US authorities evolve approach to litigation
This past year has seen a number of important developments for US tax controversy and litigation. Some of these developments, particularly in the area of privilege, could have a significant and lasting impact on how taxpayers consider and plan for potential tax disputes with the IRS. David Forst, Andrew Kim and Zach Jones of Fenwick & West provide an overview.
Waiver of attorney-client privilege in reasonable cause defence
A recent development in the Tax Court case, Eaton Corp. v. Commissioner, Docket No 5576-12 (a complex case that includes many other issues yet to be decided), will have a significant impact on taxpayers that may wish to rely on the reasonable cause defence to accuracy-related penalties. As background, IRC § 6664(c) provides penalty relief to taxpayers for an understatement of tax, provided a taxpayer is able to show that there was a reasonable cause for such understatement and that the taxpayer acted in good faith. The Treasury regulations provide that the most important factor in determining whether a taxpayer has acted with reasonable cause and in good faith is the extent of a taxpayer's efforts to assess the proper tax liability. The regulations also state that reliance on professional advice may constitute reasonable cause and good faith.
The IRS asserted that Eaton was subject to an accuracy-related penalty for a gross valuation misstatement under IRC § 6662(h). In defence against the penalty, Eaton claimed that it had reasonable cause and acted in good faith under IRC § 6664(c).
At issue was Eaton's claim that certain documents were protected from discovery by the IRS due to the attorney-client privilege, the federal tax practitioner privilege under IRC § 7525, and the work product doctrine. Eaton asserted that the disputed documents were prepared by its internal and external tax advisers in the course of adversarial administrative proceedings with the IRS, and reflected confidential communications made by the taxpayer for the purpose of obtaining tax or legal advice. The IRS contended that the documents were not protected from discovery and, in any event, that the taxpayer had waived any privilege or protection by asserting that it had reasonable cause and acted in good faith in reporting its tax liability for the years in issue.
The Tax Court agreed with the IRS, and issued an order compelling Eaton to produce the disputed documents. The Court held that Eaton had waived privilege because Eaton's reasonable cause defence put into contention the subjective intent and state of mind of parties who acted for Eaton and Eaton's good-faith efforts to comply with the tax law. According to the court, it would be unfair to deprive the government of knowledge of the legal and tax advice that Eaton received in the course of requesting and negotiating its advanced pricing agreement. The court stated that a reasonable cause/good faith defence under IRC § 6664(c) is dependent upon a review of all the pertinent facts and circumstances, and that Eaton's communications with its attorneys and tax practitioners may be the only probative evidence of the state of mind or knowledge of the persons who acted on Eaton's behalf.
The Tax Court's ruling is unfortunate, in that it may substantially limit the practical usefulness of the reasonable cause and good faith defence, which is provided for by statute. If claiming a reasonable cause and good faith defence under IRC § 6664(c) means having to waive privilege protection for otherwise confidential communications and documents, taxpayers may be much more reluctant to assert the defence. This appears to be more than just a theoretical concern, as at least one taxpayer in another case (Illinois Tool Works, Inc. v. Commissioner, Docket No 10418-14) appears to have withdrawn its reasonable cause and good faith defence to penalties in light of the Tax Court's recent order in Eaton.
IRS use of private law firm in Microsoft
In a seemingly unprecedented development, the IRS has hired a law firm, Quinn Emanuel Urquhart & Sullivan, to assist the IRS in its case against Microsoft in Federal District Court (Microsoft Corp. v. Commissioner, case No 2:15-cv-00102-RSM). According to court documents, the IRS has hired Quinn Emanuel to "support continued development, analysis, and preparation of the issues under examination"… in other words, a very broad set of duties. While the IRS frequently uses experts on cases, this is apparently the first time that the IRS has used a private law firm to assist on case development. Moreover, it likely will not be the last time. Just one month after the IRS entered into its contract with Quinn Emanuel, new temporary and proposed regulations (Treas. Reg. § 301.7602-1T(b)(3)) were released that permit private contractors to "receive books, papers, records, or other data summoned by the IRS and take testimony of a person who the IRS has summoned as a witness."
On June 17 2015, the court granted Microsoft's request for an evidentiary hearing regarding Quinn Emanuel's role. Microsoft is seeking further factual development to build a case that the IRS's use of Quinn Emanuel was an abuse of the court's procedures, as well as an improper delegation of the tax audit to the law firm. In its order, the court noted that Microsoft had raised plausible arguments that the temporary regulation allowing third parties to participate and receive information in connection with an IRS summons is invalid, both for possibly exceeding the delegation of authority granted to the Secretary to conduct audits under IRC § 7602(a)(1)-(3), as well as for possibly violating certain sections of the Administrative Procedure Act, which requires, among other things, that regulations be issued with proper notice and comment procedures. The court also notes that the issuance of the regulation shortly after the IRS's contracting with Quinn Emanuel "plausibly raises an inference of improper motive" in adopting the regulation.
The IRS has received considerable backlash from the tax community at large and, more recently, from Congress. In hearings in April of this year, members of the House Ways and Means Oversight Subcommittee sharply questioned IRS Commissioner John Koskinen on the matter.
The question remains as to whether this unprecedented move by the IRS will become the new norm. Certainly, the answer to that will largely depend on whether the IRS's use of Quinn Emanuel or its promulgation of the temporary regulation under § 7602 are found to be improper.
Altera Corp. v Commissioner, 145 T.C. No. 3 (July 27 2015)
The Tax Court has issued a resounding victory for the taxpayer in Altera that has important implications for transfer pricing cases, as well as on the intersection of tax and administrative law in the United States. In Altera, at issue was the validity of the 2003 cost-sharing regulations, which amended the 1995 cost sharing regulations by requiring controlled parties entering into qualified cost sharing agreements (QCSAs) to share costs related to stock based compensation. Treas. Reg. § 1.482-7(d)(2) (2003). The Court had previously determined in Xilinx v. Commissioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010), that such costs were not required to be shared under the 1995 cost-sharing regulations (which did not specifically mention stock based compensation) because parties operating at arm's-length would not do so.
The Court held that the regulation requiring controlled parties to share stock based compensation in a QCSA was invalid because it did not comply with the "reasoned decision-making" standard set forth in Motor Vehicle Mfrs. Ass'n of the US v State Farm Mut. Auto Ins. Co, 463 US 29 (1983). That standard, which stems from the Administrative Procedure Act, requires administrative agencies, before acting, to examine relevant evidence and to articulate a satisfactory explanation, including a "rational connection between the facts found and the choice made". State Farm, 463 US at 43 (internal citations omitted). The Court held that, in promulgating the 2003 cost-sharing regulations, the IRS did not properly consider evidence as to whether third parties shared the costs of stock based compensation at arm's-length. Thus, Altera reinforces that the arm's-length standard is based on facts and not conjecture, and also affirms that the IRS – like other government agencies – is subject to the reasoned decision-making standard.
Transfer pricing: IRS choosing to litigate
As has been the case in recent years, transfer pricing disputes are at the forefront of US tax controversy. Based on recent statements by the IRS's former chief economist, Bill Morgan, the prominence of transfer pricing disputes is only likely to rise. Morgan stated that the IRS views litigating transfer pricing cases as preferable to a lengthy and challenging effort to revise the cost sharing regulations. Morgan also stated that the IRS is intent on bringing better cases to court, especially cost sharing buy-in cases (such as Amazon and Microsoft).
Other important cases
Amazon.com v Commissioner, Docket No 31197-12
The Amazon.com case is a Tax Court case that involves a cost sharing agreement with allocated amounts of more than $1 billion for each of the two years in issue. The primary issues in Amazon.com are similar to the issues that were resolved in favour of the taxpayer in Veritas v Commissioner, 133 T.C. 297 (2009). As it did in Veritas, the IRS is asserting that the intangible property that was made available in Amazon's cost sharing arrangement has a perpetual useful life. Notably, the Tax Court rejected this argument in Veritas, where the IRS lost. Although the IRS has asserted that the holding in Veritas is limited to the facts in that case, it would seem difficult for the IRS to successfully argue for a perpetual useful life for technology intangibles, which are always evolving and subject to obsolescence. A Tax Court trial, which was closed to the public, took place in November 2014.
BMC Software Inc v Commissioner, 780 F.3d 669 (5th Cir. 2015)
The Fifth Circuit in BMC Software reversed a Tax Court decision, holding that the taxpayer's dividends received deduction under IRC § 965 was not reduced by reason of an IRC § 482-related repatriation under Rev. Proc. 99-32. Although the one-time dividends received deduction under IRC § 965 is no longer available to taxpayers, the Fifth Circuit's decision in BMC is important because it reverses a lower court decision that would have resulted in the inappropriate creation of indebtedness under other sections of the Internal Revenue Code, which could have impacted countless taxpayers. The IRS continues to litigate this same issue outside of the Fifth Circuit, however, so further developments on this issue are expected.