Former IRS chief counsel tells taxpayers what to expect in tax litigation
EXCLUSIVE: Donald Korb, now of Sullivan & Cromwell, spent almost five years as chief counsel for the Internal Revenue Service (IRS) from 2004 to 2008. He is best known for developing the litigation strategy that led to the US government’s success in tackling tax shelter cases.
International Tax Review speaks exclusively with Korb to find out what taxpayers can expect from the IRS’s litigation strategy in the future, and why multinationals might be able to look forward to lighter-touch examinations.
International Tax Review (ITR): How do you think your experience as chief counsel of the IRS can help taxpayers now that you are in the private sector?
Donald Korb (DK) (pictured left): After almost five years as chief counsel for the IRS you get a good sense of how decisions are made, what the process is, and who the key decision makers will be for a particular issue. If you understand how the organisation works and how the process plays out it is easier to identify how you can impact it.
A lot of the present IRS litigation strategies and processes were developed when I was chief counsel so when the IRS developed its approach to the codification of economic substance, for example, I could almost predict the way they would deal with it.
ITR: Do you think the IRS’s litigation strategy has changed since your time there?
DK: What I called the “three-and-out” strategy is apparently still being used. This is where the IRS is faced with a group of similar cases and aims to win three cases as quickly as possible and then use those court victories as a basis for a “global” settlement of the issue.
The IRS is still trying to clean out a lot of the tax shelter-type issues and I think that will continue. When I was chief counsel, we formed joint IRS-Department of Justice teams to try some cases, and I think that approach is still being used.
Moving forward, I believe the IRS will focus on transfer pricing cases and try to select some good cases to litigate there once it finishes the remaining tax shelter cases. Another area we are seeing is the debt-equity/hybrid instrument cases.
A particular body of law has been built up in the past decade around tax shelter cases and it will be interesting to see how the IRS applies that judicially made law to more routine structured transactions in future cases.
I also think the IRS will switch its focus towards arguing substance over form as opposed to economic substance.
I think the IRS will stop using the economic substance argument as much because they have set up internal administrative processes that will inhibit the revenue agents from making the argument, and if you make it harder for the agents to do something, they won’t do it.
Another reason for the switch from one judicial doctrine to the other is that taxpayers and advisers responded to the economic substance doctrine and became much more careful about applying that particular judicial doctrine as they structured transactions, so there is less need for the IRS to use that doctrine.
ITR: What trends do you think we are seeing now in the types of cases the IRS is taking up and where it is being successful?
DK: The IRS seems to win almost all of its tax shelter cases, so that trend should continue.
If the IRS is focusing on cross-border transactions in particular, then we will be seeing more transfer pricing, debt-equity cases and hybrid instruments down the road. If the IRS is more selective in the cases it tries it might actually have a better chance of winning some of these cases
Another group of cases we will see more of is administrative law cases. I expect more efforts will be made by the Department of Justice in particular, to take the Mayo case and the line of cases that both preceded and followed it, to make arguments that once the IRS has spoken on a particular issue in a regulation, a court must accept it and give deference to the IRS interpretation, even though there might be other possible interpretations.
This makes it easier for the government to handle cases since they don’t have to go to trial and can just argue on a motion for summary judgment which resolves the case if the court accepts it.
We will see taxpayers raise the issue of whether the IRS followed its administrative procedures properly thereby opening up the possibility that regulations and rulings the IRS used are invalid.
ITR: Do you think taxpayers are looking to settle earlier now or are they happier to go through litigation?
DK: I think most taxpayers would want to settle earlier. Litigation is very expensive and time consuming, and can last a long time so taxpayers do not get certainty over an issue for a long period. But, if a taxpayer does not want to pay any increased tax because it thinks it is 100% right, it must either convince the revenue agent to drop an issue during the examination or go through litigation.
If you go back 10 or 15 years, taxpayers were more willing to fight things out over time, but in today’s world there is much more pressure to resolve disputes sooner rather than later.
However, uncertain tax positions will play a role in this because if a taxpayer adopts the position that it is going to win and does not set up a reserve so that it does not have to report it as an uncertain tax position, then if the IRS picks it up on examination the taxpayer will almost certainly have to litigate the issue as there will be no reserve to settle it.
ITR: What general advice could you give to taxpayers about how to avoid getting into a tax dispute with the IRS? How can you ensure a speedy resolution?
DK: I would encourage taxpayers to understand the IRS’s procedures. There is a whole series of alternative ways to resolve taxpayers’ issues and taxpayers ought to know how they work.
There is also the quality examination guide which lays out the best practices for conducting a large case examination. Taxpayers should become familiar with it because it provides all sorts of ways to resolve issues before they come up.
Taxpayers can get advance private letter rulings for a particular transaction or if a transaction is completed they can file a pre-filing agreement to try and resolve the issue before the tax return is filed.
Advance pricing agreements are also available for transfer pricing arrangements which can apply for up to five years. Finally, there is the compliance assurance programme (CAP) which is a real-time audit where taxpayers engage with the IRS during the tax year so that by the time the return is due all potential issues will have been resolved.
Once a taxpayer begins working through a dispute with the IRS, there is something called fast-track appeals which is a way to expedite appeals consideration for a case before it is formally referred to appeals, and that is something I see more and more companies taking advantage of.
ITR: What advice could you give to taxpayers about how to maintain a good relationship with the IRS when they become involved in a dispute with them?
DK: Be open and transparent and, more specifically, be timely when answering information document requests. Taxpayers should treat the revenue agents with respect, but be firm on their rights. If you know what you are doing, you can be cooperative, but do this in a way that protects your interests and doesn’t give things away.
Companies should always try to resolve things sooner rather than later while the tax people involved in an issue are still there, because there is a high turnover of top tax professionals in big companies. Taxpayers can deal with that by anticipating potential conflicts and bringing in a law firm to oversee audit preparation under a relationship which protects privileged information.
ITR: What do you think taxpayers can expect from the IRS in future?
DK: I expect more self-identification of issues by taxpayers since, in effect, the IRS is trying to get taxpayers to do its work for it by highlighting issues.
As part of that, you will also see the IRS relying more on third-party tax advisers to force the taxpayers to take pro-IRS positions. US accountancy firms are sometimes tougher on taxpayers than the IRS is because they are concerned about violating the rules set out by the oversight accounting board [Public Company Accounting Oversight Board].
The uncertain tax position is a great example of this. The idea is that if taxpayers have pressure coming from third parties to take more conservative positions and to report anything the IRS might be interested in, it will increase voluntary compliance.
Another trend is that for a period of time we will see large companies get a lighter touch from the IRS than they have received in the immediate past. This is partly down to the uncertain tax position reporting because the IRS thinks this will identify the major issues.
But I think the IRS desperately wants to move on and audit companies which are not the very largest, but in the next tier, which have not had much attention in the last five or 10 years.
Therefore, I think we will see a trend of shorter, more focused audits and we will see the IRS spending less time with big companies because they expect more and more for them to report their own potentially problematic transactions.