  Although the Third Circuit declined to rehear the case, the taxpayer has now filed a petition for certiorari seeking Supreme Court review (docketed as No. 12-901).

With no conflict in the circuits on the issue presented, the petition argues that Supreme Court review is needed because of the issue is new and has potentially broad ramifications, stating:  “This is the first litigated case in the country where the Internal Revenue Service has made a broad based challenge to the allocation of Congressionally-sanctioned federal historic rehabilitation tax credits by a partnership to a partner.”

The petition elaborates by proffering three reasons why the case should be viewed as presenting tax law issues of exceptional national importance.  First, the Third Circuit’s ruling that the taxpayer was not a bona fide partner is asserted to squarely conflict with Commissioner v. Culbertson, 337 U.S. 733 (1949).  Second, the petition criticizes the court of appeals’ holding that the allocation of tax credits “should be considered a ‘sale’ or ‘repayment’ of ‘property’” as “utterly baseless” and at odds with Supreme Court precedent.  Third, the petition criticizes the Third Circuit for considering the credits themselves as a component of the substance over form analysis.

The petition urges the Court to hear the case because of its importance, stating that it undermines Congress’s intent “to encourage private investment in the restoration of historic properties” and that the issues “bear broadly on . . . thousands of [historic rehabilitation tax credit] partnership investment transactions across the nation involving billions of dollars.”  The breadth of the impact of a decision is an important factor in the Court’s consideration of whether to grant review, but the petition still faces an uphill battle, as the Court rarely grants certiorari in technical tax cases in the absence of a circuit conflict – unless the government urges it to do so.  Here, there is every reason to expect that the government will oppose the petition.

The government’s brief in response is currently due, after one 30-day extension, on March 25.

Historic Boardwalk – Petition for Writ of Certiorari

 

Briefing Complete in Bergmann

The Bergmanns participated in a listed transaction promoted by KPMG, known as the Short Option Strategy.  When the Bergmanns filed their amended return in March 2004, the IRS had already served KPMG with summonses targeted at KMPG’s promotion of the Short Option Strategy.  As discussed in an earlier post, the Tax Court held that the Bergmanns failed to timely file a qualified amended return and thus were subject to the 20-percent accuracy related penalty.  Under the regulations in effect when the taxpayers filed their return, the time for filing a qualified amended return terminated when “any person described in § 6700(a) (relating to the penalty for promoting abusive tax shelters) is first contacted by the Internal Revenue Service concerning an examination of an activity described in § 6700(a) with respect to which the taxpayer claimed any benefit on the return . . . .”  Treas. Reg. § 1.6664-2(c)(3)(ii).  The Tax Court rejected the Bergmanns’ argument that the promoter provision of the qualified amended return regulations required the IRS to establish that KPMG was liable for the § 6700 promoter penalty.

On appeal, the Bergmanns’ principal argument is that the Tax Court erroneously applied the current qualified amended return regulation rather than the regulation in effect when the amended return was filed.  The current regulation, Treas. Reg. § 1.6664-2(c)(3)(i)(B), which applies to amended returns filed on or after March 2, 2005, treats as a terminating event the “date any person is first contacted by the IRS concerning an examination of that person under § 6700   . . . for an activity with respect to which the taxpayer claimed any benefit on the return,” rather than the date “any person described in § 6700(a)” is contacted.  The Bergmanns acknowledge that their amended return would be untimely under the current regulations.

The Bergmanns argue that the Tax Court must have relied on the current regulations because its paraphrase of the regulation tracks the language of current regulation.   In its brief, the Government argues that it was clear from both the post-trial briefing and the Tax Court’s decision that the Tax Court was fully aware of which regulation was controlling and in fact cited the correct version.   The Government then argues that the Tax Court correctly interpreted the operative regulation.  Because the terminating event is the “first contact” with the promoter, the timing should not turn on the ultimate results of the § 6700 investigation of the promoter.  And, the Government argues, any ambiguity in the regulations should be resolved by deference to the agency’s interpretation of the regulation.  The Treasury Decision accompanying the amended version of the promoter provision explained that the new language was intended to “clarify the existing rules,” and, specifically, that the language “clarifies that the period for filing a qualified amended return terminates on the date the IRS first contacts a person concerning an examination under section 6700, regardless of whether the IRS ultimately establishes that such person violated section 6700.”  T.D. 9186, 2005-1 C.B. at 791-82.  The taxpayers’ reply brief largely ignores the Government’s arguments.  Oral argument has not yet been scheduled.

Bergmann – Taxpayers’ Opening Brief

Bergmann – Government’s Brief

Bergmann – Taxpayers’ Reply Brief

 

Briefing Underway in Ninth Circuit on Question of Mortgage Interest Deduction for Non-married Couples

Last spring, the Tax Court held in Sophy v. Commissioner, that the limitations on indebtedness for the mortgage interest deduction are applied on a per residence rather than per taxpayer basis.  The taxpayers appealed to the Ninth Circuit (Nos. 12-73257 and 12-73261), and filed their opening brief on January 30.  The government’s response is due in March.

Under I.R.C. § 163(h)(3), taxpayers are allowed to deduct “qualified residence interest,” which includes interest paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer.  For purposes of the deduction, acquisition indebtedness is capped at $1 million and home equity indebtedness is capped at $100,000, for a total indebtedness limit of $1.1 million on up to two residences.  The taxpayers, an unmarried couple registered as domestic partners with the State of California, had approximately $2.7 million of indebtedness associated with their primary residence in Beverly Hills and secondary residence in Rancho Mirage, California.  They argued that, together, they should be able to deduct interest paid on up to $2.2 million of indebtedness, or $1.1 million each.  The Tax Court rejected this position.  Parsing the language of the statute, the Tax Court noted repeated references to “residence” in the provisions on the indebtedness limitations and concluded that the limitations are “residence focused rather than taxpayer focused.”  The Tax Court also found support for treating the $1.1 million limitation as a per residence rather than per taxpayer limitation in the subsection of § 163(h) that provides that married taxpayers who file separate returns are limited to half of the otherwise allowable amount of indebtedness, and in the general rule that married couples filing jointly are subject to the $1.1 million limitation.

On appeal, the taxpayers argue that § 163(h) should be construed consistently with I.R.C. § 121, which limits the exclusion of gain from the sale of a taxpayer’s “principal residence” to $250,000.  Under the regulations, the limitation is applied on a per taxpayer, not per residence basis.  Section 163(h) defines “principal residence” with reference to § 121.  The taxpayers also argue there is no reason to treat non-married couples the same as married couples for purposes of § 163(h) because differential treatment “is consistent with various provisions of the Code where there is a different result for similarly situated taxpayers based on filing status.”

Sophy – Tax Court Opinion

Sophy – Taxpayers’ Opening Brief

Amicus Brief Filed in Support of the Government in PPL

[Note:  Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in support of PPL in both the Third Circuit and the Supreme Court.]

A group of legal academics, led by Professor Michael Graetz of Columbia who authored the brief, has filed an amicus brief in PPL in support of the government.  The brief argues that the UK tax should be treated as a tax on value, in line with the labels attached to it by Parliament, because it “was designed to redress both undervaluation at privatization . . . and subsequent lax regulation.”  Maintaining that adopting PPL’s position “would open the door to claims of foreign tax credits for foreign levies based on value, not income,” the brief advances a somewhat creative policy rationale for affirming the Third Circuit that goes beyond anything argued by the government.  Taking a perhaps unduly optimistic view of the political process, the brief claims that a reversal by the Supreme Court “would provide a road map to foreign governments, encouraging them to shift the costs of privatization to U.S. taxpayers by initially undervaluing public assets and companies sold to private interests and subsequently imposing a retroactive levy to compensate for the previous undervaluation.”

Although he has spent most of his career in academia (serving stints at Treasury from 1969-72 and 1990-92), Professor Graetz is not without Supreme Court experience.  He briefed and argued Hernandez v. Commissioner, 490 U.S 680 (1989) on behalf of the taxpayer, arguing (unsuccessfully) for the position that adherents of the Church of Scientology were entitled to a charitable contribution deduction for payments made to the Church for “auditing” and “training” services.

Also linked below is the amicus brief filed by Patrick Smith, et al., which was noted in an earlier post, but was not available in an electronic version at the time.

PPL – Supreme Court Amicus Brief of Law Professors in Support of the Government

PPL – Supreme Court Amicus Brief of Patrick Smith, et al. in Support of PPL

Government Brief Filed in PPL

[Note:  Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in support of PPL in both the Third Circuit and the Supreme Court.]

The government has filed its response brief in the Supreme Court in PPL.  The arguments in the brief do not closely track the analysis of the Third Circuit’s opinion.  Indeed, the government pointedly distances itself from the Third Circuit’s heavy reliance on Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3.  The Third Circuit had suggested that PPL’s position was foreclosed by Example 3, but the government’s Supreme Court brief suggests only that the example provides a “useful analogy,” while acknowledging that “the example is not directly applicable because it analyzes imputed gross receipts rather than actual gross receipts.”  [See our prior observations on Example 3 here.]

Instead, the government’s brief asks the Supreme Court to accept the characterization of the U.K. Windfall Tax as “a tax on value,” rather than an income tax.  According to the government, “[t]hat is so both because the U.K. government wrote it as a tax on value and because a company’s windfall tax liability is determined pursuant to a method of valuing property that is familiar to U.S. tax law,” where “it is common to calculate the value of property by taking into account the property’s ability to generate income.”  The brief stops short of declaring that the label attached to the tax by Parliament is “determinative,” but asserts that “the ‘labels’ and ‘form’ that a foreign government uses to formulate a tax are relevant.”

PPL’s reply brief is due February 13, with oral argument scheduled for February 20.

PPL- Supreme Court Brief for the Commissioner

Rehearing Denied in Quality Stores

Acting promptly after receiving the taxpayer’s response, the Sixth Circuit has denied the government’s petition for rehearing en banc in Quality Stores.  Even though the government’s petition pointed to a direct circuit conflict and alleged tension with the Sixth Circuit’s own precedent (see our report here), the court’s order recites that no judge on the Sixth Circuit requested a vote on the petition.

The court’s order puts the ball back in the government’s court to decide whether to seek Supreme Court review.  Given the conflict and the apparent importance of having a uniform nationwide rule, there is a significant possibility that the government will ask the Supreme Court to step in.

A petition for certiorari would be due on April 4.

 

Supreme Court Briefing Underway in PPL

[Note:  Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in both the Third Circuit and the Supreme Court.]

The taxpayer has filed its opening brief in the Supreme Court in PPL Corp. v. Commissioner, No. 12-43, a foreign tax credit case that we have covered extensively on its journey to the Court.  PPL’s brief heavily criticizes the formalism of the government’s position, stating that “the Commissioner would have the labels and form a foreign country employs, and not the substance of the tax it imposes, determine how the tax should be treated for purposes of U.S. tax law.”  Once that formalistic approach is rejected, PPL argues, this becomes an “easy case” because “[t]here is no real dispute that the U.K. windfall tax is, in substance, an excess profits tax in the U.S. sense.”

Two other companies with current disputes regarding the creditability of the U.K windfall tax — Entergy Corp. and American Electric Power Co. — filed amicus briefs in support of PPL.  The Entergy brief contains a detailed description of how the U.K. windfall tax came to be enacted in its particular form, and it states that the Third Circuit decision “disregards the real operation of the tax at issue.”  The AEP brief contains a detailed description of the prior administrative treatment of excess profits taxes and argues that the operation and effect of the U.K. windfall tax is akin to that of a traditional U.S. excess profits tax that has always been regarded as creditable.

Another amicus brief was filed by the Southeastern Legal Foundation, the Chamber of Commerce, the Cato Institute, and the Goldwater Institute.  That brief criticizes the government’s position as “opportunistic and inconsistent with the government’s usual emphasis on substance over form.”  Patrick Smith also filed an amicus brief focusing on the operation of the regulations.

The government’s brief in response is due January 14.  Oral argument has been scheduled for February 20.

PPL – Supreme Court opening brief for PPL

PPL – Supreme Court Amicus Brief of American Electric Power Co.

PPL – Supreme Court Entergy Amicus Brief

PPL – Supreme Court Amicus Brief of Southeastern Legal Foundation, et al.

Government Dismisses Appeal in Magma Power

We previously reported on the Court of Federal Claims’ decision in Magma Power that allowed an interest netting claim when the taxpayer was a member of a consolidated group for one leg of the overlap period but not during the other leg.  The government had argued that such a claim did not fall within the statutory language requiring that the overlapping interest payments involve the “same taxpayer.”  The government filed a protective notice of appeal from the decision, but it has now voluntarily dismissed the appeal in the Federal Circuit.  The Court of Federal Claims’ decision therefore will stand, and it is likely that the government will not contest future interest netting claims on this ground.

Supplying Some Missing Links

In addition to providing analysis and updates on pending tax appeals, this blog is intended to serve as a resource where readers can easily access the briefs and relevant opinions in those cases.  Because of the press of business and other reasons, the posting of a couple of the opinions in cases we have discussed has slipped through the cracks.  So we are providing links to those opinions here, even though the opinions are long past the point of “breaking news”:

The Second Circuit’s decision in TIFD (“Castle Harbour”), once again reversing the district court and holding that the banks did not qualify as partners under § 704(e)(1), and that the government could impose a penalty on the taxpayer for substantial understatement of income.

The Eleventh Circuit’s decision in Calloway, affirming the Tax Court and holding that the transaction in question was properly treated as a sale, not a loan, and upholding the penalties.  The decision approves the multi-factor approach employed by the Tax Court majority, and notes infirmities in the alternative analytical approaches suggested by Judges Halpern and Holmes in their respective concurring opinions.

The Supreme Court’s decision upholding the Affordable Care Act (linked below).  The opinion was eventually entitled NFIB v. Sebelius, although we had covered it using the caption of one of the companion cases, HHS v. Florida.  The discussion of the Anti-Injunction Act, the issue that was covered in the blog, is found at pages 11-15 of the Court’s slip opinion.  Our prior coverage (linked here only so that I can show off my against-the-mainstream prediction that the legislation would survive) can be found here and here.  The majority’s key holding that the individual mandate could be upheld as an exercise of the Taxing Power is found at pp. 33-44.

NFIB v. Sebelius Supreme Court decision (Affordable Care Act)

 

Supreme Court Review Sought in Union Carbide

Union Carbide has filed a petition for certiorari, docketed as No. 12-684, asking the Supreme Court to review the Second Circuit’s rejection of its research credit claim.  See our prior reports describing the issue and reporting on the decision.

The petition articulates two questions presented:  1) the basic substantive tax question whether, in the context of a production process experiment, the research credit is limited to the costs of supplies that would not have been incurred but for the experiment; and 2) whether the court erred in deferring to the IRS’s proffered interpretation of its own research credit regulations.  These two questions are related, of course, as the taxpayer argues that the court’s error in deferring to the IRS’s interpretation led it to misapply those regulations and deny the credit.

With respect to the first question, the petition emphasizes the importance of the decision.  It states that production process experiments must be done in the production plant itself and create the risk that the output will be “off-grade scrap” if the experiment does not go well.  Therefore, the costs of the supplies that would not be incurred but for the experiment are “trivial in comparison to the supplies that must be placed at risk of loss when conducting this type of research.”  The result of the Second Circuit’s decision, the petition continues, “is that the credit is rendered trivial for the type of plant-scale production process research that is so important to manufacturing industries generally, and the chemical industry in particular.”  Absent this deference, the petition argues, the regulation is most reasonably construed in accordance with the taxpayer’s broader reading of the term “indirect” expenses.

With respect to the second question, the petition argues that the Second Circuit stretched the concept of “Auer deference” (that is, deference to an agency’s interpretation of its own regulations) too far.  The petition asserts that the court mistakenly applied Supreme Court precedent “as requiring a seemingly extraordinary deference to the government’s interpretation of a regulation in a case in which the government itself is a financially interested party, [which] amounts to affording a naked preference to a government litigant over its non-governmental adversaries — permitting the government to place its thumb on the scales of justice.”

As noted in our prior post, the Second Circuit’s opinion did extend the concept of Auer deference beyond the specific situations in which it has thus far been applied by the Supreme Court.  In Auer v. Robbins, 519 U.S. 452 (1997), the Court had deferred to an agency’s interpretation when it was set forth in an amicus brief filed by a non-party; here, the court deferred to the IRS’s interpretation presented in a brief in which the IRS was a litigant.  Justice Scalia has suggested that he would be open to reconsidering even Auer itself in an appropriate case (even though he authored the Auer opinion).  Union Carbide is hoping that other Justices share that view or that they will be troubled by the apparent expansion of the doctrine here, and that enough of them will believe that this is an appropriate case to revisit the question of agency deference to its own regulations.  Whether or not that turns out to be the case, the petition’s focus on the broadly applicable deference issue certainly gives the Court something to think about beyond whether it wants to hear the substantive tax issue.  Ordinarily, taxpayers have a hard time persuading the Court to hear a technical tax question on which there is no circuit conflict.

The government’s brief in response to the petition is currently due January 3.  The government often obtains at least a 30-day extension to file such responses.

Union Carbide – Petition for Certiorari (partial appendix)

Appeal Dismissed in Cadrecha

The Federal Circuit yesterday dismissed the taxpayer’s appeal in Cadrecha.  As noted in our prior post, this was a formality after the parties agreed to settle the case.

Taxpayer Responds to Petition for Rehearing in Quality Stores

Following up on the Sixth Circuit’s order, the taxpayer has now filed a response to the government’s petition for rehearing en banc in Quality Stores.  See our prior reports here.  The brief offers a point-by-point response to the government’s petition, arguing in particular that the Sixth Circuit was correct in relying on Coffy v. Republic Steel Corp., 447 U.S. 191 (1980), and disputing the government’s contention that the panel’s decision was inconsistent with earlier Sixth Circuit decisions.

The petition is now back in the lap of the Sixth Circuit, which could rule in the next few weeks on whether it will rehear the case.

Quality Stores – Taxpayer Response to Petition for Rehearing

 

 

Sixth Circuit Orders Response to Government’s En Banc Petition in Quality Stores

The Sixth Circuit yesterday directed the taxpayer to file a response to the government’s petition for rehearing en banc in Quality Stores.  As we previously noted, the Federal Rules of Appellate Procedure prohibit responding to rehearing petitions unless ordered by the court, but such an order in this case was a strong possibility.  Courts of appeals frequently direct responses to rehearing petitions filed by the government, and the government’s petition highlights why this case is a strong candidate for the relatively rare action of rehearing en banc.  If the court’s order is surprising at all, it is that it took so long to issue it.

The order signifies that the Sixth Circuit is giving more than usual attention to this rehearing petition, but it does not necessarily mean that the petition will be granted.

The taxpayer’s response is due December 18.

 

Opening Briefs Filed in Rodriguez

The parties have now filed their opening briefs in the Fifth Circuit in Rodriguez, an appeal from the Tax Court’s decision that section 951 inclusion income is not to be taxed at the lower rate applicable to qualified dividends.  See our prior report here.

As they argued in the Tax Court, the taxpayers emphasize a policy argument, stating that “Subpart F’s general purpose and mechanics should govern” and “Subpart F treats the amount included in the U.S. shareholder’s gross income essentially like a dividend.”  The taxpayer also invokes substance vs. form principles and statements in the legislative history of Subpart F characterizing section 951 inclusions as deemed dividends.  The taxpayers also point to GCMs, private letter rulings, and Internal Revenue Manual sections that support deemed dividend treatment.

The government’s response, like the Tax Court, focuses mostly on the text of the Code.  It argues that the section 951 inclusion income is not literally a dividend; that the Code decrees that it should be treated as a dividend for other purposes but makes no such provision concerning the qualified dividend tax rate; and that there are some contexts in which section 951 inclusion income is not treated as a dividend, such as the earnings and profits calculation.

With respect to policy, the government asserts that the policy underlying enactment of the favorable tax rate for qualified dividends was to provide “an incentive for corporations to distribute their earnings to shareholders instead of retaining them.”  Accordingly, the government argues, it does not advance that policy to provide the preferential tax rate in a situation where the corporation did not distribute the earnings.

Finally, the government urges the court to ignore the taxpayers’ argument that the IRS had previously treated section 951 inclusions as dividends in prior pronouncements.  It states that those pronouncements did not specifically address the preferential tax rate question at issue here and that they are not the kind of IRS pronouncements that can be cited as authoritative precedent.  In any event, the government states, the Commissioner “may change an erroneous administrative interpretation if he determines that such a position is incorrect.”

Rodriguez – Taxpayers’ Opening Brief

Rodriguez – Government’s Response Brief

 

Cadrecha Appeal to Be Dismissed Following Settlement Agreement

We have previously reported on the taxpayers’ appeal in Cadrecha from an application of the statute of limitations that the Court of Federal Claims acknowledged as “harsh,” but found to be required by law.  The taxpayers’ brief emphasized the unfairness of the result, and it struck a chord with the Department of Justice, whose appellate lawyers concluded that the taxpayers ought to get a break — either because they deserved one or perhaps because DOJ feared that the facts were so sympathetic that they created a risk of an adverse Federal Circuit decision that would cause mischief down the road.

Either way, the government has now filed a motion to suspend the appeal.  The motion recites that, after consultation between DOJ and the IRS, the government has accepted a settlement offer from the taxpayers and agreed to refund “a portion of the amount of the income-tax payment that is at issue in this case.”  After the refund check is processed and paid, the parties will submit papers to the court dismissing the appeal.

Supreme Court Agrees to Hear Foreign Tax Credit Issue in PPL

The Supreme Court this morning granted PPL’s petition for certiorari and will decide the question of the availability of the foreign tax credit for payments of the U.K. Windfall Tax on which we have reported extensively before.  See here and here. The Court took no action on the government’s petition for certiorari in the companion Entergy case from the Fifth Circuit.  That is a common practice for the Court when two cases present the same issue.  The Court will “hold” (that is, continue to take no action on it) the Entergy petition until it issues a decision in PPL, and then it will dispose of the Entergy petition as appropriate in light of the PPL decision.

PPL’s brief is due December 13.  The case likely will be argued in February or March, and a decision can be expected before the end of June.

(In case you are wondering why the Court is issuing orders on a day when the rest of Washington is shut down because of a hurricane, it is something of a Court tradition to stay open when the rest of the government is closed.  In 1996, the Court heard oral arguments (as it is also doing today) on a day when the city was hit with a paralyzing blizzard.  The Court sent out four-wheel drive vehicles to bring the Justices to the Court.)

Rehearing Denied in Historic Boardwalk

The Third Circuit yesterday denied the taxpayer’s petition for rehearing en banc in Historic Boardwalk in what seems like record time (the petition was filed on October 10).  The taxpayer’s last hope is to seek Supreme Court review, though the case does not look like one that could pique the Court’s interest.  A petition for certiorari would be due on January 22.

Government Seeks Rehearing En Banc in Quality Stores

The government yesterday filed a petition for rehearing en banc in the Sixth Circuit in the Quality Stores case, asking the full court to reverse the panel and eliminate the circuit conflict on the treatment for FICA purposes of supplemental unemployment compensation benefits.  As noted in our previous post, regardless of whether the petition is granted, the mere filing of the petition has the effect of postponing the deadline for seeking Supreme Court review.  The 90-day period for filing a petition for certiorari begins to run anew from the date of the resolution of the rehearing petition.  Thus, if this case ultimately goes to the Supreme Court, there is no longer any realistic possibility that it would be heard this Term — that is, a decision could not be expected by June 2013.

The rehearing petition emphasizes that the issue is important, stating that $120 million is at stake in pending refund suits alone, and that a total of over $1 billion is at issue when all claims are taken into account.  It also recites that the IRS has suspended action on administrative refund claims totalling over $127 million from approximately 800 taxpayers located in the Sixth Circuit.

The petition argues that the Sixth Circuit panel erred in two key respects.  “First, it failed to address the actual FICA question here based on its erroneous belief that Coffy [v. Republic Steel Co., 447 U.S. 191 (1980),] establishes that SUB pay is not wages for FICA purposes.”  Coffy was not a tax case, but instead was a case interpreting the Veterans’ Reemployment Rights Act, holding that SUB benefits are a “perquisite of seniority” for which returning veterans must be given service time credit for the time they spent in the military.  (That may sound deadly dull, but I note parenthetically that Coffy was also my first Supreme Court argument.)  On this point, the petition argues that the panel’s decision is in tension with two prior Sixth Circuit decisions holding that wages for FICA purposes is not limited to compensation for work performed.

The second error asserted in the rehearing petition is that, “in construing I.R.C. § 3402(o), the panel failed to recognize that the section’s applicability is expressly limited to income-tax withholding, which was a key factor in the Federal Circuit’s CSX decision.”  That issue was a focus of the original briefing in the case, but the rehearing petition asserts that the panel failed to address it in its decision.

There is no current due date for the taxpayer’s response.  Rule 40(a)(3) of the Federal Rules of Appellate Procedure provides that parties are not to respond to petitions for rehearing unless ordered by the court.  Given the importance and complexity of this case, there is a strong probability that the court will order a response.

Quality Stores – Petition for Rehearing

Taxpayer Seeks Rehearing En Banc in Historic Boardwalk

The taxpayer has filed a petition for rehearing and rehearing en banc in Historic Boardwalk, asking the Third Circuit to reconsider its decision denying the taxpayer’s claim for historic rehabilitation credits.  Among other points, the petition criticizes the panel’s decision for analogizing this case to the Second Circuit’s Castle Harbour decision, TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), which found that the partner there had no downside risk that it would not recover its capital contribution.  The taxpayer argues that there was a risk here that the partner would not recover its capital contribution from the partnership, and the court erred in finding that there was no risk by taking the tax credits into account.  Specifically, the petition argues, “the Opinion wrongfully treats the allocation of the historic rehabilitation tax credits to [the investor] by operation of law (i.e., under the Code) as a repayment of capital to” the investor by the partnership.

There is no due date for a response by the government.  Under Rules 35 and 40 of the Federal Rules of Appellate Procedure, a party is prohibited from responding to a petition for rehearing unless it is directed to do so by the court.

Historic Boardwalk – rehearing petition

Supreme Court Expected to Act on Windfall Tax Petitions in Late October

In our previous post discussing the pending requests for Supreme Court review of the question of the creditability of the U.K. Windfall Tax, we noted that the Court had scheduled consideration of the PPL cert petition for its October 5 conference.  The Court has now postponed that consideration until its October 26 conference.  The reason for the change is to allow the Court to consider the PPL petition in tandem with the government’s petition in Entergy.

This postponement allows the Court to consider the issue with the benefit of an adversarial presentation.  As you will recall, the government “acquiesced” in PPL’s cert petition on the theory that the Court should resolve the circuit conflict, and therefore there are no briefs in that case arguing that the Court should deny certiorari.  The same is not true in Entergy, where the taxpayer vigorously argues that the Court should deny certiorari in both cases because the issue is not sufficiently significant to warrant Supreme Court review.  Entergy notes that there are only three taxpayers directly affected by the Windfall Tax issue and asserts that the Third Circuit and Fifth Circuit, though reaching different outcomes on the specific issue, do not disagree “on matters of fundamental principle” regarding the foreign tax credit provisions.  Rather, Entergy characterizes the circuit conflict as reflecting “an exceedingly narrow and technical disagreement” limited to how those principles should apply to the U.K. Windfall Tax.  In its reply brief, the government acknowledges that there are only three directly affected taxpayers, but argues that there is a difference between the two circuits on the “proper analytical approach” to foreign tax credit issues that could potentially lead to disparate results in cases involving other foreign taxes.

As a result of the schedule change, the Court will likely announce whether it will review the issue on its October 29 order list.  It is possible, if certiorari is granted, that the Court would make that announcement on October 26 in order to give the parties a head start on the briefing.

Entergy – Taxpayer’s Brief in Opposition to Certiorari

Entergy – Government Reply Brief in Support of Certiorari