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APA Challenge to Notice of Deficiency: QinetiQ Affirmed

by and | Jan 10, 2017 | , , ,

On January 6, 2017, the US Court of Appeals for the Fourth Circuit, by published opinion, affirmed the US Tax Court’s (Tax Court) earlier ruling in QinetiQ US Holdings, Inc. v. Commissioner.  We previously wrote about the case here, here, and here.  To refresh, the taxpayer had argued in Tax Court that the Notice of Deficiency issued by the Internal Revenue Service (IRS), which contained a one-sentence reason for the deficiency determination, violated the Administrative Procedure Act (APA) because it was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”  The APA provides a general rule that a reviewing court that is subject to the APA must hold unlawful and set aside an agency action unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing court. The Tax Court disagreed, emphasizing that it was well settled that the court is not subject to the APA and holding that the Notice of Deficiency adequately notified the taxpayer that a deficiency had been determined under relevant case law.  The taxpayer appealed to the Fourth Circuit.

In an opinion written by Circuit Judge Barbara Keenan, the court concluded that the IRS complied with all applicable procedural requirements.  The court reasoned that the Internal Revenue Code (Code) provided a unique system for judicial review that should govern the content requirements for a Notice of Deficiency.  Per the court, it “is that specific body of law, rather than the more general provisions for judicial review authorized by the APA, that governs the content requirements of a Notice of Deficiency.”  The court cited a Fourth Circuit opinion from 1959, in which it held that the Code’s provisions for de novo review are incompatible with limited judicial review of final agency actions allowed under the APA.

The court held that the APA’s requirement of a reasoned explanation in support of a “final” agency action does not apply to a Notice of Deficiency issued by the IRS.  A Notice of Deficiency, the Court reasoned, cannot be a “final” agency action within the meaning of the APA, because the agency action is not one “by which rights or obligations have been determined, or from which legal consequences will flow.”  After issuing a Notice of Deficiency, the IRS may later assert in Tax Court new theories and allege additional deficiencies.  Moreover, a taxpayer may also raise new matters in Tax Court.  In addition, the court cited to the Supreme Court’s 1988 opinion in Bowen v. Massachusetts, emphasizing that Congress did not intend for the APA “to duplicate the previously established special statutory procedures relating to specific agencies.”

The court also held that the Notice of Deficiency issued to QinetiQ satisfied the requirement of Code section 7522(a), which requires that the IRS “describe [in the Notice] the basis for, and identify the amounts (if any) of, the tax due, interest, additional amounts, additions [...]

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Court Opinions – A Year In Review

by | Jan 4, 2017 | , , , ,

Several notable court opinions were issued 2016 dealing with a variety of substantive and procedural matters. In our previous post – Tax Controversy 360 Year in Review: Court Procedure and Privilege – we discussed some of these matters. This post addresses some additional cases decided by the court during the year and highlights some other cases still in the pipeline.

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Court Holds that Willful Failure to File FBAR Standard is the Lesser Standard of Recklessness

by | Dec 19, 2016 | , ,

On December 2, 2016, the US District Court for the Central District of California found that taxpayers who failed to file a Report of Foreign Bank and Financial Accounts (FBARs) for three foreign accounts, one of which, in the court’s view, was intentionally kept secret from all persons except their children, for over a decade were “at least recklessly indifferent to a statutory duty.” Read more about the case here. The court found that the taxpayers were “sophisticated,” pointing to evidence that they ran a successful camera shop, and that they lacked credibility having made several misrepresentations on their failed attempt to apply to the Offshore Voluntary Disclosure Program (OVDP) and for making unbelievable assertions at trial. The court did not apply the heightened standard of willfulness applicable to criminal trials, a violation of a known legal duty, finding that civil trials apply the lesser standard of reckless disregard of a statutory duty. Additionally, the court rejected the defendants’ argument that the government had to show willfulness under the clear and convincing standard of proof and applied the typical civil preponderance of the evidence standard of proof. The taxpayers’ lawyer has stated that they will appeal the decision.

Practice note: Ensuring that OVDP applications are complete and truthful is crucial to their acceptance and, as demonstrated here, can and will be used against the taxpayer in any later proceedings. The taxpayers in this case had a number of factors working against them, and, as shown here, offshore reporting cases will often turn on their own specific facts. As more and more FBAR enforcement cases are being docketed around the country, it will be interesting to see whether reviewing courts will apply a uniform standard for willfulness under the FBAR statute.



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Graev v. Commissioner: Tax Court Divided on Penalty Procedural Rules

by and | Dec 12, 2016 | ,

In tax litigation, there are often (at least) two important categories of issues to consider: (1) substantive; and (2) procedural. A great deal of tax litigation will be focused on the substance of the Internal Revenue Service’s (IRS) adjustments (e.g., was a taxpayer entitled to a particular deduction?). But the procedural aspects should not be ignored. If the IRS did not abide by its procedural requirements before making a tax adjustment, consideration should be given to whether the IRS’s adjustment is procedurally invalid. Sometimes taxpayers win on these issues; other times they do not. The United States Tax Court’s (Tax Court) recent case, Graev v. Commissioner, is an example of the latter.

In Graev, an IRS Revenue Agent determined that a 40 percent gross valuation misstatement penalty should apply. The Revenue Agent prepared a “Penalty Approval Form” in accordance with Internal Revenue Manual (I.R.M.) procedures and submitted it to his immediate supervisor. The supervisor checked the form’s “Approved” box and initialed the form in its space for “Group Manager Initials.” The Revenue Agent then prepared a proposed notice of deficiency determining the 40 percent penalty and no other penalties.

The proposed notice of deficiency was referred to the IRS Office of Chief Counsel (Chief Counsel) for review, pursuant to I.R.M. procedures. The Chief Counsel attorney assigned to the case prepared a memorandum back to the Revenue Agent’s office with proposed revisions to the notice of deficiency. Specifically, the Chief Counsel attorney instructed the inclusion of an alternative 20 percent accuracy-related penalty. The Chief Counsel attorney signed the memorandum and his immediate supervisor initialed it.

The Revenue Agent revised the notice of deficiency to include the alternative 20 percent penalty, but his immediate supervisor did not approve it in writing. The IRS ultimately issued the revised notice of deficiency, which included a signature by an IRS Technical Services Territory Manager and a page on which the penalties were computed. Under the Internal Revenue Code (Code), the 20 percent and 40 percent penalties cannot be stacked. As a result, the computation for the 40 percent penalty was shown fully, but the computation for the 20 percent penalty was calculated as zero.

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Tax Court Inconsistent on IRS’s Use of ‘Secret Subpoenas’

by | Dec 7, 2016 | , ,

We have previously written about Judge Mark V. Holmes’ dislike of the Internal Revenue Service’s (IRS) practice of issuing subpoenas to non-parties without informing the taxpayer. To recap, Tax Court Rule 147 allows a party to issue a subpoena to a non-party but does not specifically require that prior notice be given to the other side of the issuance of the subpoena. Rather, the subpoena is enforceable as of the beginning of the court’s trial session. In contrast, Fed. R. Civ. Proc. 45 requires notice to other parties before service of non-party subpoenas for the production of documents, information or tangible things.  In two prior orders, Judge Holmes ordered that the IRS must serve on taxpayers all non-party subpoenas together with all responses and documents that the non-parties produced have been in the form of unpublished orders. In his orders, Judge Holmes adopted the notification requirement of Fed. R. Civ. Proc. 45, and explained his rationale for his orders.

Unfortunately for taxpayers, Tax Court orders are not to be treated as precedent under Tax Court Rule 50(f), and therefore are not binding on any other Judge of the Tax Court. This point is illustrated by Judge Carolyn P. Chiechi’s December 2, 2016, orders in six related cases (see, e.g., Tangel v. Commissioner), where she stated that “[a] party that issues a subpoena under Rule 147(a) and/or (b) is not required to give prior notice to the other party.” Judge Chiechi further noted that under the facts and circumstances presented the IRS did not issue the subpoenas to harass, annoy, embarrass, oppress or cause an undue burden on the taxpayers. (more…)



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December 2016 Changes to the Federal Rules of Civil and Appellate Procedure: Electronic Service and Word Counts

by | Dec 1, 2016 | , , ,

December 1 is an important day for federal litigators and for tax practitioners with cases pending in federal district and appellate courts. It brings with it changes to the rules governing their day-to-day practices. This year, those changes are few and simple but important.

First, electronic service no longer entitles litigants to three extra days to respond to something. Items not served personally have historically triggered what many practitioners referred to as a “mailbox rule” of three extra days to respond to the item, and the concept appears in Federal Rule of Civil Procedure 6(d) and Federal Rule of Appellate Procedure 26(c). For many years, items served electronically were inexplicably treated (contrary to fact) as if they were not delivered immediately. That is no longer the case. The rules have caught up to technology, and in district court and the courts of appeals serving an item by email or using the electronic case filing (ECF) system’s notice function will not give one’s adversary additional time to respond unless a local rule preserves the status quo, as Eastern District of Texas Rule of Civil Procedure 6 does.

Second, the courts of appeals have moved almost entirely to word-count limits for papers. For many years now, litigants did not have to comply with page limits for briefs if their papers complied with certain word-count limits. Other papers, however, such as motions and petitions had only page-count limits. Several applicable appellate rules (21 [mandamus petitions], 27 [motions], 29 [amicus briefs], 35 [rehearing en banc petitions], and 41 [rehearing petitions]) have been amended to include word-count limits. In addition, the word counts for briefs have been reduced from 14,000 to 13,000 for opening, response, and cross-appeal response-and-reply briefs; 16,500 to 15,300 for cross-appeal opening-and-response briefs; 7,000 to 6,500 for reply briefs.  Please see McDermott’s modified table showing the applicable word limits for the most common pleadings. These reductions were controversial when proposed and many circuits have opted out of them, as indicated in their local rules. E.g., 7th Cir. R. App. P. 32(c).

Finally, appellate practitioners need to determine how courts are implementing the changes. Some courts are applying the old rules to appeals docketed before December 1, 2016, and the new rules to ones docketed on or after December 1, 2016. Others are using the setting of the briefing schedule as the line of demarcation, and some appear willing to modify the rules in the middle of a briefing schedule.

Practice Note:  In light of these changes, now is a good time to review the local rules of the federal courts where your cases are pending or where you typically practice to ensure you are not dropping any deadlines or failing to meet your word counts.



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Court Holds Compensation Paid to Four Sons Was Not Reasonable

by and | Nov 30, 2016 | , ,

Reasonable compensation is a fact based analysis, and once again has been decided against the taxpayer. In Transupport, Inc. v Commissioner, T.C. Memo. 2016-216, the issue presented for decision was whether amounts deducted by the taxpayer, a distributor and supplier of aircraft engines and parts, during 2006‒2008 as compensation that was paid to the four sons of taxpayer’s president and majority shareholder were reasonable and deductible pursuant to Internal Revenue Code (IRC) Section 162 and whether accuracy related penalties applied. In 2005, the president and 98-percent owner of Transupport, gifted and sold shares in equal percentages to his four sons. The president and his four sons were the sole employees and officers for the tax years at issue. The president determined the compensation payable to his sons without consultation with his accountant or anyone else, and the only factors considered were reduction of reported taxable income, equal treatment of each son and share ownership. (more…)



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‘Medtronic v. Commissioner’: A Taxpayer Win on Transfer Pricing, Commensurate with Income, and Section 367 Issues

by | Nov 9, 2016 | , , , , ,

On June 9, 2016, the US Tax Court released its opinion in Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner. The Internal Revenue Service had taken issue with the transfer pricing of transactions between Medtronic, Inc. and its Puerto Rican manufacturing arm under §482 of the Internal Revenue Code. Finding the IRS’s application of the comparable profits method (CPM) to the transactions arbitrary and capricious, and taking issue as well with the taxpayer’s comparable uncontrolled transaction (CUT) methodology, the court ultimately made its own decision as to arm’s-length pricing, arriving at new allocations by making adjustments to the taxpayer’s original CUT approach.

Read the full Tax Management International Journal article.

© 2016 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.



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Court Awards $206 Million in Section 1603 Grant Wind Project Case

by and | Nov 3, 2016 | , , ,

The US Court of Federal Claims awarded damages of more than $206 million to the plaintiffs in a case involving the cash grant program pursuant to Section 1603 of the American Recovery and Reinvestment Act of 2009 (the Section 1603 Grant).  In its opinion, published on October 31, 2016, the court held that the US Treasury Department (Treasury) had underpaid the Section 1603 Grants arising from projects in the Alta Wind Energy Center because it had incorrectly reduced the plaintiffs’ eligible basis in the projects.  The court rejected the Treasury’s argument that the applicants’ basis in the facilities was limited to only development and construction costs, and accepted the plaintiffs’ position that the arm’s length purchase price of the projects prior to their placed-in-service date was a reasonable starting point to determine the projects’ value.  The court determined that the facilities, having not yet been placed in service and having only one customer pursuant to a master power purchase agreement (PPA), could not have any value assigned to goodwill or going concern value which would reduce the amount of eligible costs for purposes of the Section 1603 Grant.  The court noted that the transactions surrounding the sales of the facilities were conducted at arm’s length by economically self-interested parties, and that the purchase prices and side agreements were not marked by “peculiar circumstances” that influenced the parties to agree to a price in excess of the assets’ value.  Importantly, the court also held that PPAs were more like land leases, and should not be viewed as separate intangible assets from the underlying facilities, and are thus eligible property for purposes of the Section 1603 Grant.  Finally, the court accepted the plaintiffs’ pro rata allocation of costs between eligible and ineligible property.

An interesting side note to the trial was the court’s refusal to allow the government’s economics expert to testify. According to the court’s procedural rules, experts are required to list “all publications authored in the previous ten years.”  During voir dire, the expert confirmed that he had provided a listing of all of his articles, not just the ones that he had published in the last 10 years.  The plaintiffs’ counsel also introduced a report that the government’s expert had authored in another case, and the expert also confirmed that the second report had a listing of all of his articles.  However, during trial, the plaintiffs’ counsel exposed that the government’s expert had “attempted to conceal articles he wrote for Marxist and East German publications.”  While the hidden articles had nothing to do with the testimony he was prepared to give to the court, nonetheless, the court refused to admit him as an expert and to testify explaining “[t]he Court simply could not rely on the substantive expert testimony of a witness who was untruthful in describing his background and qualifications.”  As a result, the government had no expert to rebut the plaintiffs’ case and to support its counterclaims against the plaintiffs.



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Former Tax Court Judge Pleads Guilty to Tax Crimes

by and | Oct 24, 2016 | ,

Following up on our prior coverage (see here), former US Tax Court Judge Diane L. Kroupa pleaded guilty on Friday to multiple tax criminal charges related to her tax returns and interactions with the Internal Revenue Service. The government stipulated during the hearing that all charges except defrauding the United States would be dropped if Kroupa agreed to be sentenced on the fraud charge. Based on sentencing guidelines, the recommended sentence is between 30-37 months, although the judge may ultimately sentence Kroupa to more or less time. A copy of the Change of Plea Hearing can be found here.



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