Seventh Circuit Sets Up Likely Supreme Court Showdown By Reversing Tax Court on Intermountain Issue

The Seventh Circuit today became the first court of appeals to weigh in on the Intermountain issue subsequent to the issuance of the temporary regulations, and it handed the government a big victory.  Interestingly, the court did not rely on the regulations, instead ruling that the term “omission from gross income” is best read to include overstatements of basis – at least in “non-trade or business situations.”  The Court ruled that Colony did not control this issue because that case involved a construction of the 1939 Code, not the 1954 Code.  Describing it as a “close call,” the Seventh Circuit ruled that “a close reading of Colony” (which includes explaining away the Colony Court’s observation that the language in the 1954 Code is unambiguous) justifies the conclusion that “an overstatement of basis can be treated as an omission from gross income under the 1954 Code.”

The Seventh Circuit acknowledged that its decision directly conflicts with the two court of appeals decisions that prompted the Treasury Department to attack this issue by issuing temporary regulations, Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007).  The court explained that it disagreed with the reasoning in those decisions, and cited approvingly to Judge Newman’s dissenting opinion in Salman Ranch.  Thus, there is a clear conflict in the circuits, and the only way that conflict could disappear would be if the government prevails in every single circuit (including the Federal and Ninth Circuits) on its post-regulation appeals.  Such a clean sweep is unlikely.  With the government anxious to have this issue heard by the Supreme Court, and claiming that $1 billion is at stake, it appears almost inevitable that the Court will ultimately decide the Intermountain issue sometime in 2012.

As we noted in our original post on these cases, the Seventh Circuit panel was the most sympathetic to the government at oral argument and seemed particularly troubled by the bottom line outcome of allowing the taxpayers to retain massive tax benefits from what the court regarded as a tax shelter.  That attitude is reflected in the opinion as well, which goes out of its way to commend the government’s description of the transaction as an “abusive . . . tax shelter.”  Thus, the court’s reliance on a somewhat strained statutory interpretation might be understood as the least disruptive way to reach what it believed to be the “right result,” while avoiding having to make broad pronouncements on difficult issues of deference owed to temporary regulations.  The court indeed stated explicitly that, “[b]ecause we find that Colony is not controlling, we need not reach” the issue of deference to the regulations.

Curiously, though, the court then added two sentences stating in conclusory fashion that it “would have been inclined to grant the temporary regulation Chevron deference,” simply citing some cases in which the court had previously accorded deference to Treasury regulations.  Whatever the court’s motivation for adding this dictum, it does not address the difficult issues involved in deferring to these particular regulations.  Accordingly, the dictum is unlikely to carry much weight with other courts of appeals that do not agree that Colony is irrelevant to construing the statutory text and therefore are struggling with the question of the degree of deference owed to the regulations.

Seventh Circuit decision in Beard

Supreme Court Opts for Chevron Analysis of Treasury Regulations, Discarding the Traditional National Muffler Dealers Analysis

The Supreme Court this morning issued its opinion in the Mayo Foundation case, ruling unanimously that medical residents are not “students” exempt from FICA taxation.  As previously discussed several times on this blog (see here, here, and here), the Mayo case carried the potential for broad ramifications beyond its specific context because the parties had framed the question of whether deference to Treasury regulations is governed solely by general Chevron principles that supersede the deference analysis previously developed in tax cases like National Muffler Dealers.  The Court in fact addressed that question and has now endorsed use of the Chevron standard in tax cases, thereby providing the IRS with a big victory that will make it more difficult for taxpayers to prevail in court in the face of contrary regulations, even if they are “bootstrap” regulations designed primarily to influence the outcome of litigation.  And for good measure, the Court obliterated the long-held view by many in the tax world that “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under Code section 7805(a) are entitled to less deference than “legislative” regulations promulgated pursuant to more specific rulemaking authority.

The Court’s opinion was authored by the Chief Justice, who was the Justice who spoke out most forcefully during the oral argument in favor of the position that Chevron had superseded earlier decisions in tax cases, as noted in our previous post.  Thus, the opinion sought to be very clear on this point and to identify some of the familiar approaches to regulatory deference in tax cases that the Court was now consigning to the trash heap.  First, the Court pinpointed some of the key factors that had been identified as important under the National Muffler Dealers analysis, stating that under that analysis “a court might view an agency’s interpretation of a statute with heightened skepticism when it has not been consistent over time, when it was promulgated years after the relevant statute was enacted, or because of the way in which the regulation evolved.”  Slip op., at 8-9 (citing Muffler Dealers, 440 U.S. at 477).  The Court continued:  “Under Chevron, in contrast, deference to an agency’s interpretation of an ambiguous statute does not turn on such considerations.”  Id. at 9.

The Court amplified its rejection of the Muffler Dealers analysis by citing a series of non-tax decisions under Chevron that decline to attribute significance to these considerations.  Thus, the Court remarked that it had “repeatedly held that ‘[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the Chevron framework’” (quoting National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967, 981 (2005)); “that ‘neither antiquity nor contemporaneity with [a] statute is a condition of [a regulation’s] validity’” (quoting Smiley v. Citibank, N.A., 517 U.S. 735, 740 (1996)); and that it is “immaterial to our analysis that a ‘regulation was prompted by litigation’” (quoting Smiley, 517 U.S. at 741).  Trying to link these decisions to its tax law jurisprudence, the Court then observed that in United Dominion Industries, Inc. v. United States, 532 U.S. 822, 838 (2001) (which involved the calculation of product liability losses for affiliated entities under Code section 172(j)), it had “expressly invited the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of the case.”  Mayo slip op., at 9.  The Court emphasized that it saw no good reason “to carve out an approach to administrative review good for tax law only.”  Id.  Thus, the Court concluded:  “We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.”  Id. at 10.

Second, the Court moved to squash another area where it discerned a difference between Chevron principles and those developed in tax cases – even though the parties had not focused on that point.  Pointing to an amicus brief filed by Professor Carlton Smith arguing for reduced deference because the regulations in Mayo were “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under 26 U.S.C. § 7805(a), the Court acknowledged that there is pre-Chevron authority for the proposition that courts “‘owe the [Treasury Department’s] interpretation less deference’ when it is contained in a rule adopted under that ‘general authority’ than when it is ‘issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision’” (slip op., at 10-11 (quoting Rowan Cos. v. United States, 452 U.S. 247, 253 (1981)).  The Court tossed that precedent aside as well, ruling that the Rowan statement was not compatible with the current approach to administrative deference, which is unaffected by “whether Congress’s delegation of authority was general or specific.”  Slip op., at 11.

With the Chevron analytical framework in place, the Court made short work of the FICA issue before it.  It reasonably concluded that the statutory text did not unambiguously resolve whether medical residents qualify for the FICA student objection.  Hence, the Court moved to “Chevron stage two” – namely, whether the regulation was a “reasonable interpretation” of the statute.  Observing that “[r]egulation, like legislation, often requires drawing lines” (slip op., at 13), the Court held that it was reasonable for Treasury to establish a rule that anyone who works a 40-hour week, even a medical resident, is not a “student” for purposes of the FICA student exception.

In sum, the Court’s decision in Mayo resolves the deference issues that have recently divided the lower courts in a way that is extremely favorable to the government.  Treasury likely will be emboldened to issue regulations that seek directly to overturn cases that the government loses in court on statutory interpretation issues, or to issue regulations even earlier to sway the outcome of pending litigation before the courts interpret the statute in the first place.  Of course, we have seen that phenomenon already in the Mayo case itself, with respect to the statute of limitations issue litigated in Intermountain and a host of other cases (see here and here), and in other settings.  The Mayo decision will further encourage the Treasury Department to issue such regulations and will make it tougher for taxpayers to prevail in court in the face of those regulations.

 Mayo Foundation – Supreme Cout opinion

Taxpayer’s Brief Filed in Intermountain

The taxpayer has filed its response brief in the D.C. Circuit in Intermountain.  The brief does not add much new to the debate, which is hardly surprising at this point.  It relies in the alternative on all of the different rationales advanced by the various Tax Court opinions for rejecting the IRS’s position (and adds an additional argument that the basis was adequately disclosed on the return).  The taxpayer does not jump into the National Muffler Dealers vs. Chevron debate, content to argue that there is no Chevron deference owed in these circumstances under the established rules for Chevron analysis.  The taxpayer does not directly address whether the issuance of final regulations changes that analysis, instead arguing that it is too late for the government to rely on the issuance of the final regs because it did not refer to them in its opening brief.

In the companion UTAM case, the briefing lags the Intermountain schedule by a month.  The government has just opened the briefing in that case, and the taxpayer’s response brief is due February 7, 2011.  Again not surprisingly, the government’s brief looks a lot like the brief it filed in Intermountain a month ago, though it does refer to the final regulations.  The new briefs in the two cases are attached below.

The cases are both scheduled for oral argument on April 5, 2011.

Intermountain – taxpayer’s response brief

UTAM – Government’s opening brief

IRS Issues Final Regulations on Intermountain Six-Year Statute of Limitations Issue

As we have previously discussed, the IRS sought to buttress its reliance on the six-year statute of limitations in Son-of-BOSS cases by issuing temporary regulations that interpret the term “omission” of gross income in Code sections 6229 and 6501 to include understatements of gross income attributable to overstatements of basis.  Because that interpretation strains the language of the statute and flies in the face of the Supreme Court’s decision in Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958), the government has argued for application of Chevron deference to the temporary regulations.  The Tax Court has rejected that argument, and it is now pending in several courts of appeals.  Last week, the IRS issued final regulations that supplant the temporary regulations.  The final regulations have the same effective date as the temporary regulations (Sept. 14, 2009), and they are essentially the same, although they do clarify what the Tax Court majority in Intermountain found to be an ambiguity — making clear that the regulations are intended to apply to all cases for which the six-year statute of limitations remained open on the effective date.

The government is now submitting the final regulations as supplemental authority to the appellate courts considering the Intermountain issue.  (This is an example of the government’s supplemental submission, taken from the Fifth Circuit cases, with the final regulations attached.)  In the government’s view, the issuance of the final regulations strenghtens the argument for Chevron deference.  Taxpayers have objected that such deference was not owed to the temporary regulations because, among other reasons, they were temporary and issued without notice-and-comment.  Indeed, more than a quarter of the pages of argument in the government’s opening brief in Intermountain (here) were devoted to arguing that the temporary regulations were valid and entitled to deference notwithstanding the absence of notice-and-comment.  The final regulations arguably eliminate those objections, since the final regulations provided notice and opportunity for comment (even if the comments were disregarded).  Notice-and-comment aside, however, the government’s deference argument still faces the formidable obstacle of the contrary Supreme Court decision in Colony.

Briefing Underway in Intermountain

We recently surveyed the nationwide litigation addressing the government’s efforts to apply a six-year statute of limitations to Son-of-BOSS cases, including its efforts to have the courts defer to a late-issued temporary regulation.  The government has now filed its opening brief in the D.C. Circuit in Intermountain, the case in which the Tax Court addressed the issue.  Of note, the brief contains an extensive argument for applying Chevron deference to the temporary regulation, rather than “the differing standards of pre-Chevron jurisprudence” (an apparent reference to National Muffler Dealers, though the brief declines to acknowledge that case by name), and notwithstanding the lack of opportunity for notice and comment.  As we have discussed before here and here, the Supreme Court may shed some light in the next few months on the extent to which Chevron deference applies to Treasury regulations.

The taxpayer’s response brief is due January 5, 2011.

Intermountain – US opening brief

The Curious Non-Appeal of Veritas

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

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

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

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

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

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

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

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

Son-of-BOSS Statute of Limitations Issue Inundates the Courts of Appeals

The government has successfully challenged understatements of income attributable to stepped-up basis in so-called Son-of-BOSS tax shelters.  See, e.g., American Boat Co., LLC v. United States, 583 F.3d 471, 473 (7th Cir. 2009).  But it has been stymied in some cases by the three-year statute of limitations for issuing notices of deficiency.  Code section 6501(e)(1)(A) provides for a six-year statute “[i]f the taxpayer omits from gross income an amount” that exceeds the stated gross income by 25 percent.  Section 6229(c)(2) provides a similar six-year statute for cases governed by the TEFRA partnership rules.  The IRS has argued, unsuccessfully so far, that this section applies when there is a substantial understatement of income that is attributable not to a direct omission of income but rather to an overstatement of basis of sold assets.

The major obstacle to the government’s argument is that the Supreme Court long ago rejected essentially the same argument with respect to the predecessor of section 6501(e)(1)(A) (§ 275(c) of the 1939 Code).  The Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958).  The IRS argued there that the six-year statute applies “where a cost item is overstated” and thus causes an understatement of gross income.  Id. at 32.  The Court agreed with the taxpayer, however, that the six-year statute “is limited to situations in which specific receipts or accruals of income items are left out of the computation of gross income.”  Id. at 33.  The Court added that, although this was the best reading, it did not find the statutory language “unambiguous.”  Id.  Accordingly, the Court noted that its interpretation derived additional support from the legislative history and that it was “in harmony with the unambiguous language of [the newly enacted] section 6501(e)(1)(A).”  Id. at 37.  Based largely on the precedent of Colony, the Tax Court and two courts of appeals have already rejected the government’s attempts to invoke the six-year statute of limitations in Son-of-BOSS cases.  See Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007).

Seeking to rescue numerous other cases that were still pending in the courts or administratively, the government responded by issuing temporary regulations on September 24, 2009, that purported to provide a regulatory interpretation of the statutory language to which the courts would afford Chevron deference.  The temporary regulations provide that “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of [sections 6229(c)(2) and 6501(e)(1)(A)].”  Temp Regs. §§ 301.6229(c)(2) – 1T, 301.6501(e)-1T. 

The Tax Court was the first tribunal to consider the efficacy of this aggressive (one might say, desperate) effort to use the regulatory process to trump settled precedent, as the IRS moved the Tax Court to reconsider its adverse decision in Intermountain Ins. Service v. Commissioner, T.C. Memo. 2009-195, in the wake of the temporary regulations.  The reception was underwhelming.  The Tax Court denied the motion for reconsideration by a 13-0 vote, generating three different opinions.  The majority opinion, joined by seven judges, was the only one to base its ruling on rejecting the substance of the government’s argument that courts should defer to the regulations notwithstanding the Supreme Court’s Colony decision.  (Four judges stated simply that the new contention about the temporary regulations should not be entertained on a motion for reconsideration; two judges stated that the temporary regulations are procedurally invalid for failure to submit them for notice and comment.)

The government’s deference argument rests on Nat’l Cable and Telecommunications Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), which ruled that a “court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.”  (In a concurring opinion, Justice Stevens stated his view that this rule would not apply to a Supreme Court decision, since that would automatically render the statute unambiguous, but that remains an open question.).  The Tax Court majority ruled that the Supreme Court’s statement in Colony that the statute was ambiguous “was only a preliminary conclusion,” but “[a]fter thoroughly reviewing the legislative history, the Supreme Court concluded that Congress’ intent was clear and that the statutory provision was unambiguous.”  Accordingly, the majority concluded that Brand X did not apply, and “the temporary regulations are invalid and are not entitled to deferential treatment.”  (The two judges who found the regulations procedurally invalid questioned the majority’s reasoning and suggested that the Court should not have reached the substantive issue).

The Tax Court’s decision in Intermountain is just the first skirmish in what will be an extended battle over the temporary regulations.  The Justice Department has asserted that there are currently 35-50 cases pending in the federal courts that raise the same issue, with approximately $1 billion at stake.  Accordingly, the government is pursuing an appeal to the D.C. Circuit in Intermountain, and it is arguing for deference to the temporary regulations in other cases pending on appeal in other circuits, even where those regulations were not considered by the trial court.  The government seems determined to litigate the issue in every possible court of appeals, presumably hoping that it can win somewhere and then persuade the Supreme Court to grant certiorari and reconsider Colony.  The current map looks like this:

D.C. Circuit:  Briefing schedules have been issued in Intermountain, No. 10-1204, and in an appeal from another Tax Court case, UTAM Ltd. v. Commissioner, No. 10-1262.  The government’s opening brief is due in Intermountain on December 6, 2010, and in UTAM on January 6, 2011.  The panel assigned to both cases is Judges Sentelle, Tatel, and Randolph.

Federal Circuit:  Grapevine Imports, Ltd. v. United States, No. 2008-5090, is fully briefed and scheduled for oral argument on January 12, 2011.  The Federal Circuit has already rejected the government’s invocation of the six-year statute in Salman Ranch, but the government is arguing in Grapevine that the Federal Circuit should reverse its position in light of the temporary regulations, which were not previously before the court.

Fourth Circuit:  Home Concrete & Supply, LLC v. United States, No. 09-2353, is fully briefed and was argued on October 27, 2010, before Judges Wilkinson, Gregory, and Wynn.  In that case, the district court had ruled for the government, distinguishing Colony as limited to situations in which the taxpayer is in a trade or business engaged in the sale of goods or services.  That was the rationale of the Court of Federal Claims in the Salman Ranch case, but that decision was reversed by the Federal Circuit.

Fifth Circuit:  Burks v. United States, No. 09-11061 (consolidated with Commissioner v. MITA, No. 09-60827) is fully briefed and was argued on November 1, 2010, before Judges DeMoss, Benavides, and Elrod.  In its briefs on this issue in various courts, the government has often invoked the Fifth Circuit’s decision in Phinney v. Chambers, 392 F.2d 680 (1968), the only court of appeals decision that has applied the six-year statute in the absence of a complete omission of gross income.  In Phinney, the taxpayer on her return had mislabeled proceeds from payment of an installment note as proceeds from a sale of stock with basis equivalent to the proceeds, reporting no income from that sale.  The Fifth Circuit accepted the government’s contention that the six-year statute applied, finding that it applies not only in the Colony situation where there is “a complete omission of an item of income of the requisite amount,” but also where there is a “misstating of the nature of an item of income which places the Commissioner . . . at a special disadvantage in detecting errors.”  392 F.2d at 685.  The government has argued that Phinney essentially involved an overstatement of basis, and therefore strongly supports its position in the Son-of-BOSS cases.  Indeed, the district court in Burks ruled for the government based on Phinney.  The government therefore likely viewed the Fifth Circuit as the most favorable appellate forum for the current dispute. 

At oral argument, however, the panel appeared sympathetic to the taxpayer’s position that Phinney involved a situation where the taxpayer had taken steps akin to a direct omission that would make it difficult for the IRS to discover the potential tax liability.  Therefore, the taxpayer maintains, Phinney is fully consistent with the position that the six-year statute does not generally apply to overstatements of basis. 

In addition, the discussion of the temporary regulation at oral argument specifically addressed the debate over whether deference to Treasury regulations is governed by Chevron principles or by ­­the less deferential National Muffler Dealers standard.  As we have discussed elsewhere, the Supreme Court may resolve that question in the next few months in the Mayo Foundation case.

Seventh Circuit:  Beard v. Commissioner, No. 09-3741 is fully briefed and was argued on September 27, 2010, before Judges Rovner, Evans, and Williams.  Although the panel, particularly Judge Rovner, expressed skepticism about some of the IRS’s legal arguments, Judges Williams and Evans appeared troubled by the prospect of allowing the taxpayer to escape scrutiny on statute of limitations grounds.  Judge Williams suggested that the taxpayer still ought to have the relevant records and that there was no apparent reason why a misstatement should be treated different from an omission.  Judge Evans emphasized that the taxpayer’s position with respect to tax liability was very weak and suggested that Colony might be distinguishable because it involved a return that was much easier for the IRS to decipher than the complex return involved in Beard.  Thus, to some extent, the government seemed to have found a sympathetic ear in the Seventh Circuit, though that will not necessarily translate into a reversal of the Tax Court.

Ninth Circuit:  Reynolds Properties, L.P. v. Commissioner, No. 10-72406.  The court of appeals vacated the briefing schedule to allow the parties to participate in the court’s appellate mediation program.  The government, however, has indicated that the case is not suitable for mediation, and therefore a new briefing schedule is likely to be issued soon.  The Ninth Circuit has already ruled in Bakersfield that the six-year statute does not apply to overstatements of basis.  Presumably, the government will ask the court to reverse itself in light of the temporary regulations, which were not previously before the court.

Tenth Circuit:  Salman Ranch Ltd. v. United States, No. 09-9015, is fully briefed and was argued on September 22, 2010, before Judges Tacha, Seymour, and Lucero.  This case comes from the Tax Court, but involves the same partnership that prevailed in front of the Federal Circuit. 

Attached below as a sampling are the briefs filed in the Fourth and Seventh Circuit cases.

Home Concrete – Taxpayer’s opening brief

Home Concrete – United States response brief

Home Concrete – Taxpayer’s reply brief

Beard – United States opening brief

Beard – Taxpayer’s response brief

Beard – United States reply brief

Government Argues for Abandoning the Muffler Dealers Test for Deference to IRS Regulations

In our initial post on the Mayo Foundation case pending in the Supreme Court, which concerns whether medical residents are exempt from FICA taxation, we noted that the case potentially raised a broad question that has surfaced in the courts of appeals and the Tax Court in recent years — namely, whether Chevron deference principles have supplanted the traditional Muffler Dealers approach to analyzing the deference owed to Treasury regulations.  Although that issue was not flagged by the parties at the certiorari stage, we later observed that the taxpayers’ opening merits brief served that ball into the government’s court by relying heavily on some of the Muffler Dealers factors that are not ordinarily part of the Chevron analysis.  The government has now responded by directly challenging the continuing vitality of Muffler Dealers.  (The government’s brief is attached below.)  As a result, there is a good chance that the Supreme Court will address the question and resolve the disagreement between the Tax Court and some courts of appeals on the proper analysis of deference to Treasury regulations.

The government’s brief does not mince words.  It states that Muffler Dealers “has been superseded by Chevron” and therefore “the considerations on which [taxpayers] rely are largely irrelevant.”  In particular, the government identifies three Muffler Dealers factors relied upon by the taxpayers that are allegedly irrelevant under Chevron:  (1) “the recency of [the] adoption” of the regulation; (2) that the new regulation “was enacted ‘to overturn judicial decisions’ interpreting the student exemption”; and (3) that “Treasury’s interpretation of the student exemption has purportedly been inconsistent.”

It is by no means a foregone conclusion that the Supreme Court will resolve the question of the proper deference standard, as there are many ways to resolve the ultimate question of the applicability of the FICA exemption without having to decide on a deference standard.  Nor is it as clear as the government would like that Chevron did or should supersede Muffler Dealers.  (If it were, the question probably would not still be open 26 years after Chevron was decided).  The IRS is often in an adversarial relationship with taxpayers; it has an inherent fiscal interest in interpreting the Internal Revenue Code in a way that maximizes tax revenues.  Therefore, there are good reasons for the courts to afford less deference to Treasury regulations that would determine the outcome of tax disputes than to regulations of more neutral agencies that are merely administering a federal statute.  Can the government really respond to an IRS defeat in court by promulgating a regulation to overturn the decision and then expect the courts to defer to that regulation without taking any account of how it came to pass?  Or can it reverse a regulatory interpretation simply because it determines that the reversal will benefit the public fisc, without paying some price in terms of judicial deference?  Perhaps the Supreme Court will answer those questions soon. 

Oral argument in the Mayo Foundation case is scheduled for November 8.

Mayo Foundation – United States Response Brief

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

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

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

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

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

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

“I’m not a mile high,” said Alice.

“You are,” said the King.

“Nearly two miles high,” added the Queen.

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

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

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

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

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