Court Procedure Matters Archives - TAX CONTROVERSY 360

Court Procedure Matters

Supreme Court Overrules Chevron, Opening Door for New Tax Reg Challenges

by Timothy S. Shuman, Susan E. Ryba, Parisa M. Griess and Samuel J. Preston | Jul 10, 2024 | Court Procedure Matters

On June 28, 2024, the Supreme Court of the United States reshaped the federal tax landscape when it overturned the long-standing Chevron doctrine in Loper Bright Enterprises v. Raimondo, No. 22-451. The Chevron doctrine, a pillar of US administrative law for four decades, required courts to defer to an agency’s reasonable interpretation of an ambiguous statute even where the court concluded that a different interpretation was better supported.

By ending the Chevron doctrine, Loper Bright has created new opportunities for taxpayers to challenge federal tax regulations. While taxpayers have long challenged federal tax regulations, Chevron’s deferential regime hampered many challenges to tax regulations because where there was statutory ambiguity or silence, courts generally deferred to agency interpretations. Loper Bright has evened the playing field between taxpayers and agencies because now both must convince courts that their interpretation of the statute is the best interpretation.

Supreme Court Rules Against Taxpayers in IRC Section 965 Case

by Kevin Spencer, Evan Walters and Samuel J. Preston | Jun 21, 2024 | Court Procedure Matters, Trial Courts

On June 20, 2024, the Supreme Court of the United States issued a 7-2 opinion in Moore v. United States, 602 U.S. __ (2024), ruling in favor of the Internal Revenue Service (IRS).

Moore concerned whether US Congress and the IRS could tax US shareholders of controlled foreign corporations (CFCs) on those corporations’ earnings even though the earnings were not distributed to the shareholders. The case specifically focused on the so-called “mandatory repatriation tax” under Internal Revenue Code (IRC) Section 965, a one-time tax on certain undistributed income of a CFC that is payable not by the CFC but by its US shareholders. Some viewed the case as hinging upon whether Congress has the power to tax economic gains that have not been “realized.” (i.e., In the case of a house whose value has appreciated from $500,000 to $600,000, the increased value is “realized” only when the house is sold and the additional $100,000 reaches the taxpayer’s coffers.)

However, Justice Brett Kavanaugh, joined by Chief Justice John Roberts and Justices Sonia Sotomayor, Elena Kagan and Ketanji Brown Jackson, rejected that position on the ground that the mandatory repatriation tax “does tax realized income,” albeit income realized by a CFC. On this basis, they reasoned that the question at issue was whether Congress has the power to attribute realized income of a CFC to (and tax) US shareholders on their respective shares of the undistributed income. This group of justices ultimately decided Congress does have the power.

The majority went out of its way to avoid expressing any opinion as to whether Congress can tax unrealized appreciation, with Justice Amy Coney Barrett’s concurrence and Justice Clarence Thomas’s dissent asserting that it cannot. Perhaps the Court was signaling a distaste for the Billionaire Minimum Income Tax proposed by US President Joe Biden, which would impose a minimum 20% tax on the total income of the wealthiest American households, including both realized and unrealized amounts, among other Democratic proposals.

Practice Point: We previously noted that certain taxpayers should consider filing protective refund claims contingent on the possibility that Moore would be decided in favor of the taxpayers. In light of the case’s outcome, however, those protective claims are now moot.

United States v. Eaton: IRS Summons Power Overrides EU Privacy Laws

by Edward L. Froelich and Susan E. Ryba | May 31, 2024 | Court Procedure Matters, IRS Audits, Trial Courts

A US federal district court judge recently endorsed the broad investigative powers of the Internal Revenue Service (IRS) in United States v. Eaton Corp., No. 1:23-mc-00037, May 16, 2024 (N.D. Ohio). During its audit of Eaton’s transfer pricing of a royalty arrangement with Eaton’s Irish affiliate, the IRS sought performance evaluations of certain employees of the affiliate. Eaton declined to provide the evaluations citing relevancy and legal objections based on EU privacy laws. The IRS subsequently served Eaton with an administrative summons seeking the evaluations.

In the ensuing summons enforcement action, Eaton initially prevailed before a magistrate judge on both grounds. However, the IRS persuaded the district court judge to reject the magistrate’s recommendation and enforce the summons.

The district court judge rejected Eaton’s position that a heightened relevancy standard applies when the IRS seeks personal information, such as employee valuations. The judge distinguished between civil discovery disputes where such a standard might apply and summons enforcement disputes, which engage the broad authority of the IRS to seek information that may be relevant to its audit. While the IRS’s case for relevancy could have been stronger, the judge nonetheless found that the IRS had sufficiently supported the connection between potential information in the evaluations and its audit of the royalty arrangement.

The district court judge also ruled that the European Union’s General Data Protection Regulation (GDPR) did not bar the IRS’s legitimate exercise of its audit powers. The judge acknowledged that the GDPR generally prohibits the transfer of personal information, such as employee valuations, outside of the EU. However, the judge also found that exceptions to that prohibition applied where the IRS properly requested the information as part of its audit function and the EU Member State (in this case Ireland) had entered into a treaty with the United States that addressed corporate cross-border relationships and sought generally to combat tax evasion by resident entities. Comity concerns did not prevent enforcement of the summons according to the judge.

Practice Point: Given the effort the IRS expended in this case to obtain marginally relevant information, we clearly see the effects of increased audit resources at work and of the IRS’s mandate to target large corporate taxpayers. While there are certainly instances in every audit where a taxpayer should not expend resources just to fight a battle, the difficulty in cases like this is that absent this decision, Eaton likely felt bound to adhere to the GDPR for the sake of the employees working for its Irish affiliate.

Understanding the IRC’s Excessive Refund Claim Penalty

by Kevin Spencer, Edward L. Froelich and Samuel J. Preston | May 8, 2024 | Court Procedure Matters, IRS Audits, Tax Refunds, Trial Courts

Recently, the Internal Revenue Service (IRS) has been asserting the Internal Revenue Code Section 6676 penalty much more frequently in examinations and in court. For example, in 2023, a government counterclaim in the US District Court for the Middle District of Georgia sought to recover Section 6676 penalties in Townley v. United States. And, internal IRS guidance requires examiners to consider whether to assert the penalty in every case in which a refund is disallowed.

In light of these factors, and major questions being raised in high-profile tax cases like Moore v. United States, which is currently pending before the Supreme Court of the United States, taxpayers are wondering whether the penalty can be asserted as a protective refund claim.

IRS (Belatedly) Strikes Back Against FedEx in Ongoing Foreign Tax Credit Case

by Edward L. Froelich | Mar 14, 2024 | Court Procedure Matters, Trial Courts

FedEx Corporation, previously the victor in a closely watched dispute regarding the government’s regulatory attempt to prevent taxpayers from claiming foreign tax credits on offset earnings (131 AFTR 2d 2023-1284 (W.D. Tenn. 2023)), recently filed a motion for judgment in the US District Court for the Western District of Tennessee to confirm its resulting refund amount. FedEx says it filed the motion because the government ended negotiations for a joint proposal of judgment, told FedEx to file a motion and said it would oppose the motion based on a new argument that would reduce FedEx’s refund amount. The government did not provide a written description of its new argument, so FedEx forged ahead with what it could gather based on conversations with the government and filed its motion on March 8, 2024.

According to FedEx, the government’s new argument appears to rest on a different regulation (Treasury Regulation Section 1.965-5(c)(1)(i)), which limits foreign tax credits by withholding taxes paid to a foreign jurisdiction. This is known as the “Haircut Rule.” FedEx provides several reasons why the government’s argument based on the Haircut Rule should be rejected, including that the rule cannot apply where a taxpayer did not claim foreign tax credits based on withholding taxes, that the rule itself is procedurally deficient under the Administrative Procedure Act and that the government is simply too late in presenting the argument.

Practice Point: Given the late stage of the litigation, the government will likely face headwinds to get the court to consider its argument of whether the Haircut Rule applies. It is unclear from the motion how transparent the government was with the court while the parties attempted to reach a mutually agreeable refund computation. However, it appears fairly clear that the government could have argued the Haircut Rule as an alternative to its main position throughout the course of the 2023 briefing before the court. As with any argument newly conceived in the heat of litigation, parties should carefully consider the consequences of waiting to bring the argument to the court’s attention (with one of those consequences being that such new argument is rejected for dilatoriness).

Tax Court Rules Limited Partners May Be Subject to Self-Employment Tax

by Kevin Spencer and Samuel J. Preston | Dec 1, 2023 | Court Procedure Matters, Trial Courts

On November 28, 2023, the US Tax Court granted partial summary judgment in favor of the Internal Revenue Service (IRS) in Soroban Capital Partners LP v. Commissioner and held that “limited partners” are defined functionally—not by state law—for purposes of Internal Revenue Code (IRC) Section 1402(a)(13), which excludes distributions to a “limited partner, as such” from self-employment tax.

Partners are generally required to include their distributive shares of partnership income in their net earnings from self-employment under IRC Sections 1402(a) and 702(a)(8). IRC Section 1402(a)(13), however, provides an exception. It excludes “the distributive share of any item of income or loss of a limited partner, as such, other than [certain] guaranteed payments” from self-employment tax. However, in the context of IRC Section 1402(a)(13), “limited partner” is not defined. The Tax Court previously held that “limited partners” are determined functionally (e.g., by what they actually do with respect to the partnership), not by their status or title under state law, in the context of a limited liability partnership. (See Renkemeyer v. Commissioner, 136 T.C. 137 (2011).) Soroban argued that in the distinct context of a limited liability partnership, plain statutory meaning, legislative history, past guidance from the US Department of the Treasury (Treasury) and the IRS, and policy considerations all pointed to the same conclusion: “limited partner” for purposes of the self-employment tax must be determined by reference to state law.

The Tax Court disagreed. The Court fixed its attention on the phrase “limited partner, as such” and found that under the canon of construction against surplusage, the words “as such” demonstrate “that the limited partner exception applies only to a limited partner who is functioning as a limited partner.” To the extent legislative history or Soroban’s “myriad other arguments” suggest otherwise, they cannot “overcome the plain meaning of the statute.”

The Tax Court held that IRC Section 1402(a)(13) applies only to “passive investors” and excludes “earnings from a mere investment” only. Therefore, the Court “must examine the functions and roles of the limited partners in the partnership to determine whether their shares of earnings are excluded from net earnings from self-employment.” The Court concluded that it has jurisdiction to complete this task during partnership-level proceedings because the applicability of IRC Section 1402(a)(13) “is a partnership item” under Treasury Regulation § 301.6231(a)(3)-1.

Practice Point: The Court’s holding in Soroban will likely provide the IRS with additional incentive to audit taxpayers as part of the IRS’s Self-Employment Contributions Act compliance campaign, which the IRS placed on hold to see “what develops in” cases like Soroban. This issue has been hotly contested in the Tax Court, with several cases currently being litigated, including Denham Capital Management LP v. Commissioner, Docket. No. 9973-23, and Point72 Asset Management LP v. Commissioner, Docket. No. 12752-23. We will see whether the taxpayer in Soroban seeks review by an appellate court. In the meantime, if you have this issue, we advise consulting with your tax professional to ensure you are poised to [...]

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Taxpayer Loses Claim for Research Credit

by Edward L. Froelich | Nov 30, 2023 | Appellate Courts, Court Procedure Matters, Trial Courts

In United States v. Grigsby, Docket No. 22-30764, the US Court of Appeals for the Fifth Circuit held that a refund claim based on claimed Internal Revenue Code (IRC) Section 41 credits was erroneous. Cajun Industries LLC, a subchapter S corporation, filed a refund claim that identified four highly specialized construction projects (two refineries and two flood control systems) as “business components,” which, in turn, gave rise to qualified research expenses (QRE). Cajun fabricated the systems under four separate contracts. The Internal Revenue Service (IRS) granted the claim and issued the refund (ultimately to Cajun’s shareholders who are the taxpayers in this case) but later regretted the decision and filed a suit for recovery of an erroneous refund under IRC Section 7405. The decision turned on two main factors:

A failure to plead
The funded contract exception under IRC Section 41(d)(4)(H)

PLEADING FAILURE

After discovery, the parties prepared for trial and moved for summary judgment. In its motion for summary judgment (and about a month before trial), for the first time in the litigation, the taxpayers identified certain construction processes as additional “business components,” giving rise to the claimed QRE. The Fifth Circuit held that the district court did not abuse its discretion by declining to consider these new processes as “components” in support of the claimed QRE. In short, the taxpayer was too late and paid the price for its delay. One taxpayer faced a similar problem in 2000 when it sought to put into evidence additional QRE beyond the amount described in its detailed refund claim. There, the Federal Circuit cited the doctrine of variance (i.e., a taxpayer must provide adequate notice of the grounds of the refund claim and any substantial variance from those grounds is not permitted in litigation) and declined to put the additional QRE into evidence. Variance may not have been applicable in the Grigsby case because the refund claim was reviewed and issued, but the taxpayers could have improved their position in court by including the construction processes at the beginning of the litigation or at the latest during discovery.

FUNDED EXCEPTION

The Fifth Circuit then analyzed the four contracts and focused particularly on terms pertinent to the ownership of research results and whether payment to Cajun was contingent upon success of its research. (Regulations promulgated under IRC Section 41(d)(4)(h) provide that research is funded and thus not eligible for the credit if the researcher does not retain substantial rights in its research.) The Court held that three of the contracts awarded sole rights in the research to the customer and removed any substantial rights from Cajun. The fourth contract (firm fixed price) was simply considered “funded” because payment was not contingent upon the success of any research performed by the taxpayer. The Court also rejected a Fairchild risk argument negating the funded nature of this fourth contract.

In general, regarding the three contracts, it’s not clear that Cajun retained zero substantial rights in its research. For [...]

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Federal District Court Rules Codified Economic Substance Doctrine Vitiates Tax Transaction Benefits

by Timothy S. Shuman, Kevin Spencer and Samuel J. Preston | Nov 3, 2023 | Court Procedure Matters, Trial Courts

On October 31, 2023, the US District Court for the District of Colorado, in Liberty Global, Inc. v. United States, applied the codified economic substance doctrine and held—on summary judgment—that Liberty Global, Inc. (LGI) must recognize $2.4 billion in taxable gain. At issue was a four-step transaction that took place in 2018, as a result of which LGI took the position that a dividends received deduction offset a $2.4 billion taxable gain based on a purported “mismatch” between (1) the rules for taxation of global intangible low-taxed income (GILTI) or subpart F income of a controlled foreign corporation (CFC) and (2) the qualification of an entity as a CFC.

In rejecting what it described as LGI’s “scheme” to “exploit” the apparent mismatch, the Court made three preliminary holdings. First, LGI argued that the prefatory clause in Internal Revenue Code (IRC) section 7701(o)—“[i]n the case of any transaction to which the economic substance doctrine is relevant”—requires courts to conduct a threshold analysis into whether the economic substance doctrine is “relevant” to the transaction at issue, and only then can courts consider whether the transaction has “economic substance.” The Court rejected this argument, stating that “there is no threshold ‘relevance’ inquiry that precedes the inquiry” into a transaction’s economic substance. Instead, “the doctrine’s relevance is coextensive with the statute’s test for economic substance.” Second, the Court held that the proper unit of analysis is “the transaction in aggregate” and did not analyze any step or phase in isolation, even if it could be said that the tax benefit at issue was “created” because of a particular step. And third, the Court denied LGI’s contention that its transaction falls under any exception to the economic substance doctrine. The Court determined that LGI’s transaction was not a “basic business transaction” and, although a series of transactions that constitute a corporate organization or reorganization might fall outside the economic substance doctrine, a series of transactions that merely includes a reorganization is not necessarily exempt.

The Court then applied the economic substance doctrine. LGI conceded that steps one through three “did not change, in a meaningful way, LGI’s economic position,” so the Court considered whether the steps had a substantial, non-tax purpose. LGI asserted that the transaction was “in furtherance” of Belgian corporate law requirements, but the Court found LGI had failed to indicate how the transaction facilitated such compliance. Moreover, an action may be “in furtherance” of some end without being a “substantial purpose” of the action, as IRC Section 7701(o) requires. Even if an isolated step provided substantial, non-tax benefits for LGI, that does not suggest the existence of a non-tax purpose for “the entire scheme.” Thus, the Court held that “the only substantial purpose of the transaction was tax evasion.”

The Court concluded that steps one through three of the transaction must be disregarded under federal law, resulting in $2.4 billion of taxable gain on LGI’s sale of its subsidiary during step four without such gain being converted to a dividend and [...]

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Court Rules Taxpayer Can Offset Foreign Tax Credits With NIIT Liability Under Tax Treaty

by Steven Hadjilogiou and Le Chen | Oct 26, 2023 | Court Procedure Matters, Tax Reform, Tax Refunds, Trial Courts

In 2013, the net investment income tax (NIIT) found in Internal Revenue Code (IRC) Section 1411 went into effect. Since then, United States taxpayers residing outside of the US have lived with uncertainty as to whether the taxes they pay in their local country can be used as a tax credit to offset the NIIT. A recent court decision held that certain tax treaties may allow for US foreign tax credits (FTCs) to be applicable, allowing eligible taxpayers to seek refunds for potentially up to 10 years of paid NIIT.

On October 23, 2023, in Christensen v. United States, the US Court of Federal Claims ruled that two US citizens residing in France were permitted, under a tax treaty between the US and France, to use FTCs arising from French income tax liability to offset NIIT liability. Christensen is the first case to hold that, although FTCs cannot be used to offset NIIT liability under US domestic law, this restriction can be overridden by a US-France tax treaty provision, which is replicated in many US tax treaties, that provides broader FTC coverage for US citizens residing abroad.

The taxpayers in Christensen were married US citizens residing in France. The taxpayers earned income that was subject to both French income tax and (by virtue of their US citizenship) US federal income tax, including the NIIT. On their US federal income tax return, the taxpayers netted the FTCs arising from their French income tax liability against their NIIT liability, relying on Articles 24(2)(a) and 24(2)(b) of the US-France tax treaty for support.

Article 24(2)(a) of the treaty is a general provision that provides that the US shall grant its citizens a credit against US federal income tax for French income taxes paid “[i]n accordance with the provisions and subject to the limitations of the law of the United States.” In Christensen, the Court of Federal Claims noted that the NIIT was a tax imposed by IRC Chapter 2A and that the FTC provisions in IRC Section 901 et seq. restricted FTCs from offsetting US federal income tax liability arising under IRC Chapter 1. Therefore, the Court held that Article 24(2)(a) did not permit the taxpayers to use FTCs to offset NIIT liability because granting FTCs under Article 24(2)(a) was “subject to the limitations of the law of the United States,” including the limitation that FTCs could not offset liability incurred pursuant to Chapter 2A. This holding was consistent with holdings in two other recent cases that also addressed the interaction of FTCs and NIIT: Toulouse v. Commissioner, 157 T.C. 49 (2021), and Kim v. United States, 2023 WL 3213547 (C.D. Cal. Mar. 28, 2023).

However, Article 24(2)(b) of the treaty contains a special provision applicable to US citizens residing in France. This provision generally provides that, when applying the “three bites” rule for determining the order in which US and French FTCs are applied with respect to such persons, the US shall grant such persons a credit against US [...]

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Can the Government Sue for Tax Debts Outside Internal Revenue Code Procedures?

by Kevin Spencer, Edward L. Froelich and Evan Walters | Jul 21, 2023 | Appellate Courts, Court Procedure Matters, Trial Courts

On June 1, 2023, in United States v. Liberty Global, Inc., the US District Court for the District of Colorado held that the US Department of Justice (DOJ) can assert and seek judgment for federal income tax deficiencies using a common law right of action, bypassing the usual statutory tax deficiency procedures outlined in the Internal Revenue Code (IRC). This decision might encourage the DOJ to seek tax collections through court judgments moving forward without following the IRC’s deficiency procedures.

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