When Does Underpayment Interest Begin When IRS Retroactively Revokes Corporation’s Tax Exempt Status

A recent case in Tax Court, CreditGuard of America v Commissioner, considers how interest on underpayments applies when there is a retroactive revocation of a corporation’s tax exempt status. In so doing it walks us though the provisions that impose interest on underpayments.

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I will simplify the facts to get to the issue. IRS began examining CreditGuard of America’s Form 990 for 2002 back in late December 2003. Fast forward (or slow forward) 9 years or so to February of 2012, and IRS retroactively revoked its tax exempt status for years starting January 1, 2002.

In revoking its status, IRS informed CreditGuard of America (CreditGuard) that it was obligated to file corporate income tax returns for years starting in 2002. When CreditGuard did not file its corporate income tax return for 2002, IRS helpfully filed a substitute for return and a statutory notice of deficiency. CreditGuard eventually petitioned the Tax Court and agreed to a stipulated decision for a deficiency of about $216,000. The stipulaion stated that “interest will be assessed as provided by law on the deficiency in income tax due from petitioner.”

IRS assessed the tax and interest of about $142,000 on the deficiency. In calculating the interest, the IRS used the start date of the underpayment interest as March 17, 2003, the due date of the 2002 corporate income tax return.

When CreditGuard did not pay the tax or interest, IRS commenced administrative collection and filed a notice of federal tax lien. In response, CreditGuard filed a CDP request seeking an offer in compromise, but also challenging the interest computation. According to CreditGuard, interest should have only run from 2012– the date of the IRS’s revocation of its tax exempt status.

The CDP case allowed the court to get to the merits of the interest issue. As a threshold issue, the court held that there was no prior opportunity to consider the interest calculation; while the Tax Court had limited jurisdiction to order a refund if the party in a case believes it has overpaid interest that does not give the court the power to determine the correct amount of interest in the first instance.

Once clearing that hurdle, the court turned to the interest issue, one of first impression in the Tax Court, leading to this being a division opinion. The taxpayer’s essential argument was straightforward: it had no obligation to file a corporate tax return in 2003; in fact that obligation only arose 9 years later when IRS revoked its status.

While there is a superficial appeal to CreditGuard’s argument, the Tax Court held that the statute mandates that interest ran from 2003:

Under section 6601(a), interest runs from the “last date prescribed for payment.” Under section 6151(a), the “last date prescribed for payment” is the date “fixed for filing the return.” Because the date fixed for filing petitioner’s 2002 Form 1120 was March 17, 2003, these provisions indicate that petitioner must pay interest on the unpaid tax “for the period from such last date to the date paid.” See sec. 6601(a).

To deflect that statutory reading, CreditGuard argued that the interest provisions that apply to “taxes not otherwise prescribed” under Section 6601(b)(5) applied to revocations. That section applies to taxes “payable by stamp and in all other cases in which the last date for payment is not otherwise prescribed.” For those taxes, the “last date for payment” is the date the liability for tax arises, a date that CreditGuard argued pushed the interest start date to 2012.

The Tax Court disagreed, holding that the corporate income tax was otherwise prescribed with a deadline (as per Section 6072(b)), and in any event, even if it were not, the liability for the tax arose during 2002, not when the IRS revoked its status or when it agreed to the stipulated decision in the Tax Court.

The part of the opinion addressing when the tax arose is a little like a dog chasing its tail, but as our good friend Professor Bryan Camp discusses in a thoughtful blogpost on Taxprof  it highlights the difference between a liability and an assessment. The liability arose back in the year the corporate income tax return should have been filed; the assessment that followed the Tax Court’s decision did not alter the essential time when the liability arose.

The opinion’s statement that retroactivity has real consequences is important. Its citation to Bergerco Can. v. U.S. Treasury Dep’t, Office of Foreign Assets Control, 129 F.3d 189, 192 (D.C. Cir. 1997) and its discussion of those consequences situate the nature of the court’s view of the issue and why the IRS position was right as policy matter:

To be sure, “until we devise time machines, a change can have its effects only in the future.” …. But the purpose of making a change retroactive is to suspend reality and invoke a counterfactual premise. Here, the premise is that petitioner was not in fact tax exempt during 2002 but rather was a corporation subject to the regular corporate income tax. Because petitioner did not actually pay that tax on the date prescribed for payment, it is liable for interest beginning on that date.

After the language cited above, the opinion does drop a footnote to Section 6501(g)(2), which provides that for sol purposes a corporation’s good faith filing of a Form 990 “shall be deemed the return of the organization” for purposes of starting the period of limitations on assessment.” That is an important point, as IRS cannot revoke status for stale tax years (absent the sol remaining open for other reasons). Yet, as the opinion notes, the interest provisions are designed to compensate the government for the use of money. By agreeing with the IRS that it should not have been tax exempt back in 2002, CreditGuard essentially agreed that it did not pay what it was required to pay had it properly reported its status in the first place. As a result, the court’s approach to make the government whole is consistent with the underlying purpose of the interest provisions.

Federal Bar Association Tax Section Writing Competition

Last month PT celebrated its 1,000th post and its 2,000th comment. One aspect of the success of the site is that we are occasionally asked to post an announcement because of the number of readers who look at PT. Today, we are happy to comply with a request from the Federal Bar Association Tax Section to publicize its writing competition.

The website for the competition is here. The rules for the competition can be found here and a flyer about the competition can be found here. Effective writing skills will serve any budding tax attorney well. This is a great competition and winning would provide quite an honor (in addition to cash and a trip to D.C.)

We encourage eligible students to write on tax procedures issues and suggest that they can find many good topics from the posts on this blog.

Designated Orders: 10/2/17 to 10/6/2017

LITC Director for Kansas Legal Services William Schmidt reviews interesting procedural issues in this week’s edition of designated orders. Two of the cases he discusses involve bench opinions which we have written about previously here and here. We got a little bit behind in publishing our weekly review of designated orders making this the second post of the week on such orders.  We hope to go back to our “normal” pattern of posting each Friday.  Keith

Out of 8 designated orders last week, I am focusing on two cases that relate to the last known address of the Petitioner (reinforcing the necessity of communicating address changes to the IRS) and one case where Petitioner needed to provide more evidence to support his claims.

The first two cases cited are bench opinions, authorized under IRC section 7459(b). Tax Court practice is to read a bench opinion into the record, wait to receive the printed transcript weeks later, then issue an order serving the written copies of the transcripts to the parties (who may or may not have paid the court reporter for those transcripts). Bench opinions are just as subject to appeal as other cases, so long as the case involved has not been designated a small tax case under 7463.  The written version of the bench opinion is useful for the appellate court.

Last Known Address Case 1

Docket # 22293-16, Nathanael L. Kenan v. C.I.R. (Order Here).

Mr. Kenan filed his 2011 tax return from his address on Ivanhoe Lane in Southfield, Michigan. Mr. Kenan alleges that he moved to a new address, Franklin Hills Drive, in Southfield prior to February 2013 and notified the U.S. Postal Service regarding his change of address. The IRS mailed a statutory notice of deficiency (“SNOD”) to the original address on February 19, 2013.   Mr. Kenan filed his 2012 tax return from the second address. Once Petitioner verified the SNOD, he filed a petition with the Tax Court with the argument that no SNOD was ever mailed out.

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I previously reported on this case in this blog posting regarding The Court’s denial of Respondent’s motion to dismiss for lack of jurisdiction. Within that post, I noted that the IRS is required to update their addresses based on U.S. Postal Service (“USPS”) Change of Address notifications and those notifications are influential to determine jurisdiction for Tax Court.

The Court held an evidentiary hearing in Detroit, Michigan, on September 18, 2017. Petitioner bore the burden of proof regarding his change of address with the USPS. Petitioner gave oral testimony that he submitted his change of address notification to the USPS after he moved in June 2012 and before the IRS issued the SNOD in February 2013. Petitioner was to give specific details of when he gave notice and what he stated on the form. He did not provide any further specifics or provide documents in support of his statements.

The Court did not have evidence of what Petitioner submitted to the USPS so could not compare the USPS or IRS data (for example, if a name or address submitted to the USPS was misspelled). Based on that lack of evidence, the conclusion was that the IRS acted on the last known address they had for the Petitioner. The Court dismissed Petitioner’s petition for lack of jurisdiction as being untimely filed.

Last Known Address Case 2

Docket # 9469-16 L, Mark Marineau v. C.I.R. (Order Here).

Patrick Thomas previously reported on this case in this blog posting. At last report, the question was why the IRS sent a SNOD to the Petitioner in Michigan if Petitioner lives in Florida.

Here is the procedural background – Following Petitioner’s Tax Court petition, Respondent filed a motion for summary judgment, supported by a declaration from the settlement officer. The Court directed by order on July 5, 2016, for Petitioner to file a response, but he filed his own motion for summary judgment instead where he objected to Respondent’s motion (filed October 19). Respondent filed a response January 23, 2017, objecting to Petitioner’s motion. Petitioner filed a reply to Respondent’s response on March 24, 2017. The Court ordered Respondent to explain the disparity between the address listed on the Form 3877, the notice of deficiency address and the address where the notice of deficiency was sent. On July 28, Respondent filed a First Supplement to Motion for Summary Judgment, supported by a declaration supported by Respondent’s counsel. Petitioner was ordered to file a response on or before September 14 but did not.

This began when the IRS prepared a substitute return for Petitioner for 2012 because Petitioner failed to file his tax return. On June 8, 2015, Petitioner mailed a letter to IRS headquarters that told of his change of address to a post office box in Fraser, Michigan, stating that it was an official notification and requesting that they update their records. On June 18, 2015, the IRS mailed the notice of deficiency to Petitioner at a Pensacola, Florida, address. Even though the notice was mailed to Florida, the USPS attempted delivery to a Roseville, Michigan, address. The IRS has not explained why it was sent to that Roseville address even though it was addressed to the Pensacola address. The notice went unclaimed and the USPS returned it back to the IRS on July 21, 2015.

Petitioner did not file a petition for redetermination of the notice of deficiency for 2012. The IRS sent demand for payment regarding the full 2012 tax liabilities that Petitioner did not pay.

Following this, the IRS and Petitioner corresponded based off his Pensacola address. First, the IRS mailed a notice of intent to levy and Petitioner filed a Form 12153, Request for Collection Due Process or Equivalent Hearing. Petitioner said he would like to have a face-to-face hearing. He did not check any box to propose a collection alternative but wrote in his statement that he would like to discuss collection options if it is proven he owes the tax. The settlement officer’s response was that in order to have a face-to-face hearing, Petitioner needs to complete Form 433-A and submit a tax return for 2012, plus returns for 2013 and 2014 (or explain why he was not required to file a return for that year/years). Petitioner again requested the meeting but did not supply any of the requested documents so the settlement officer followed up with a reminder letter and second copy of the original letter. Petitioner did not call for the March 1, 2016, hearing date and did not supply the documents. The Appeals Office sent a notice of determination March 17, 2016, to his Pensacola address. Petitioner again responded to request a face-to-face hearing without providing any documents. Petitioner timely filed a petition with the Tax Court and listed his Pensacola address as his mailing address.

The Court concluded there is still an issue of material fact regarding whether the June 8, 2015 notice of deficiency was mailed to Petitioner’s last known address. One issue is while Petitioner’s method of notification to the IRS was unorthodox, Petitioner argues it was a “clear and concise notification” of his change of address. The Court denied both the Petitioner’s motion for summary judgment and the Respondent’s motion for summary judgment.

Evidence Presented at Trial

Docket # 23891-15, Abdul M. Muhammad v. C.I.R. (Order Here).

This case concerns a SNOD sent to Petitioner regarding tax years 2012 and 2013. At issue were $15 in taxable interest unreported in 2013, one dependent exemption in 2012 and two exemptions in 2013, head of household status for both years, American Opportunity Credit or other education credits for both years, a deduction for $7,743 for charitable contributions in 2013, ability to deduct Schedule C business expenses in 2013, penalty for failure to timely file a tax return in 2012, and accuracy related penalty under IRC section 6662(a) in both years.

At trial September 18, 2017, in Detroit, Michigan, Petitioner represented himself and had the burden of proof requirement regarding these noted issues below.

  • Interest Income: Petitioner presented no evidence to dispute that the $15 was taxable interest income.
  • Qualifying Children: Petitioner presented no records (school, medical or otherwise) to show that the children lived with him for more than half the year.
  • Education: Petitioner was enrolled in online courses at the University of Phoenix and had expenses of $4,178 in 2012 and $3,977 in 2013.
  • Charitable Contributions: Petitioner did not have documentary evidence to show charitable contributions he made to his mosque.
  • Business Expenses: Petitioner did not offer documentary evidence to support his claim of $10,299 in expenses as a roofer in 2013.
  • Accuracy Related Penalty: No reasonable cause was provided to dispute the burden in 6662(a) or (b)(1) for a taxpayer’s negligence or disregard of rules and regulations.

As a result, the IRS adjustments were sustained regarding the interest income, dependency exemptions, head of household filing status, business expenses and accuracy related penalties.

However, the IRS did not provide convincing proof regarding Petitioner’s late filing of his 2012 tax return (their documents provided contradictory dates so did not meet the burden of proof). Also, Petitioner claimed $4,377 in charitable contributions but the deficiency stated $7,743 (a difference of $3,366) so the deficiency needed to be recomputed. He was also entitled to the education credits for both years.

Takeaway: Providing evidence at Tax Court, especially documentary evidence, is necessary to win on issues at trial. When the Petitioner only provides oral evidence restating a position on the issue, it is unlikely that will be a successful tactic.

 

Getting a Double Penalty Benefit or Getting to the Right Result

It’s easy to feel sorry for the people who invested in Son of Boss tax shelters. They really wanted to pay the right amount of taxes but were hoodwinked into investing into tax shelters that did not turn out like they hoped causing them to have significant problems with the IRS that they never intended.

If that’s your take on Son of Boss investors, you will love a case that came out earlier this summer. If that’s not your take, you might still find the situation amusing. I think the IRS found the situation just slightly less amusing than paying out attorney’s fees to tax shelter promoter BASR. In Ervin v. United States, the district court found that investors in a Son of Boss shelter were entitled to a refund of penalties paid to the IRS even though they recovered the penalties from their tax advisors who brought them into the tax shelter in the first place. How did we get there?

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The investors brought a suit against the IRS to obtain a refund of the valuation misstatement penalty and penalty interest payments. They convinced a jury of their peers that they had reasonable cause for the tax positions they took. Now, they want the IRS to give them a refund of the penalties they paid.

In the meantime, the investors sued some of their tax advisors – BDO Seidman and Curtis Mallet – to recover the penalties asserted against them for investing in the Son of Boss shelter and they won that suit also. It came out in the tax refund suit that they had won the suit against their advisors and recovered a substantial amount of money. The IRS argued that it should not have to refund the penalties and interest to them because the recovery that the investors received from their advisors was intended to pay for the penalty. If the investors got to keep the recovery and did not have to pay the penalty, the investors would receive a windfall. The IRS argued that it should keep the money the investors paid to it because they were already made whole and the payments by the advisors represented the true payments of the penalties. The investors argued that they should receive the entire refund despite the private settlement. They also argued that the IRS does not have a claim of right with respect to the penalty payments.

The Court rejected the argument made by the IRS and rejected it without giving the IRS any further discovery. It finds that the investors did not fail to disclose a matter “bearing on the nature and extent of injuries suffered.” The suit was about their liability for penalties and the private suit against their advisors really had nothing to do with it. The Court said that it could not find a single instance in which a court has excused the IRS from its obligation to repay the improperly assessed and collected tax in a refund suit and ordered the IRS to pay here.

This case brings up an issue that Steve and I have debated before and he has written about. When a taxpayer argues reasonable cause based on the advice of tax advisor, the case is in many ways the malpractice case involving the advisor. If the taxpayer succeeds in fending off the penalty, maybe the taxpayer does not pursue the advisor. So, a victory for the taxpayer may be an economic victory for the party who caused the problem just as much for the taxpayer.

If taxpayers are going to defend against the IRS and sue their advisor in situations in which they can win both cases because they were reasonable in relying on the advisor and the advisor did give bad advice, maybe this feels bad to the IRS but it puts the economic loss in the right place, or maybe it misallocates the placement of the economic loss which is why the IRS was complaining.

The advisor who gives the bad advice should be liable and pay for the damages caused by the bad advice. The bad advice has really harmed both the IRS and the taxpayer. If the taxpayer pays the right amount of tax after the audit, the IRS is whole from the perspective of collecting the correct amount of tax but has still had to expend effort to collect that tax instead of having the self-reporting system work as it should. If the taxpayer pays the correct amount of tax in the end, should the taxpayer be freed from paying the advisor who caused the taxpayer to incur the problem in the first place? The taxpayer may have had to pay more money to fight with the IRS about the correct amount of tax and certainly did not get the value bargained for.

In cases where the taxpayer avoids an otherwise appropriate penalty because the taxpayer reasonably relied upon the advisor, should the system penalize the advisor so that the IRS recovers something akin to the appropriate penalty and so that the advisor feels the pain of causing the problem while also allowing the taxpayer to recover from the advisor at least the cost of the original bad advice plus perhaps the cost of the advice to fix the problem created? The IRS is right to complain here, in the sense that some penalty payment seems appropriate. It also seems right to allow the taxpayer to avoid paying the penalty to the IRS where the taxpayer reasonably relied on the advice of a professional and to allow the taxpayer to recover the cost the taxpayer paid for the bad advice. Maybe we should look at recasting the penalty scheme to bring all of the players to the table. Where I am particularly bothered, the advisor is continuing to represent the taxpayer in the reasonable cause litigation and I felt that the advisor was using the taxpayer’s more sympathetic case as a shield for the advisors’ less sympathetic one.

 

Designated Orders 9/25 to 9/29

Professor Samantha Galvin of University of Denver Sturm College of Law brings us this week’s edition of Designated Orders. This week she looks at an order involving a Collection Due Process case in which the notes of the Settlement Officer and the determination letter ultimately sent do not match. She also writes about an order ruling on the admissibility of the testimony of an expert witness because the expert witness left some information off of his report tending to show that he might be favorably disposed to the IRS. I have written before about disqualification of an expert witness. A motion to disqualify an expert creates a serious point in any case in which a party relies on such a witness and failing to properly set up such testimony can have consequences that can easily change the outcome of the case.  Samantha found a third order, the one in the Gabr case linked first in the next paragraph, to be of enough importance that she is going to write a standalone post on that case. Keith 

The Tax Court designated six orders last week and two are discussed below. The orders not discussed involved: 1) a faxed CDP request and a question of the Court’s jurisdiction (here); 2) an order granting a motion for continuance (here); 3) an order addressing several of petitioner’s various motions (here); and 4) an order denying a petitioner’s motion to seal (here).

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Notes are Not Determination

Docket #: 21235-16L, Scott Kimrey Goldsmith v. C.I.R. (Order and Decision Here)

This designated order covers a topic that is often blogged about by PT and in other designated orders, which is whether or not underlying liability can be raised during a CDP hearing. This time, however, the petitioner has an interesting argument for raising the underlying liability and for why he should not be liable. The petitioner resides in the 8th Circuit, so the Court has to follow Robinette v. Commissioner, 439 F.3d 455 (8th Cir. 2006), and review the determination based on the administrative record. Both parties have moved for summary judgment.

Petitioner was a lawyer and this is not the first time he has been before the Tax Court. He was before the Court on a different, but related issue where he was indicted and convicted for failure to pay over income and FICA taxes owed, in addition to other charges.

The tax at issue also concerns employment taxes owed by his now inactive law firm, and specifically, the trust fund recovery penalties (TFRP) assessed to petitioner in his individual capacity. Trust fund recovery penalties can be assessed without the right to judicial review, but a taxpayer has the right to request a hearing with an IRS appeals officer before the assessment takes place. Petitioner received a Letter 1153, proposing to assess TFRP, and he requested such a hearing.

In his pre-assessment hearing, the petitioner argued that the had filed returns for the quarters at issue more than three years prior when he gave the returns to an IRS criminal investigator, and therefore, the IRS’s assessment statute had expired before the assessment at issue was made. To make this argument, petitioner incorrectly relied on Dingman v. Commissioner, 101 T.C.M. 1562 (2011). The appeals officer, in the pre-assessment hearing, disagreed that the returns had been filed because unlike in Dingman, the returns had not actually been filed, and found petitioner liable for the underlying employment taxes, and thus, the TFRP.

The IRS sent petitioner a Notice of Federal Tax Lien and notice of intent to levy and petitioner requested another hearing, this time a collection due process hearing. In this CDP hearing, petitioner attempted to make the same argument he had made in his pre-assessment hearing. This time, the appeals officer assigned to the CDP hearing believed petitioner was correct and made notes in the file stating that the “taxpayer can raise liability and the assessment is not valid.”

These notes were never written into a notice of determination, and instead the appeals officer was removed from the case. The case was reassigned, but the second appeals officer had had prior involvement so was also removed from the case.

A third appeals officer was assigned to the CDP case and sustained the lien, but not the levy. Similar to the appeals officer in the petitioner’s pre-assessment hearing, the third appeals officer found that turning over the returns to an IRS criminal investigator was not a filing, so the assessment statute had not expired. He also found that petitioner had no right to challenge the liability in the CDP hearing, since he had had a prior opportunity to do so.

Petitioner petitioned Tax Court on the third appeals officer’s notice of determination. Petitioner argued that first appeals officer’s notes should be treated as the determination and that the Court give full force and effect to the first CDP hearing appeals officer’s findings, decisions and agreements.

Code sections 6320 and 6330 do not define the word determination, but the applicable regulation defines it by stating that a notice of determination will be sent by certified or registered mail and set forth Appeals’ findings and decisions. The determination defined in the regulations is the type of determination that is needed to establish the Court’s jurisdiction, so the IRS’s preliminary notes or drafts are not a determination.

Since petitioner had an opportunity to raise the underlying liability in his pre-assessment hearing, the Court found he could not do so again in the CDP context. The Court found that the appeals officer did not abuse his discretion, denied petitioner’s motion for summary judgment, granted respondent’s motion and allowed respondent to proceed with the collection of the TFRP for the relevant periods.

Petitioner Out of Luck, Expert Testimony Not Struck

Docket #: 17152-13, Estate of Michael J. Jackson, Deceased, John G. Branca, Co-Executor and John McClain, Co-Executor v. C.I.R. (Order Here)

PT previously covered a different designated order from the Estate of Michael Jackson’s case a few months ago. The first, here, involved section 6751(b).

In this designated order involving a completely different issue, petitioner moved to strike the testimony of respondent’s expert witness. The expert witness testified about the value of some of the estate’s assets. The expert witness was also respondent’s only witness, so without his testimony the Respondent will have no evidence.

In his motion, petitioner argued that Tucker v. Commissioner should apply. In Tucker, the Court excluded an expert witness’s testimony for violating Tax Court Rule 143(g).

Rule 143(g) governs expert witness reports and establishes requirements for what the reports should contain. The requirements relevant in Tucker, as well as this case, are: 1) the witness’s qualifications, including a list of all publications authored in the previous ten years; and 2) a list of all other cases in which, during the previous four years, the witness testified as an expert at trial or by deposition. If the requirements are not, the rule also requires that the witness’s testimony be excluded altogether unless good cause is shown, and the failure does not unduly prejudice the opposing party.

In Tucker, the Court excluded the witness’s testimony because he failed to disclose two cases in which he had testified as an expert during the previous four years and the Court could not find good cause for the omission. The witness also omitted or exaggerated other information which caused the Court to be concerned.

In the present case, the petitioner asserted that the witness lied when he testified that he had not worked similar issues for the IRS, but the witness admitted to the lie during trial when confronted by documentary evidence and further questioning. The witness also omitted two items, one case and one publication, from his CV.

Petitioner argued that the Court should strike all of the witness’s testimony and expert reports due to perjury, however, perjury is a criminal offense and this is not a criminal case so instead the Court finds, and neither party disputes, that the witness lied under oath.

Respondent, to show good cause, stated the witness’s omissions were a clerical error and the Court agreed with that reasoning because the witness disclosed hundreds of cases and more than 100 publications, so omitting only two items was an oversight. The petitioner also did not assert that it was unduly prejudiced by the omission.

Petitioner also argued the witness is biased in favor of the Respondent. The Court pointed out that bias goes to weight of testimony and not admissibility, unless the report is absurd or “so far beyond the realm of usefulness” to be admissible.

The petitioner also argued that Rule of Evidence 702 (addressing reliability) and 402 (addressing relevancy) should apply to exclude the evidence. The Court finds excluding the evidence is too severe since it will result in leaving Respondent without any evidence about one of the key issues in the case and instead, a proportionate remedy is to discount credibility and weight given to the expert witness’s opinions.

 

Ninth Circuit Hears Altera Tomorrow

We welcome back guest bloggers Professor Susan C. Morse from University of Texas School of Law and my colleague Senior Lecturer on Law Stephen E. Shay from Harvard.  Professors Morse and Shay, building on an earlier post as well as their amicus brief, explain that the Tax Court went too far in striking down Treasury regulations requiring the sharing of stock-based compensation costs in Altera.  The underlying issue as well as the procedural issue make this a case to watch. We have previously blogged about Altera here and here.   Keith

On Wednesday of this week, October 11, the Ninth Circuit will hear argument in Altera, a case about transfer pricing and administrative law. Politically, Altera is a case about big multinational technology companies and under-resourced government regulators. Technically, it is about the transfer of intellectual property rights from U.S. affiliates of a multinational firm (a “U.S. group”) to one or more non-U.S. offshore subsidiaries under a qualified cost sharing arrangement (QCSA).

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Firms from Google and Apple to Altera, a semiconductor company owned by Intel, use the QCSA “cost sharing” strategy to support the attribution of intellectual property for tax purposes to low-tax offshore subsidiaries and thereby justify allocation of substantial taxable income to those subsidiaries. The smaller the amount of U.S. group costs included in the pool, the more tax revenue the U.S. loses with respect to the cost-shared IP. Billions of dollars are at stake. Two amicus briefs prepared pro bono by academics and former tax practitioners support the government and multiple amicus briefs on behalf of interested business groups support the taxpayer in this important litigation.

Altera challenged a final Treasury regulation that requires multinationals who enter into QCSAs with offshore affiliates to include the cost of stock options granted to employees who develop the IP (among other expenses) in the pool of costs to be shared. Under cost sharing, if net costs are borne by the U.S. group the non-U.S. affiliates must reimburse the U.S. group for that amount. Prior regulations did not specifically address the issue of stock option cost allocation in a QCSA. In a prior case, Xilinx, the Tax Court and Ninth Circuit held that the government could not make offshore affiliates pay a share of stock option expense under these earlier regulations.

The revised final regulation requires taxpayers to include stock option costs in the pool of expenses for determining cost sharing payments. They provide that this is required under the arm’s length standard and, consistent with the directive of Section 482 of the Internal Revenue Code, is necessary clearly to reflect the income of the U.S. group.

Taxpayers challenged the final regulation and won in Tax Court in a reviewed decision that was unanimous among the judges that participated. The Court held that the regulations departed from the historic understanding of “arm’s length standard” which required the use of data about unrelated party transactions. The Tax Court proceeded to conclude, under a review based on State Farm (US 1983), that the regulatory change was arbitrary and capricious under § 706(2)(A) of the Administrative Procedure Act.

The misconception in the Tax Court’s decision is fundamental. One reason is that the historic understanding of “arm’s length standard” does not require the starting point of data about unrelated party transactions. Sometimes an application of the arm’s length standard uses unrelated party data. For example, if a taxpayer sells a commodity to related affiliates and unrelated firms, the unrelated firm price is the right starting point for the related affiliate price, because it is sufficiently comparable. But in other cases, unrelated party transactions are not comparable enough to serve as good starting points.

The arm’s length standard has always been a counterfactual inquiry. It has always asked how a related party transaction would be treated if, contrary to fact, the same transaction (including the actual relationships presented in fact) were conducted by unrelated parties (i..e, as though the relationship did not exist). This does not mean insisting that the reasoning begin with an unrelated party transaction if that transaction has sufficiently different facts and is not comparable.

Several transfer pricing methods, including the comparable and residual profit split methods, do not require use of unrelated party prices as starting points.   Moreover, large chunks of the 482 rules prove that the arm’s length standard is not a brittle instruction to use whatever unrelated party information is available. The 482 regs include many pages of comparability adjustments which at every turn show that a starting unrelated party price, even if available, often needs a lot of work before it can be considered a comparable.

Altera and other multinational tech companies want to avoid paying for the stock option cost component of technology by arguing that unrelated firms that share technology do not require payment for stock option costs. They say that the arm’s length standard requires a starting unrelated party data point, and further that any departure from the unrelated party data point requirement is a significant regulatory change.

One reason that Altera should lose in the Ninth Circuit is because the arm’s length standard does not, and never has, required a starting unrelated party data point in all cases. Government briefs include this argument. They show that uncontrolled joint development agreements were not relevant to the question of whether to include stock option costs in QCSAs because clear reflection of income for high-profit intangibles cannot succeed if it relies on uncontrolled party data.  One amicus brief points out that Section 482’s reference to pricing “commensurate with income” only makes sense if the arm’s length standard embraces transfer pricing that is not bound to unrelated party pricing.

Another amicus brief (ours, with coauthors) explains that unrelated party data points cannot be starting points for an arm’s length analysis if the unrelated information is wholly incomparable to the related party situation. This is the case for the evidence that Altera points to, which consists of technology sharing deals among unrelated parties that do not mention stock option costs. This evidence is not relevant for QCSAs because it is not comparable.

The facts of Example 2 in our brief illustrate the lack of comparability between unrelated party joint ventures and related party technology transfer agreements:

Assume that Company C and Company D are unrelated and want to share the R&D costs and benefits for a new innovation on a 50/50 basis.

Company C pays cash compensation of 80 and grants stock options with an expected cost of 20 for its R&D employees. Company D pays cash compensation of 20 and grants stock options with an expected cost of 80 for its R&D employees. There are two possible ways of looking at the R&D costs in this deal:

Option 1: If stock option expenses are included, the pool of expenses is 200, and each company pays 100. No transfer between C and D is required to achieve a 50/50 split of expenses.

Option 2: If stock option expenses are not included, the pool of expenses is 100: 80 contributed by Company C and 20 contributed by Company D. D would transfer 30 to C to achieve a 50/50 split of expenses.

The correct answer is Option 1. Any rational economic actor would estimate and incorporate the stock option expense cost. Note that Company C and Company D do not need to mention stock option costs in order to consider and incorporate them into their transaction. The lack of a specific mention of stock options in the unrelated party deal document does not mean that stock option costs are priced at zero or intentionally disregarded.

The arm’s length standard has always recognized the absence of comparable third-party transactions in some areas of transfer pricing, including the large-scale licensing of IP among related parties. Thus the revised regulation at issue in Altera does not revolutionize the meaning of arm’s length. Instead it stays true to the meaning of clear reflection of income.

Tune in again after October 11 to hear how the taxpayer, the government and the judges of the Ninth Circuit approached this case at oral argument.

 

Appeals Backtracks on Removing Face to Face Conferences

We discussed last year around this time that Appeals was putting in place procedures that severely limited the opportunity for face to face meetings. Practitioners strongly opposed Appeals’ decision. While this past summer Appeals announced that it was piloting a web based virtual conference option, in the last few weeks leadership in Appeals has told practitioners that it is going to offer face to face in person conferences again for cases in field offices. To reflect the change, we understand that Appeals will soon publish interim guidance. While Appeals has decided not to offer virtual face to face meetings for the issues it handles in Service Centers it did not rule it out in the future if it could work out logistical barriers to doing so.

The decision to review and allow taxpayers the demonstrates that Appeals’ meetings with practitioner groups (such as the ABA Tax Section) was not for show and that despite losing 1/3rd of its staff since 2010 Appeals is committed to trying to work out cases in the most effective manner.

 

As If: Tax Court Holds that Restitution Assessment Does Not Attract Late Payment Penalties or Interest

This week in Klein v Commissioner the Tax Court in a division opinion held that assessments of restitution do not generate underpayment interest or late payment penalties. This is an important holding and a case of first impression.

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Section 6201(a)(4) gives the Service to power to assess restitution “in the same manner as if such amount were such tax.” Following a restitution assessment, Internal Revenue Manual provisions and Service policy has been to impose underpayment interest and late payment penalties on amounts that are unpaid similar to other unpaid tax.

To the facts at hand. In Klein, after some delay, the taxpayer fully paid the restitution, as well as interest that accrued pursuant to the statute in Title 18 that allowed for restitution. The taxpayer did not pay the separate Title 26 interest and late payment penalties that the Service imposed and assessed.

The IRS commenced administrative collection with respect to the unpaid interest and penalties. In a CDP proceeding the taxpayer challenged the Service’s right to impose underpayment interest and civil penalties, having claimed that it fully paid what was due.

The taxpayer had to clear the hurdle that she could challenge the Service’s imposition of penalties and interest in the CDP proceeding. The Court found that it was possible, noting that in a CDP proceeding, “underlying tax liability refers to the assessed liabilities that the IRS is seeking to collect via the challenged lien or levy.”

The opinion then considered the Service’s interest and penalty procedures in place for restitution assessments under the Internal Revenue Manual. The Tax Court held that the statutory language that gives IRS the power to assess restitution “as if” it were a tax does not transform the assessed restitution into a tax for purposes of the penalty and interest provisions. In doing so, the opinion discusses how the statute is drafted in the subjunctive mood.

For those who may have forgotten their Latin, the opinion explains what that means:

This clause is drafted in the subjunctive mood. Clauses of this type are commonly used to express a counterfactual hypothesis. See, e.g., Andrea A. Lunsford, The St. Martin’s Handbook 633 (5th ed. 2003) (describing the subjunctive mood as expressing “a wish, suggestion, requirement, or a condi- tion contrary to fact”). For example, assume a statute providing that certain per- sons (green card holders, perhaps) shall be treated “in the same manner as if they were citizens.” In such a statute, Congress would necessarily presume that such persons were not in fact citizens, providing merely that they should be accorded the treatment which citizens receive.

So as Alicia Silverstone in Clueless can attest, “as if” is an important phrase. As the opinion explains, the “as if” in the statute provides “the counterfactual hypothesis that restitution is a tax for the limited purpose of enabling the IRS to assess that amount, thus creating an account receivable on the taxpayer’s transcript against which the restitution payment can be credited.” It is treated like a tax but is not a tax.

In addition to parsing the statute, the opinion notes that the criminal concepts of tax loss and restitution do not neatly equate with the concepts of civil tax liability. In 2010 when Congress gave the IRS the power to assess (and collect) restitution it did not alter the fundamental distinction between the separate criminal and civil concepts.

To be sure, if the Service gets around to a civil examination, it can potentially generate an assessment that would be based on deficiency procedures. (for readers who would like more background on the interplay of the deficiency assessment procedures and the relatively new restitution assessment procedures see Keith’s post from this past spring discussing the issue here). If the Service were to conduct a civil examination and the amount assessed under deficiency procedures is both unpaid and exceeds what has previously been collected, it will be possible for Title 26 interest and civil penalties to start running.