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

by and | Oct 26, 2023 | , , ,

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 , and | Jul 21, 2023 | , ,

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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Tax Court Says Pollution Control Systems Are Not Pilot Models, Rejects Tax Research Credits

by and | Jul 14, 2023 | ,

On July 6, 2023, the US Tax Court issued its decision in Betz v. Commissioner, T.C. Memo. 2023-84. Betz considers the application of the pilot model supply rule to expenses incurred by a designer (CPI[1]) of made-to-order air pollution control systems called oxidizers. At issue was approximately $500,000 of research and development tax credits pursuant to Internal Revenue Code (IRC) Section 41 on wage and supplies expenses for 19 different oxidizers that CPI produced under various purchase agreements or purchase orders. Generally, IRC Section 41 grants qualifying taxpayers federal income tax credits for increasing research activities, calculated with respect to the amount of “qualified research expenses” (QREs) incurred by the taxpayer during the tax year over a base amount. The statute is complex and has been the subject of substantial controversy between the Internal Revenue Service (IRS) and taxpayers since its enactment in 1981.

In Betz, CPI generally oversaw the component fabrication process and the assembly of the systems at its subcontractor facilities and then installed or oversaw installation of the oxidizer at the customer’s location. Testing of the oxidizers generally occurred after assembly or after installation. The supply expenses generally included the major components of the various oxidizers, all of which were fabricated by subcontractors. CPI claimed the credit based on a study performed by a tax consultancy group, the fees for which were capped at a percentage of the research credits identified.

The IRS challenged whether the taxpayer met the test in IRC Section 41 that the research must be research “with respect to which expenditures may be treated as expenses under [IRC] section 174.” (See IRC Section 41(d)(1)(A).) The Tax Court found that CPI failed to substantiate that the claimed wages and supplies constituted IRC Section 174 “investigative” activities. CPI’s primary evidence was in the form of testimony from CPI executives and supervisory personnel whom the Tax Court found to be “vague, in conflict with the record, and lacking in credibility[.]” Alternatively, the Tax Court found that, even assuming CPI engaged in IRC Section 174 research activities that gave rise to IRC Section 41 creditable expenses, five of the projects constituted funded research given CPI’s complete transfer of rights in the results of any such research to its customers.

Regarding the supply QREs, the Tax Court held that taxpayer intent was essential to determining whether its efforts to create a pilot model satisfy the “uncertainty” standard in IRC Section 174 regulations. In that regard, the taxpayer had to show “that its purpose in producing that representation or model was to evaluate and resolve uncertainty about the product (i.e., to obtain unavailable information necessary to establish capability, method, or appropriate design).” The taxpayer failed to make this showing. The Tax Court pointed to the lack of “early-stage” testing as an indication that the oxidizers were not used as pilot models but were, in fact, final products.

Practice Point: Betz demonstrates that the IRS continues to scrutinize claims of qualified research expenses. The Tax Court’s [...]

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With the IRS, Mail Delivery Counts!

by and | Jun 29, 2023 | , , ,

Over the years, case law has developed around when a mail delivery method is acceptable to prove that a tax filing was made.

The US Court of Appeals for the Fourth Circuit’s recent decision in Pond v. United States[1]  addresses how a taxpayer can prove delivery of a filing where the Internal Revenue Service (IRS) disputes physical delivery.

Stephen Pond, the taxpayer, filed two claims for refund in the same envelope. One claim pertained to his 2012 tax year and the other pertained to his 2013 tax year. The government acknowledged receipt of Pond’s 2012 claim. An IRS agent contacted Pond for more information in September 2017, after which Pond faxed a duplicate copy of his 2012 claim for refund but not his 2013 claim. In March 2018, the government issued a refund to Pond for his 2012 claim. However, after receiving no response about his 2013 claim, Pond again contacted the IRS. The IRS could not locate his claim for refund, so he faxed a duplicate copy of the 2013 claim.[2] Pond later received a “Notice of Denial” from the IRS informing him that it denied his 2013 claim for refund because the statute of limitations on claiming a refund or credit had expired.

Pond filed a refund suit in US federal district court, where the court dismissed his claim pursuant to Federal Rule of Civil Procedure 12(b)(6) for failure to allege facts upon which the court’s subject matter jurisdiction could be based. Stated differently, assuming all reasonable inferences in favor of the taxpayer, the district court ruled that the taxpayer’s pleadings did not sufficiently establish that he timely filed his 2013 claim for refund, a statutory requirement for the district court to have jurisdiction.

IRC Section 7502(a) creates a presumption of timeliness if a mailing sent by US Mail is postmarked before the deadline.[3] IRC Section 7502(c) creates a presumption of delivery, but only if the mailing is sent by US Postal Service (USPS) registered or certified mail.[4] Unfortunately, Pond sent his refund claims via USPS first-class mail, rather than registered or certified mail. Thus, he was not entitled to the presumption of delivery under IRC Section 7502. Further, according to the Fourth Circuit (and consistent with case law in the Second and Sixth Circuits), Pond could not rely upon federal common law principles because IRC Section 7502 supplanted the common law rule.[5] Thus, Pond needed more than the postmark alone to establish that he actually filed his 2013 claim for refund. He had to show that the claim for refund was physically delivered.

Nonetheless, Pond was entitled to present evidence to establish physical delivery. The Fourth Circuit cited three factual allegations that could establish a triable issue of fact. First, the envelope he claimed included the claim for a refund was postmarked. Although this fact is not sufficient in the case of mail sent by means other than USPS registered or certified, it was still evidence of [...]

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Tax Court Tells IRS It Cannot Assess or Collect Certain Tax Penalties

by , , and | Apr 26, 2023 | , , ,

On April 3, 2023, the US Tax Court issued its opinion in Farhy v. Commissioner, holding that the Internal Revenue Service (IRS) lacked the statutory authority to both assess tax penalties under Internal Revenue Code (Code) Section 6038(b) and collect said penalties via a levy against the taxpayer.

The decision in Farhy is significant because the IRS regularly assesses civil tax penalties for the late filing of international information return forms, such as Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations. Moreover, for any taxpayer who paid a penalty for filing Form 5471 late, arguably the assessment of that penalty was improper, and the taxpayer may be able to seek a refund of the penalty paid.

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IRS Proposes New Regulations to Settle Supervisory Approval of Penalties Requirements

by and | Apr 14, 2023 | , , , ,

The Internal Revenue Service (IRS) has proposed regulations to clarify the rules regarding supervisory approval of federal civil tax penalties under IRC Section 6751(b). Since Chai v. Commissioner, there has been a substantial number of cases litigating issues involving supervisory approval of federal civil tax penalties. Back in September, we posted about the US Court of Appeals for the Ninth and Eleventh Circuits split in which both Courts departed from long-standing US Tax Court precedence on the timing requirement of supervisor approval. Those two decisions, along with others, prompted this new guidance “to have clear and uniform regulatory standards.”

The proposed regulations address three timing rules: (1) penalties subject to pre-assessment review in the Tax Court; (2) penalties raised in the Tax Court after a petition and (3) penalties assessed without prior opportunity for Tax Court review.

Specifically, the proposed regulations allow supervisors to approve the initial determination of a penalty up until the time the IRS issues a pre-assessment notice, such as a Statutory Notice of Deficiency, which is the notice that provides taxpayers with a ticket to the Tax Court. The proposed regulations explain that “earlier deadlines created by the Tax Court do not ensure that penalties are only imposed where appropriate” and the “bright-line rule relieves supervisors from having to predict whether approval at a certain point will be too early or too late.” Additionally, penalties raised in the Tax Court after a petition is filed, such as an answer or an amended answer, would need supervisory approval any time prior to the penalty being raised. Supervisory approval for penalties not subject to pre-assessment review in the Tax Court may be obtained at any time prior to the assessment.

The proposed regulations require the approval of “the immediate supervisor,” which is defined as “any individual with responsibility to approve another individual’s proposal of penalties without the proposal being subject to an intermediary’s approval.” The term is also not limited to any particular individual.

Comments and requests for a public hearing must be received by July 10, 2023.

Practice Point: Penalties continue to be a hot topic in the tax controversy arena. The updated guidance promises to clarify and standardize the requirements of supervisory approval of IRS penalties, with the hope and expectation of reducing litigation on the issue. From the taxpayer’s perspective, ideally, the new regulations will enable examiners and managers the opportunity to thoroughly review the facts and circumstances of cases before deciding if penalties are warranted. We will continue to follow and report on any new developments.

Please see the links to our prior commentary on Code Section 6751 below:



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Tax Court Rules That the IRS Cannot Assess or Collect Certain Tax Penalties

by , and | Apr 5, 2023 | , , ,

On April 3, 2023, the US Tax Court issued its opinion in Farhy v. Commissioner, ruling that the Internal Revenue Service (IRS) could neither assess tax penalties under Internal Revenue Code (Code) Section 6038(b) against Alon Farhy nor collect those penalties via a levy.

This is a significant development because the IRS automatically assesses these penalties on any late-filed Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations. This practice will presumably be immediately ceased. Moreover, any taxpayer who was assessed and paid a penalty on a late-filed Form 5471 may be able to obtain a refund on the penalty paid.

Farhy had failed to file Form 5471 with his US federal income tax return. Failure to timely file Form 5471 comes with a civil tax penalty of $10,000 for each year. (See IRC Section 6038(b)(1).) If the IRS sends the taxpayer notice of its failure to file Form 5471, the taxpayer has 90 days after the notice is mailed to comply with the filing requirement. Failure to comply within the 90-day period subjects the taxpayer to an additional penalty of $10,000 for each 30-day period, with a $50,000 maximum. (See IRC Section 6038(b)(2).)

Code Section 6201(a) permits the IRS to “assess” taxes and assessable penalties. Assessment is the act of formally recording a tax liability on the IRS’s records for a taxpayer. After assessment and failure to pay, the IRS can enforce the collection of tax, penalties and interest by asserting a lien on property or by levying (taking) property.

The Code provides statutes that permit the IRS to assess taxes (including interest, additional amounts and additions to tax) and certain types of penalties (assessable penalties). In Farhy, the Tax Court held that the Code does not contain any statute that permits the IRS to assess the penalty provided in Code Section 6038(b). As such, although the IRS correctly determined that Farhy should be penalized for failing to file Form 5471 with his return, the IRS lacked the statutory ability under the Code to assess and collect the penalty under traditional assessment and collection procedures that they use for other penalties (essentially treated similar to deemed taxes).

The Tax Court did note that the government had other tools at its disposal to collect the penalties, for example, 28 U.S.C. § 2461(a): “Whenever a civil fine, penalty or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action.”

Practice Point: Farhy is a major taxpayer victory and demonstrates that a technical deficiency in the Code can have substantial ramifications for the administration of our tax laws and the potential collection of penalties relating to violations thereof. Clearly, Congress intended to permit the IRS the ability to collect the penalties determined under the Code but failing to connect Code Section 6038(b) with the statutory provisions to assess tax and penalties makes the IRS unable to practically and efficiently collect said penalties. We expect (and are [...]

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Supreme Court Punts on Attorney-Client Privilege Question

by , and | Feb 2, 2023 | , , , ,

In a surprising move, the Supreme Court of the United States (SCOTUS) dismissed a dispute involving the proper test to apply when determining whether an unnamed law firm’s mixed bag of communications involving both legal advice and discussions of tax preparation was privilege. The dismissal came less than two weeks after oral arguments, with SCOTUS stating that “[t]he writ of certiorari is dismissed as improvidently granted” (commonly known as a “DIG,” which infrequently happens when SCOTUS determines there is no conflict warranting review, one or both parties have changed their position, or no consensus can be reached by the Justices and dismissal is preferable to fractured opinions with no controlling rationale).

BACKGROUND

The law firm and an unnamed company were each served with subpoenas for documents and communication related to a criminal investigation. Both produced some documents but withheld others on the grounds of attorney-client privilege and the work-product doctrine. The government moved to compel production, which the district court granted in part, explaining that the documents were not protected by any privilege, and they were discoverable under the crime-fraud exception. The company and law firm continued to withhold the documents, and the government filed motions to hold them in contempt. The district court ruled that certain dual-purpose communications were not privileged because the “primary purpose” of the documents was to obtain tax advice, not legal advice. On appeal to the US Court of Appeals for the Ninth Circuit, the law firm and the company argued that the court should have relied on a broader, “because of” test, not the “primary purpose” test. The Ninth Circuit disagreed and concluded that the “primary purpose” test governs, and the primary purpose of the communications was tax advice. SCOTUS granted certiorari in October 2022.

SUPREME COURT

In its brief, the law firm asked SCOTUS to adopt a more expansive “significant purpose” test, which was applied by the US Court of Appeals for the District of Columbia Circuit in In re Kellogg Brown & Root, Inc. The law firm argued that the test applied in Kellogg “appropriately protects attorney-client dual purpose communications” and that the test “asks a single question that arises directly from the long-established test for attorney-client privilege: whether a client is seeking or obtaining confidential legal advice from his or her lawyer.”

The government argued that courts consistently emphasize the need to construe the attorney-client privilege narrowly and that the primary or predominant purpose test “thus molds the scope of the privilege to its purpose of encouraging effective legal advice, while avoiding sweeping in communications predominantly about a nonlegal matter.”

During oral argument, the Justices seemed skeptical of a need to change the test and expressed some confusion as to how any privilege analysis would change from a practice perspective. Justice Kagan invoked the saying “if it ain’t broke, don’t fix it.” Shortly thereafter, SCOTUS issued the DIG.

Practice Point: More [...]

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Tax Court Holds That Deficiency Petition 90-Day Time Limit Is Jurisdictional

by , and | Dec 1, 2022 | , ,

Last summer, the Supreme Court of the United States held that the 30-day time limit to file a Collection Due Process (CDP) petition is a non-jurisdictional deadline subject to equitable tolling (Boechler, P.C. v. Commissioner). (Our prior discussion of Boechler can be found here.) The natural follow-up issue was whether this holding extended to the 90-day limit for deficiency petitions.

On November 29, 2022, in a unanimous 17-0 opinion in Hallmark Research Collective v. Commissioner, the US Tax Court held that the 90-day time limit is jurisdictional not subject to equitable tolling. The taxpayer in that case filed its deficiency petition one day late but argued that the 90-day limit is non-jurisdictional under Boechler and that it should be allowed to show cause for equitable tolling of the limitations period.

The Tax Court analyzed the relevant statute (Internal Revenue Code (IRC) Section 6213(a)) and found that the statutory text, context and relevant historical treatment all confirmed that the 90-day time limit clearly provided that the deadline was jurisdictional. Its analysis started with the US Constitution and tracked the deficiency procedures from the days of its predecessor (the Board of Tax Appeals) through various statutory changes and the overall framework of the procedures. Based on its analysis of almost 100 years of statutory and judicial precedent, the Tax Court concluded that it and the US Courts of Appeals have expressly and uniformly treated the 90-day time limit as jurisdictional, and the US Congress was presumptively aware of this treatment and had acquiesced in it.

The Tax Court rejected the taxpayer’s arguments to the contrary. It noted that the Supreme Court in Boechler rejected the analogy of the statutory 30-day limit for a CDP petition to the statutory 90-day limit for a deficiency petition. The Court also provided separate reasons why the statutory 30-day time limit was different, both in its text and in prior judicial constructions from the 90-day time limit.

Practice Point: The Tax Court’s opinion in Hallmark will not be the last word on the issue, and we expect further developments in this area. Additionally, there are other types of petitions that can be filed in the Tax Court (e.g., so-called “innocent spouse” petitions filed in non-deficiency cases) that contain language different from the statutes addressed in Boechler and Hallmark. We will continue to follow this area and provide relevant updates as they develop.



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Supreme Court Denies Certiorari in Whirlpool

by and | Nov 21, 2022 | , , ,

On November 21, 2022, the Supreme Court of the United States denied certiorari in Whirlpool Financial Corp., et al., Petitioners v. Commissioner of Internal Revenue, No. 22-9. This means that the US Court of Appeals for the Sixth Circuit’s decision remains in effect and is binding on the taxpayers who reside in that circuit. However, for taxpayers in other circuits, the Sixth Circuit’s decision is only persuasive authority and not binding precedent. Thus, it remains to be seen whether taxpayers in other jurisdictions will challenge the result reached in Whirlpool, and if they do, how appellate courts outside the Sixth Circuit will rule.

Prior coverage of this case can be found below:



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