A Second Review of Ninth Circuit Argument in Altera v. Commissioner

Today we welcome back guest blogger Stu Bassin for his take on the argument in the Altera case. Stu has blogged with us on several occasions. Because of the importance of the case, we are providing two views of the argument in Altera today. Keith

The Ninth Circuit held the long-awaited argument on the Government appeal of the Tax Court’s ruling in Altera Corp. v. Commissioner, 145 T.C., No. 3 (2015), on Wednesday, October 11. The case arose out of an IRS notice of deficiency which invoked Section 482 (and, specifically, Treas. Reg. §1.482-7(d)(2)) to redetermine the transfer prices employed for intra-group transactions amongst Altera corporate affiliates.   The Tax Court’s ruling, which invalidated the regulation under the Administrative Procedure Act (the “APA”) because of defects in the rulemaking process, has drawn wide-spread interest amongst practitioners involved in both transfer pricing and regulation validity matters.

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Before the Tax Court, the parties agreed that the law generally requires participants in intra-group transactions to determine transfer prices in accordance with the prices comparable unrelated parties employ in arms-length agreements. The parties disagreed, however, regarding the proper allocation of stock-based compensation costs amongst the affiliates. The IRS supported its deficiency notice with a regulation which specifically required affiliates to share stock-based compensation costs in computing the transfer price, while the taxpayer contended that the regulation was invalid under the APA because it deviated from the comparable arms-length transaction test traditionally employed in computing transfer prices.

According to the taxpayer, during the rule-making process, commenters submitted substantial evidence supporting the proposition that, in practice, cost sharing agreements amongst unrelated entities operating at arms-length do not require sharing of compensation costs. The IRS did not identify any instance of a cost sharing agreement which provided for sharing of compensation costs in the preamble to the final regulations. Instead, it asserted an economic theory-based policy analysis to support its determination that cost sharing agreements must provide for sharing of compensation costs. The taxpayer, therefore, argued that the regulation was invalid because its requirement of sharing compensation costs in computing transfer prices was arbitrary, capricious, and inconsistent with the evidence before the Service during the rulemaking process.

The Tax Court unanimously ruled in favor of the taxpayer, invalidating the regulation and rejecting the proposed Section 482 adjustment.   The Tax Court’s analysis focused upon the second stage of the regulation validity inquiry mandated by Mayo Foundation v. United States— whether the determinations reflected in the regulation were arbitrary and capricious. The opinion criticized the IRS for failing to engage in actual fact-finding, failing to provide factual support for its determination that unrelated parties would share compensation costs in their cost-sharing agreements, failing to respond to significant comments, and acting contrary to the factual evidence before Treasury. Accordingly, the regulation failed to satisfy the reasoned decision-making standard established by Supreme Court precedent under Mayo and related cases.

On appeal, Altera was heard by a panel consisting of Chief Judge Thomas, Judge Reinhardt (the dissenter in the Ninth Circuit’s earlier Xilinx decision in favor of the taxpayer in a similar Section 482 case), and Judge O’Malley of the Federal Circuit. All three judges were appointed by Democratic presidents. Arthur Catterall, one of the top appellate lawyers from the Justice Department’s Tax Division, argued the case on behalf of the Government.   Donald Falk, a general appellate litigation specialist from Mayer Brown, argued the case on behalf of the taxpayer.  Appellate junkies familiar with appellate arguments in tax cases where the panel is largely silent may be surprised to learn that all three judges actively questioned both lawyers and that the argument extended to a full hour.

The Government focused its argument upon the first stage of the Mayo analysis—the agency’s statutory authority to issue a regulation which departed from the comparable arms-length standard for evaluating transfer pricing arrangements. It argued that the Treasury had authority to regulate on the treatment of cost-sharing agreements because of statutory ambiguity produced by tension between the two sentences of Section 482. The text of the statute provides—

“In any case of two or more organizations . . . owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”

The first sentence, which has been part of the Code for decades and is consistently reflected in many tax treaties, has historically been construed by Treasury and the courts to incorporate a requirement that a taxpayer’s transfer prices be evaluated based upon their comparability to the arrangements negotiated by unrelated entities operating at arms-length. The second sentence, added in 1986 and focusing upon transfers of intellectual property, requires that the income from the transfer be apportioned in a manner “commensurate with income.” According to the Government, the differing results occasionally produced by a commensurate with income standard and comparable arms-length transaction standard create an ambiguity which allows Treasury to issue regulations which deviate from the arms-length standard for cost allocation.

The taxpayer acknowledged that the arms-length comparability standard and the commensurate with income standard are somewhat different and can produce different results in some cases. That difference, however, did not authorize Treasury to abandon the arms-length comparability standard for allocation of stock-based compensation costs. According to the taxpayer, both the statutory language and the legislative history of the 1986 amendment support a far narrower role for the commensurate with income standard. While the legislative history demonstrates that Congress was concerned about problems which had arisen with arms-length comparability analyses employed in connection with intellectual property transfers, the legislative history contains many references endorsing arms-length comparability analysis in other contexts. Similarly, the statutory language of the commensurate with income provision only applies to intellectual property transfers. Ultimately, the taxpayer contended the commensurate with income statutory language did not support abandonment of arms-length comparability in evaluating the allocation of compensation costs under the taxpayer’s cost-sharing agreement.

Virtually all of the panel’s questions focused upon the statutory construction questions and their implications for the scope of Treasury’s authority to promulgate regulations inconsistent with the arms-length comparability standard. The panel appeared to recognize the tension between the arms-length comparability standard and the commensurate with income standard. It questioned, however, the scope of the tension and the range of costs which Treasury could allocate without regard to arms-length comparability analysis. The government contended that the tension allowed Treasury to promulgate regulations governing all aspects of cost sharing agreements, while the taxpayer tried to limit such regulations to the intellectual property transfer arena.

Interestingly, the argument gave relatively little attention to the second stage of the Mayo analysis—the arbitrariness of Treasury’s determination.   The government did not challenge the Tax Court’s conclusions that the regulation was contrary to the evidence regarding comparable arms-length transactions. Instead, it argued that Treasury had almost unlimited discretion to prescribe the allocation of costs if the court agreed that Treasury had authority to prescribe rules contrary to the arms-length comparability evidence. To the contrary, the taxpayer argued that the absence of any arms-length comparability evidence rendered the regulation arbitrary and capricious. The panel, however, did not pursue this line of argument, notwithstanding the Tax Court’s focus on the issue.

The panel gave no indication of when it would render its decision in Altera. Full opinions on appeals to the Ninth Circuit tend to take a long time, so it seems likely that it will be several months before a decision is issued.

 

 

 

 

 

 

 

The Altera Oral Argument

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, build on their post last week to fill us in on what happened before the 9th Circuit in Altera. Keith

At the Ninth Circuit on Wednesday October 11, government counsel carefully threaded the needle of statutory and regulatory interpretation in Altera, a case about transfer pricing and administrative law. Taxpayer counsel appeared to overreach. It refused to concede that Treasury has any authority to regulate the pricing of intercompany intellectual property sharing under qualified cost sharing arrangements (QCSAs) unless the guidance proceeds from the starting data point of unrelated party dealings, otherwise known as comparability analysis.

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The panel included Ninth Circuit Chief Judge Sidney Thomas, Ninth Circuit Judge Stephen Reinhardt, and D.C. Circuit Judge Kathleen O’Malley, sitting by designation. Reinhardt joined the first Ninth Circuit Xilinx decision overturning the Tax Court decision, which interpreted the prior cost sharing regulation to allow the IRS to include stock option costs in the pool of shared costs. After a rehearing, Reinhardt dissented in the superceding Ninth Circuit Xilinx opinion that upheld the Tax Court. In Xilinx, he would have allowed the government to require inclusion of stock option costs in a cost-sharing pool even under earlier regulations that did not explicitly address stock options. The final regulations at issue in Altera, the current case, plainly say that stock option costs must be included in a QCSA cost pool, to the disadvantage of U.S. multinational groups which as a result may take fewer tax deductions resulting from the exercise of stock options. Billions of dollars of tax revenue are at stake in Altera.

The oral argument featured three important threads: The imposition of an administrative law framework with a Chevron starting point; the argument that “arm’s length” is not synonymous with “comparability analysis”; and the idea that the second sentence of section 482, which refers to “commensurate with income” payment for intellectual property “transfers”, specifically envisioned transfer pricing not tethered to unrelated party data points.

Judge O’Malley, who brought seven years’ worth of D.C. Circuit administrative law experience    to the hearing, repeatedly insisted on a textbook administrative law analysis. She asked both parties whether there is statutory authority for these regulations under Chevron. Yes, replied the government. Chief Judge Thomas asked whether the government has the statutory authority to “eliminate” comparability analysis altogether, for all transactions. No, replied the government, here trying to thread the needle. The statute does not say “arm’s length,” let alone comparability. Both are described in regulations. But there is “too much history.”

Well, then if the government cannot erase the arm’s length standard, how can it write regulations that set aside unrelated party data, like the agreements taxpayers point to under which unrelated parties develop technology together without mentioning stock options? Judge Reinhardt suggested that the validity of the regulation had to do with its subject: the sharing of intangible assets. Perhaps comparability analysis is not relevant for transactions involving intangibles in particular, he suggested. Agree, with respect to cost-sharing arrangements, replied the government.

But why doesn’t the departure from comparability analysis for intangibles violate the arm’s length standard? In response to prompts from the panel, the government agreed that arm’s length and comparability do not “go hand in hand” and are “not synonymous.” There are several “means to [the] end” of an arm’s length result. In the case of QCSAs, unrelated party data is “inherently not comparable” and cannot support clear reflection of income.

Taxpayer counsel, in contrast, contended that “it has to be an empirical analysis” and that “you have to take comparables as far as they will go,” and appeared to argue that this approach was required by the statute itself. “What if [the comparables] don’t go anywhere?” asked Chief Judge Thomas. Well, replied taxpayer counsel, then the government should “erase” regulations’ reference to an arm’s length standard. In rebuttal, the government further argued that the term “arm’s length standard” is a “term of art” and that Treasury’s interpretation is entitled to deference.

The second sentence of Section 482, added in 1986, allows the government to adjust related parties’ inclusions from “transfer” of intangibles so that they are “commensurate with income.” As the government pointed out, the legislative history clearly explains that unrelated party data points – i.e., comparability analysis – are not sufficient to allow clear reflection of income in these situations involving intangibles. This is strong evidence of statutory authority for the government to write regulations that depart from comparability analysis. Taxpayer counsel suggested that a QCSA might not qualify as a “transfer” under this sentence of the statute, so that perhaps it was not statutory authority at all. But government counsel disagreed, arguing that the word “transfer” was broad enough to encompass QCSAs and noting that this issue was apparently briefed, and ignored, in Xilinx.

The Tax Court cited State Farm, which requires reasonable explanation of policy changes, in its decision to set aside the Treasury’s regulations. Other reasonable explanation cases include Fox Television and Encino Motorcars, both of which came up during oral argument. O’Malley asked government counsel why the regulations requiring cost sharing were not a change; the government replied that the policy of requiring stock options costs to be included in pools had existed since 1997, years before the regulations were promulgated. Later, taxpayer counsel pushed the State Farm argument, insisting that some of the government’s arguments in litigation were “not what they said” in the preamble. But the panel did not pursue the specifics of the preamble’s language. And taxpayer counsel’s assertion that Chevron should be the “last step” of the analysis of regulatory validity was met with silence by the court.

Stay tuned for our analysis of the Ninth Circuit’s Altera decision – we’ll blog it here in due course.

 

 

 

 

 

 

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.

 

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.

 

Designated Orders: 9/18 – 9/22/2017

Professor Patrick Thomas brings us this week’s Designated Orders, which this week touch on challenges to the amount or existence of a liability in a CDP case without the right to that review, a pro se taxpayer fighting through a blizzard of a few differing assessments and an offset, and the somewhat odd case of the IRS arguing that a taxpayer’s mailing was within a 30-day statutory period to petition a determination notice. Les

Thank goodness for Judge Armen’s designated orders last Wednesday. In addition to Judge Halpern’s order in the Gebman case on the same day (which Bryan Camp recently blogged about in detail), Judge Armen’s three orders were the only designated orders for the entire week.

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A Review of the Underlying Liability, without a Statutory Right

Dkt. # 7500-16L, Curran v. C.I.R. (Order Here)

The Curran order presents a fairly typical CDP case, though both the IRS, and I’d argue the Court, give the Petitioners a bit more than they were entitled to under the law. Mr. Curran was disabled in 2011, and received nearly $100,000 in disability payments from his employer, Jet Blue. Under section 104(a)(3), such payments are included in gross income if the employer paid the premiums for the disability policy (or otherwise contributed to the cost of the eventual disability payments). If the employee, on the other hand, paid the premiums, the benefits are excluded from gross income.

It appears that Jet Blue paid for Mr. Curran’s benefits, but Mr. Curran did not report these on his 2011 Form 1040. Unfortunately for Mr. Curran, employers (or, in this case, insurance companies contracted with the employer to provide disability benefits) are required to report these benefits on a Form W-2. The IRS noticed the W-2, audited Mr. Curran, and issued a Notice of Deficiency by certified mail to Mr. Curran’s last known address, to which he did not respond. The IRS then began collection procedures, ultimately issuing a Notice of Intent to Levy under section 6330 and a Notice of Determination upholding the levy.

The Court does not critically examine the last known address issue, but presumes that the Petitioner has lived at the same address since filing the return in 2012. So, ordinarily, Petitioners would not have had the opportunity to challenge the liability, either in the CDP hearing or in the Tax Court.

Nevertheless, the IRS did analyze the underlying liability in the CDP hearing, yet concluded that Mr. Curran’s disability payments were included in gross income under section 104(a)(3). The Court also examines the substantive issue regarding the underlying liability, though notes that Petitioners do not have the authority to raise the liability issue. Of particular note, the IRS’s consideration of the liability does not waive the bar to consideration of the liability, and most importantly, does not grant the Court any additional jurisdiction to consider that challenge. Yet, Judge Armen still engages in a substantive analysis, concluding that Petitioners’ arguments on the merits would fail.

It’s also worth noting that the Petitioners provided convincing evidence that, at some point after 2011, they repaid some of the disability benefits (likely because he also received Social Security Disability payments, and his contract with the insurance company required repayment commensurate with those SSDI benefits). Under the claim of right rule, Petitioners were required to report the benefits as income in the year of receipt. Repayment of the benefits in a latter year does not affect taxation in that earlier year; rather, the Petitioners were authorized to claim a deduction (for the benefits repaid) or a credit (for the allocable taxes paid) in the year of repayment.

Three Assessments, Two Refund Offsets, and One Confused Taxpayer

Dkt. # 24295-16, McDonald v. C.I.R. (Order Here)

In LITC practice, we often encounter taxpayers who are confused as to why the IRS is bothering them, what the problem is, and even why they’re in Tax Court. Indeed, at a recent calendar call I attended, a pro se taxpayer asked the judge for permission to file a “Petition”. This mystified the judge for a moment; further colloquy revealed the Petitioner actually desired a continuance.

In McDonald, we see a similarly confused taxpayer, though I must also admit confusion in how the taxpayer’s controversy came to be. Initially, the taxpayer filed a 2014 return that reported taxable income of $24,662, but a tax of $40.35. Anyone who has prepared a tax return can immediately see a problem; while tax reform proposals currently abound, no one has proposed a tax bracket or rate of 0.16%. Additionally, Mr. McDonald did self-report an Individual Shared Responsibility Payment (ISRP) under section 5000A of nearly $1,000 for failure to maintain minimum essential health coverage during 2014.

So, the IRS reasonably concluded that Mr. McDonald made a mathematical error as to his income tax, and assessed tax under section 6213(b)(1). Such assessments are not subject to deficiency procedures. Because the assessment meant that Mr. McDonald owed additional tax, the IRS offset his 2015 tax refund to satisfy the liability. Another portion of his refund was offset to his ISRP liability (which appeared on a separate account transcript—likely further confusing matters for Mr. McDonald).

But then the IRS noticed, very likely through its Automated Underreporter program, that Mr. McDonald did not report his Social Security income for 2014. Unreported income does not constitute a mathematical error, and so the IRS had to use deficiency procedures to assess this tax. The IRS sent Mr. McDonald a Notice of Deficiency, from which he petitioned the Tax Court.

Mr. McDonald filed for summary judgment, pro se, arguing that he had already paid the tax in question. Indeed, he had paid some unreported tax—but not the tax at issue in this deficiency proceeding. Rather, this was the tax that had already been assessed, pursuant to the Service’s math error authority—and of course the ISRP, that Mr. McDonald self-assessed. Accordingly, Judge Armen denied summary judgment, since Petitioner could not prove his entitlement to the relief he sought.

Headline: IRS Argues for the Petitioner; Loses

Dkt. # 23413-16SL, Matta v. C.I.R. (Order Here)

I just taught sections 7502 and 7503 to my class, so this order is fairly timely. Judge Armen ordered the parties to show cause why the case shouldn’t be dismissed for lack of jurisdiction due to an untimely petition.

Now why the Petition was filed in the first instance, I can’t quite discern. The Notice of Determination, upon which the Petition was based, determined that the taxpayer was entitled to an installment agreement, and did not sustain the levy. The Notice was dated on September 12, 2016, but the mailing date was unclear. (This is where the eventual dispute lies).

A petition was received by the Court on October 31, 2016. Clearly, this date is beyond the 30-day period in section 6330(d) to petition from a Notice of Determination. However, the Court found that the mailing date of the petition was October 13, 2016, as noted on the envelope. The mail must have been particularly slow then. This creates a much closer call.

The twist that I can’t quite figure out is that it’s the Service here that’s arguing for the Petitioner’s case to be saved, rather than the Petitioner, who doesn’t respond. The Service argues that, although the Notice was issued on September 12, it wasn’t actually mailed until September 13—which would cause the October 13 petition to fall within the 30-day period. The Service argues that because the Notice arrived at the USPS on September 13, that’s the mailing date.

But Judge Armen digs a bit deeper, noting that the USPS facility the Service references is the “mid-processing and distribution center”, and that it arrived there at 1:55a.m. Piecing things together, Judge Armen surmises that the certified mail receipt, showing mailing on September 12, must mean that the Notice was accepted for mailing by the USPS on September 12, and then early the next morning, sent to the next stage in the mailing chain. That means the Notice was mailed on September 12, and that accordingly, the Petition was mailed 31 days after the determination.

Helpfully for Petitioner, it looks as if decision documents were executed in this case, as Judge Armen orders those to be nullified. Perhaps the Service and the Petitioner can come to an agreement administratively after all, as Judge Armen suggests.

More on the Successful Challenge to the Anti-inversion Regulations

Today Professor Bryan Camp shares with us some of his views on the government’s loss in Chamber of Commerce v IRS, the challenge to Treasury’s anti-inversion regs that I discussed here.The case has been generating significant comment. For example, Professor Andy Grewal on the Notice & Comment blog nicely summarized the outcome and gave some additional context.

Below Professor Camp discusses why the court’s approach may be out of sync with traditional views of the Anti-Injunction Act. As Bryan suggests, the AIA battle is likely to be one where the Treasury may be able to circle the wagons and fend off early challenges to its rulemaking procedures. Les

I know everyone is chomping at the bit to get to the cool APA stuff, but I think the Anti-Injunction Act is the big issue here.  Or at least should be.  If I read the decision correctly (a big if), this appears to be a suit by an Association and they get standing only because one of their members believed that the regulation under attack would deny them a tax benefit they believed they would get absent this section 7874 regulation on inversion.

The court took an extremely narrow view of the Anti-Injunction Act, seeming to say that it only applies when a particular taxpayer seeks to contest an already assessed tax.  The court believed that ANY attack on the procedural validity of ANY regulation is permissible under the anti-injunction act.   The court says “Here, Plaintiffs do not seek to restrain assessment or collection of a tax against or from them or one of their members.  Rather, Plaintiffs challenge the validity of the 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.”

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That statement reflects a poor understanding of tax administration.  You could say that about ANY substantive tax reg.  Is the court really saying that ANY tax regulation can be attacked by any taxpayer whose taxes are potentially affected by the regulation???  That cuts against loads of precedent going at least as far back at Fleet Equipment Co. v. Simon, 76-2 U.S. Tax Cas. (CCH) P16,231 (D.D.C. 2976).  This is exactly the kind of suit that the Anti-Injunction Act is supposed to stop.

In contrast to substantive regs the courts have allowed suits to restrain implementation of regulations that go to tax administration, such as return preparer regulations or information reporting regulations.  Those cannot be attacked in a refund suit and they do not affect the self-reporting taxpayers of the taxpayers subject to them.  But the time and place to attack a substantive tax regulation is in a refund suit.  Gosh and golly.

If the TP here wanted to attack the regulation, it could do so in a refund suit if it takes a different position, gets audited, and wants to fight.  Sure, the regulation would be in place, but the TP would argue that the regulation gets zero deference because it was (allegedly) invalidly promulgated.  Without the regulation, the IRS would still take the same position on the return item but the court would be faced with the TP’s position and the IRS position, unsupported by the authority of a valid regulation.  Just like an assessment is not valid when not properly done.

 

Tax Court Reverses Course and Allows Taxpayers to Change Filing Status

Today we are privileged to have Tom Thomas as our guest blogger. Tom and I worked together for many years at Chief Counsel’s Office though we were never working together in the same office at the same time. When I retired, he was my boss’s, boss’s boss. Put another way, he was the head lawyer for all of the Chief Counsel attorneys in the SBSE stovepipe. These are the lawyers who primarily populate the field offices of Chief Counsel, who try the bulk of the Tax Court cases and who provide the collection advice to the IRS. Tom held that position for about a decade before he retired a couple of years ago. In retirement he found the pull to work in a low income tax clinic and he is now the Assistant Director of the Kansas City Tax Clinic. That clinic and the low income taxpayers of Kansas City are extremely lucky to have Tom providing assistance.

The case Tom discusses marks an important shift at the Tax Court in its approach to taxpayers who use the wrong filing status on their original return and want to shift to a correct and usually more favorable filing status in response to a notice of deficiency. As Tom discusses, the Court reaches its decision in a fully reviewed, precedential opinion. Although the issue has existed for decades and come before the Tax Court on several occasions, it had previously only addressed the issue in non-precedential memorandum opinions. The life of this issue in Tax Court opinions provides an interesting glimpse in how and when a case becomes precedential. Unfortunately, I cannot say that the glimpse makes the process any clearer to me.

The case also provides an important glimpse at what makes the Tax Court so wonderful. Judge Thornton provides a beautifully written law review like explanation of the history of the statute involving joint returns. He does this without the benefit of a much help from the petitioners who were pro se. I recently presented a paper to the Harvard faculty on access to judicial review in tax cases. I concluded in the paper that the best answer to the problem I perceived was to insure access to the Tax Court, and I drew a question from a professor on why I preferred to insure access to an Article I court rather than an Article III court. The Camara case is my answer. The Tax Court puts a lot of effort into finding the right answer for a pro se taxpayer on an issue that typically plagues low income taxpayers. While I do not always agree with the Tax Court, I am always impressed with the efforts it takes to insure equal justice for all taxpayers appearing before it. The opinion here is worth reading for the education it provides on filing status issues but also for the care it takes to find the answer with little help from the pro se taxpayers who appeared before it. Keith

In a fully reviewed opinion, a unanimous Tax Court held that petitioner Fansu Camara’s originally filed return, erroneously claiming “single” status, did not constitute a “separate return” under section 6013(b) and, thus, petitioner is not barred from filing a subsequent joint return. Camara v. Commissioner, 149 T.C. No. 13 (September 28, 2017). Section 6013(b)(2) bars a joint return for a married taxpayer who initially filed a separate return if either spouse received a notice of deficiency and files a petition with the Tax Court. Because Mr. Camara did not file a separate return within the meaning of section 6013(b)(2), he and his wife were entitled to file a joint return and enjoy joint tax rates and filing status.

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In holding for Mr. Camara, the Tax Court rejected its own precedent in several memorandum opinions, the most recent being Ibrahim v. Commissioner, T.C. Memo. 2014-8, rev’d and remanded, 788 F.3d 835 (8th Cir. 2015). In rejecting those memorandum opinions, Judge Thornton noted that the Tax Court has never addressed the issue in a reported or reviewed opinion. Further, Ibrahim was reversed by the Court of Appeals for the Eighth Circuit in 2015. Also, in Glaze v. United States, 641 F.2d 339 (5th Cir. Unit B Apr. 1981), aff’g 45 A.F.T.R2d (RIA) 80-740 (N.D. Ga. 1979), the Court of Appeals for the Fifth Circuit in 1981 held that a single return is not a “separate” return under section 6013(b). In light of these circuit court opinions, Judge Thornton concluded “that the importance of reaching the right result in this case outweighs the importance of following our precedent.”

This issue has been of interest to our clinics. Ibrahim was tried by a student attorney under the supervision of Professor Kathryn Sedo of the University of Minnesota Law School; the student also successful argued the case in the Eighth Circuit. Mr. Ibrahim had erroneously filed as head of household before filing a joint return with his spouse. If his HOH return was a separate return, as the IRS and the Tax Court found, he would have been precluded from claiming his earned income credit.

The Code and the regulations do not define “separate return” within the context of section 6013. The Tax Court found that the term means a return on which a married taxpayer has elected to file a married filing separate return, rather than a return on which a married taxpayer files a return with an incorrect filing status, that is, a single or head of household status. Judge Thornton reasoned that because section 6013(b)(1) refers to an “election,” an erroneous filing status impermissible under the Code cannot be an election. Further, the Tax Court’s exhaustive review of the legislative history reveals that the ability under the Code to switch from one allowable filing status to another was never intended to preclude one from correcting a return with an erroneous filing status.

Mr. Camara pursued his Tax Court case pro se. The case was submitted under Rule 122, that is, by stipulation without trial. The Tax Court ordered briefs, but Mr. Camara did not file one. It appears that the Tax Court was on the lookout for a vehicle to reconsider the issue.

Where do we go from here? Judge Thornton’s opinion in Camara is as well reasoned as it is taxpayer friendly. The next step is for IRS Chief Counsel’s office to decide whether to recommend that the Department of Justice appeal the opinion to the Sixth Circuit Court of Appeals or acquiesce in the Tax Court opinion. If the IRS acquiesces, it will issue an action on decision (AOD) and abandon its current postion. If it recommends an appeal, it will be up to the Department of Justice to decide whether to continue pursuing the issue. In either case, the Camara opinion is a big step forward for taxpayers.