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IRS Seeks to Speed Up FATCA Reporting with Imposition of Year End Deadline to Finalize IGAs

The Foreign Account Tax Compliance Act (“FATCA”) was enacted in 2010 by Congress to target non-compliance by U.S. taxpayers using foreign accounts. FATCA requires foreign financial institutions (FFIs) to report to the Internal Revenue Service (“IRS”) information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest.   FATCA obliges all U.S. paying agents to withhold tax, at a rate of 30 per cent, from payments of U.S. source income to non-U.S. persons who are classified as FFIs unless that FFI is located in a country which has entered into an intergovernmental agreement (“IGA”) with the IRS to report information on relevant account holders to the IRS.

An IGA is a bilateral agreement with the U.S. to simplify reporting compliance and avoid FATCA withholding. Under a Model 1 IGA, FFIs in partner jurisdictions report information on U.S. account holders to their national tax authorities, which in turn will provide this information to the IRS. Under a Model 2 IGA, FFIs report account information directly to the IRS.

Since the implementation of FATCA, the IRS has permitted numerous jurisdictions to benefit from having status as IGA, even if they did not have a finalized IGA in force. Notice 2013-43 (2013-31 I.R.B.113) provided that a jurisdiction that had signed but not yet brought into force an IGA was treated as if it had an IGA in effect as long as the jurisdiction was taking the steps necessary to bring the IGA into force within a reasonable period of time. Announcement 2014-17 (2014-18 I.R.B. 1001) and Announcement 2014-38 (2014-51 I.R.B. 951) provided that jurisdictions treated as if they have an IGA in effect also include jurisdictions that, before November 30, 2014, had reached an agreement in substance with the United States on the terms of an IGA as long as the jurisdiction continued to demonstrate firm resolve to sign the IGA as soon as possible. Notice 2015-66 (2015-41 I.R.B. 541) announced that FFIs in partner jurisdictions with a signed or “agreed in substance” Model 1 IGA that had not entered into force as of September 30, 2015, would continue to be treated as complying with, and not subject to withholding under, FATCA so long as the partner jurisdiction continued to demonstrate firm resolve to bring the IGA into force and any information that would have been reportable under the IGA on September 30, 2015, is exchanged by September 30, 2016, together with any information that is reportable under the IGA on September 30, 2016.

In Announcement 2016-17, however, the IRS pressures jurisdictions that have been lagging on this process to substantially complete it by year-end, or risk their FFIs to be subject to the 30 percent withholding in coming years. Specifically, the Announcement provides that, on January 1, 2017, Treasury will begin updating the IGA List to provide that certain jurisdictions that have not brought their IGA into force will no longer be treated as if they have an IGA in effect. Each jurisdiction with an IGA that is not yet in force and that wishes to continue to be treated as having an IGA in effect must provide to Treasury by December 31, 2016, a detailed explanation of why the jurisdiction has not yet brought the IGA into force and a step-by-step plan that the jurisdiction intends to follow in order to sign the IGA (if it has not yet been signed) and bring the IGA into force, including expected dates for achieving each step. In evaluating whether a jurisdiction will continue to be treated as if it has an IGA in effect, Treasury will consider whether: (1) the jurisdiction has submitted the explanation and plan (with dates) described above; and (2) that explanation and plan, as well as the jurisdiction’s prior course of conduct in connection with IGA discussions, show that the jurisdiction continues to demonstrate firm resolve to bring its IGA into force.

This Announcement reflects the IRS’s eagerness to gather information on U.S.-owned bank accounts in foreign jurisdictions, which has been repeatedly delayed due to the complexities that arose in the implementation of FATCA. The risk of the substantial withholding tax under FATCA for FFIs in non-IGA jurisdictions may incentivize lagging jurisdictions to speed the process along.

The Streamline Program Turns Two

The Streamlined Filing Compliance Procedure (SFCP) is now two years old. The SFCP was designed for taxpayers whose failure to disclose their offshore accounts was “non-willful,” due to a lack of understanding or knowledge of reporting requirements for U.S. persons. Unlike the full blown Offshore Voluntary Disclosure Program (“OVDP”), the SFCP places the burden of proving that the taxpayer’s noncompliance was willful on the IRS once the taxpayer has asserted that their non-compliance was not willful. Taxpayers who’s tax returns and informational filing requirements satisfy the SFCP are only required to file tax returns for the previous 3 years and FBAR’s for the previous 6 years while taxpayers in the OVDP must file tax and information returns and FBAR’s for the previous eight years.

One point of contention for taxpayers who entered into the OVDP before the SFCP was introduced in 2014, and whose noncompliance would have qualified them for the SFCP, is that they should be able to switch to the SFCP and take advantage of the reduced penalties on the income tax liability and file only 3 years of income tax returns. While the reduced miscellaneous penalty is available under the OVDP by requesting transitional relief, such relief is not guaranteed and often denied.

Recently, a group of taxpayers brought suit in the Washington D.C. District Court to challenge the IRS’s position that taxpayers who were enlisted in the OVDP prior to the implementation of the SFCP, cannot have their matter transferred to the SFCP. The taxpayers in this case contend they were being treated unfairly under this system as they were no different than those who came forward later in time and entered the SFCP.

Unfortunately, the court did not decide the merits of the case. Rather, the court held that the suit hinders the IRS’s ability to make decisions regarding the enforcement of tax liabilities and dismissed the suit as being barred under the Tax Anti-Injunction Act (26 U.S.C. § 7421), which prohibits suits that restrain the assessment and collection of taxes.   This case highlights the difficulties that can arise when the Service creates settlement programs independent from regulatory oversight and commentary.

Is the Yates Memo Impacting Internal Investigations? The Importance of Individual Representation

Since it’s release more than ten months ago, the so-called Yates Memo has stirred up its fair share of commentary. The memo, which requires prosecutors to pursue – and companies seeking cooperation credit to identify – individual bad actors, generated concern that the new requirement would make investigations more difficult and even discourage companies from cooperating at all. Now that the Yates Memo is coming out of its infancy, some report that employees are more nervous about cooperating with corporate counsel, and requesting personal legal representation much earlier in the process, such that investigations are, in fact, becoming more challenging and more costly. Others, however, report seeing less of an impact and do not perceive the Yate Memo as (at least as of yet) having had the dire consequences that were feared.

Even with this divide, there seems to be agreement on at least one thing: the Yates Memo has highlighted – and perhaps increased – the need of individual representation in corporate investigations. Cooperation of in-house employees is important to corporate counsel’s ability to conduct a thorough and objective investigation. Since the Yates Memo, companies and their employees are more aware of and sensitive to the possibility that prosecutors will pursue individuals suspected of wrongdoing. It is a tense dynamic, but one that can be allayed by providing employees with individual representation. This has long been a good practice of companies and their corporate counsel, and while it does increase costs, in a post-Yates Memo world, it can go along way toward reassuring employees that their personal interests are being taken into account and foster internal cooperation that will, in turn, help the company pursue its goals.

Tax Court Finds Predictive Coding Satisfies Reasonable Inquiry Standard for Responding to Discovery Requests

The Tax Court recently denied the Internal Revenue Service’s (“IRS”) motion to compel the production of electronically stored information by Petitioner, Dynamo Holding Limited Partnership, which was not delivered as part of a discovery response based on the mutually agreed-upon use of “predictive coding.” Dynamo holdings, Ltd. v. Comm’r, Docket Nos. 2685-11, 8393-12. Predictive coding is an electronic discovery method that involves the use of keyword search, filtering and sampling to automate portions of an e-discovery document review. This method attempts to reduce the number of irrelevant and non-responsive documents that need to be reviewed manually.

The IRS and Petitioners had agreed that Petitioners would run a search for terms determined by the IRS on the potentially relevant documents. Petitioners used the predictive coding model to provide the IRS with a selection of documents that the model determined to be relevant.

The IRS, believing the response to be incomplete, served Petitioners with a new discovery request asking for all documents containing any of a series of search terms under a simple keyword or Boolean search, speculating that these documents were “highly likely to be relevant.”   Petitioners objected to this new discovery request as duplicative of the previous discovery responses made through the use of predictive coding. Petitioners contended that the predictive coding algorithm worked correctly, and that the 765 documents excluded as not relevant by the predictive coding algorithm, were properly excluded because they were outside the relevant time frame or otherwise are not relevant. The IRS thereafter filed a motion to compel the production of these documents.

The Tax Court denied the motion, asserting that it was predicated on two myths. The first of these stated myths was the “myth of human review” that “manual review by humans of large amounts of information is as accurate and complete as possible – perhaps even perfect – and constitutes the gold standard by which all searches should be measured.” The second myth was “the myth of a perfect response,” which is beyond the requirements of the Tax Court Rules. The Tax Court found that that the Tax Court Rules and the Federal Rules of Civil Procedure require only that the responding party make a “reasonable inquiry” when making a discovery response. The court explained that “when the responding party is signing the response to a discovery demand, he is not certifying that he turned over everything, he is certifying that he made a reasonable inquiry and to the best of his knowledge, his response is complete.”  As this standard was satisfied by Petitioners in their utilization of predictive coding to locate the relevant documents, the IRS’s attempt to expand e-discovery beyond the agreed upon predictive coding was unsuccessful.

House Ways and Means Wants Probable Cause Before Seizure

The Internal Revenue Service (IRS) has come under scrutiny recently for seizing assets that the IRS claims were the subject of structuring violations. Structuring is the practice of consistently making cash deposits and/or withdrawals of less than $10,000 to avoid mandatory reporting requirements (filing a form 8300), a large part of which were put in place to prevent money laundering and tax evasion. Prior to a policy change in 2014, the IRS was seizing funds that they believed were the subject of structuring violations whether or not the IRS knew that the funds were coming from a legal or an illegal source.

Recent hearings conducted by the House Ways and Means Committee have shown that there are more than 600 cases of the government seizing legally sourced funds prior to the 2014 policy shift and frozen assets involved in these 600 cases yet to be returned to the taxpayers.

As a result of the Committee hearings, legislation has been introduced that would require the IRS to establish probable cause to show that the source of funds involved in a structuring scheme originated from an illegal source before the funds could be seized.   Under the proposed legislation, the IRS would be required, in most cases, to give 30 days of pre-seizure notice and hold a post-seizure hearing within 30 days of the notice.   Additionally, as a bonus, any interest that accrues on the wrongly seized funds will be exempt from income tax. The proposed legislation was scheduled for a mark up by the House Ways and Means Committee on July 7, 2016.

Next Up: Singapore? Summonses Could Hit More Global Financial Institutions

A recent summons showdown with UBS shows that DOJ and the IRS are far from done with offshore enforcement efforts, and are expanding those efforts beyond Europe Among the most likely of new targets is Singapore, and since there is no Tax Information Exchange Agreement (TIEA) or other tax treaty between the United States and Singapore, foreign financial institutions could see IRS summonses being served on their U.S. branches.

Such summonses often are referred to as Bank of Nova Scotia summons. In the recent case involving UBS, the IRS served a third-party summons on a branch of UBS AG in the United States seeking records for an account at UBS in Singapore held by a U.S. citizen living in Hong Kong UBS refused to turn over the records on grounds that Singapore’s bank secrecy laws prohibited disclosure without permission from the accountholder. The IRS sought to enforce the summons in federal court – and the case was teed up for litigation – until the accountholder consented to release of the records and UBS complied with the summons. The IRS thereafter withdrew the enforcement action.

We cannot know whether UBS or the government ultimately would have won the day in court. Many factors are taken into consideration in such enforcement actions, and past cases have had varied results. What we do know is that the government maintains the summons served on UBS was enforceable, and was willing to go the distance. With Singapore – and potentially other jurisdictions without TIEA’s or tax treaties – on the enforcement horizon, more global financial institutions are likely to see IRS summonses coming their way.

IRS on Alert of Partners Attempting to Slip Through the Cracks Before New Partnership Audit Regime Takes Effect

Despite the significant uncertainty surrounding the new partnership audit regime implemented under the 2015 Bipartisan Budget Act (Pub. L. No. 114-74) (“BBA”), the IRS expressed its intention to watch for partners exiting partnerships to avoid tax, during a District of Columbia Bar event on June 23, 2016.

The new rules, effective in 2018, require partnership-level audits of large partnerships, and make it simpler for IRS examiners to undertake an audit because the system will be able to calculate and collect adjustments at the partnership level.   Since there can be several years between when a return is filed and when an audit adjustment is levied, however, it leads to the possibility that partners could sell their interest before the commencement of an audit and avoid adjustments that may have been attributable to them.

Although the panel suggested amending partnership agreements so that partners who sell their interests would still be on the hook for any tax due later, it is unclear whether partners intending on exiting partnerships in light of the new rules would agree to such an amendment. Further, because of the vast uncertainty regarding various areas of the partnership audit rules, most partnerships are not amending their agreements at this time.

The IRS intends to issue regulations with an effective date of January 1, 2018, which would address the scope of the rules and how statute of limitations are applied in this context.   Many areas of uncertainty with the new rules, however, have not yet been addressed by the IRS.

One major area of uncertainty revolves around the “partnership representative,” which is an expanded version of the “tax matters partner” role under prior law. The partnership representative, which is not required to be a partner, will have sole authority to act on behalf of the partnership in an audit proceeding, and will bind both the partnership and the partners by its actions in the audit. The IRS no longer will be required to notify partners of partnership audit proceedings or adjustments, and partners will be bound by determinations made at the partnership level.

It appears that partners neither will have rights to participate in partnership audits or related judicial proceedings, nor standing to bring a judicial action if the partnership representative does not challenge an assessment. Accordingly, the partnership representative is vested with significant responsibility and power under the BBA, and would likely need to devote the majority of his or her time addressing these issues. This raises the possibility that certain individuals might be compensated for this role, and the role might be limited by the provisions of the partnership agreement. At the very least, there should be provisions in place to have a degree of control over elections made at the entity level, or final determinations at the entity level.

Another noteworthy area of concern is how the new rules would impact State tax filings. States have not yet reacted to the new rules, and thus, partners may be reluctant to make amendments until they are aware of both the state and federal implications of the audit rules. The IRS expects to issue guidance in stages to alleviate some of the concerns expressed by practitioners and allow them to move forward with amendments to partnership agreements.

Notwithstanding the uncertainty, it is clear that the IRS is watching for those seeking to take advantage of the new regime to avoid tax.

U.S. Country-by-Country Reporting Coming Sooner Than Anticipated – Though Possibility of Local Filing Requirements During “Gap” Period Remains

The Department of Treasury has announced that it plans to finalize its rules on country-by-country reporting by June 30, 2016 – just in time for U.S. companies with tax years beginning in the latter half of the year to start reporting.  Covered U.S. companies meeting the reporting threshold will have to start filing reports for tax years beginning after June 30th, including years beginning on July 1, 2016, and years beginning on September 1, 2016.

With the announcement came urging for other countries to be flexible in their local reporting requirements.  Many countries already have implemented country-by-country reporting.  Others, like the United States, have been slower to do so.  The effect of such staggered implementation for multinational corporations based is that, until their home countries begin to require reporting, their subsidiaries may be subject to local reporting requirements in other countries that have implemented reporting requirements.

Generally, country-by-country reporting obligations fall on parent companies in their country of residence, and not on subsidiary companies, but where a parent company’s home country does not require reporting, its subsidiaries can be required to file local reports in their countries of residence.  Because of this, the possibility that the United States would not have reporting requirements until 2017 had raised concern among U.S. multinational corporations that, during the “gap” period, their subsidiaries could be subject to myriad local reporting requirements in multiple jurisdictions.

Although the announcement of earlier implementation in the United States will help to curb the “gap” problem for U.S. multinationals, the issue remains.The United States is not the only country dealing with the issue of staggered implementation.  Canada has not yet passed any implementing legislation, and Japan will first start requiring reporting for tax years beginning on or after April 1, 2016.

For questions regarding BEPS and related matters, contact Jim Mastracchio (james.mastracchio@dentons.com); Jeff Erney (jeffry.erney@dentons.com) or Jennifer Walrath (Jennifer.walrath@dentons.com).

LB&I Introduces New Examination Process Designed to Provide Transparency and Collaboration

The Internal Revenue Service (“IRS”) Large and International Business (LB&I) has announced it will be implementing changes to its examination process, effective May 1, 2016.  LB&I’s new procedures are designed to provide an organizational approach for conducting professional examinations from the first contact with the taxpayer through the final stages of issue resolution.  By adopting these procedures, the IRS hopes to add efficiency to the examination process and permits the taxpayer and the examination team to work together in “the spirit of cooperation, responsiveness, and transparency.” Under the new procedures, the examination will be divided into three phases: planning, execution, and resolution, each of which focus on achieving certain specified goals.

The planning phase is focused upon identifying specific issues in the taxpayer’s case.  Once issues are identified, the exam team will explain to the taxpayer why each issue is being considered.  Thereafter, an issue team, comprising LB&I employees most familiar with the particular issue, will work with the taxpayer to establish the relevant facts.  Although a case manager will have overall responsibility for the case, each issue will have a designated manager who oversees the planning, execution and resolution of the issue.

During the execution phase, the issue teams will fully develop their particular issue, including determining the facts, applying the law to those facts, and understanding the various tax implications of the issue.  This process will include interactive discussions with the taxpayer followed by the issuance of Information Document Requests (IDRs) to develop the facts.  The new procedures note that a meaningful discussion with the taxpayer prior to issuing an IDR will result in a more effective process.  After gathering relevant facts, the issue team will document the agreed facts and obtain acknowledgement from the taxpayer with respect to the unagreed facts.

Finally, in the resolution phase, LB&I encourages its employees to use all available tools to resolve issues.  As facts have been fully developed and documented in the execution phase, the taxpayer and the issue team will be able to work more productively in the resolution stage.  Although there are numerous strategies to work towards resolution, LB&I requires its employees to consider Fast Track Settlement for all unagreed issues.  Fast Track consists of a mediation where the taxpayer, the issue team and Appeals must agree to participate and agree to a mutual resolution.   The goal of the resolution phase is tax certainty for both the taxpayer and LB&I.  Thus, at the conclusion of the resolution phase, taxpayers and LB&I may be asked to perform a joint critique of the exam process and recommend improvements.

LB&I emphasizes the significance of bringing all information to light as soon as possible to avoid issues relating to the expiration of the statute of limitations, or the possibility of new information coming to light during the Appeals process, which would return the case to Examination.  This policy is reflected in LB&I’s request that taxpayer’s bring any potential refund claim to the exam team’s attention as soon as possible.  LB&I specifically indicated it would only accept informal claims that are provided to the exam team within 30 calendar days of the opening conference.  If such claims are brought within that time period, they can be developed and processed by exam, providing higher possibilities for tax certainty for both the taxpayer & LB&I.  Refund claims submitted within this time period must meet the standards of Treas. Reg. § 301.6402-2, which provides that a valid claim must set forth in detail each ground upon which credit or refund is claimed, present facts sufficient to apprise the IRS of the exact basis for the claim, and contain a written declaration that it is made under penalties of perjury.   However, in the interest of incentivizing taxpayer’s to bring refund claims forward in a timely manner, LB&I has indicated it will discuss deficiencies not meeting the Treasury Regulations and provide the taxpayer an opportunity to correct the deficiencies.  If refund claims are not brought within the specified 30 days, they must be filed using the applicable amended tax return or Form 843, Claim for Refund and Request for Abatement.

The reorganization of the LB&I examination process reflects the IRS’s desire to achieve fair and final resolutions during the Examination Process that is achieved with an issue specific approach, involving issue teams that are well versed on the facts to fully develop the facts relevant to each issue.  Notably, Publication 5125 mentions the significance of meaningful discussions with the taxpayer on numerous occasions, including conversations to ensure the taxpayer fully understands the issues are identified, conversations prior to issuing IDRs, and acknowledgements of agreed and unagreed issues.  Upon its implementation, the IRS hopes the new examination process will allow LB&I to work transparently in a collaborative manner with the taxpayer to understand their business and share the issues that have been identified for examination.  This, in turn, should lead to LB&I’s ultimate goal of increasing the final resolutions reached during the exam process.

Please contact Jeffry Erney (jeffry.erney@dentons.com) or Sunny Dhaliwal (sunny.dhaliwal@dentons.com).

FinCEN Seeks to Renew Information Sharing Requirements for U.S. Financial Institutions

The Treasury Department’s Financial Crimes Enforcement Network (FinCEN) is seeking comments regarding the renewal of its program for information sharing between government agencies and financial institutions.

Under the program, U.S. and certain foreign law enforcement agencies can ask FinCEN to request of U.S. financial institutions information concerning any person or entity an agency certifies is engaged in or suspected, based on credible evidence, of engaging in terrorist activity or money laundering.  Foreign agencies can participate in the program only if they are in a jurisdiction that allows the United States reciprocal access to comparable information.  FinCEN sends approved requests to relevant U.S. financial institutions, which then must “expeditiously” search their records to determine whether they have maintained an account or conducted any transaction with the individual or entity identified in the inquiry and report back to FinCEN regarding any such transaction or account.

Approximately 20,134 financial institutions are covered by the program.  FinCEN estimates that that there are 90 requests per year, each usually concerning multiple subjects.  Of the 90 requests, 10 are from FinCEN on its own behalf, 50 are from U.S. state and local law enforcement, and 30 are from European Union countries approved by treaty.

For questions regarding FINCEN filings, please reach Jim Mastracchio (james.mastracchio@dentons.com) or Jennifer Walrath (jennifer.walrath@dentons.com).

Vox Tax: Global Protections for Tax Advice

Shortly before the end of 2014, Dentons published a new edition of Vox Tax. This edition of Vox Tax analyzes global protections available for tax advice and provides a high-level overview of legal privileges and protections that may preclude the production of sensitive tax advice in administrative tax examinations and judicial proceedings.

In the report, lawyers from Dentons’ Global Tax Team examine privileges and protections in 17 countries across North America, Europe, and Asia. The report addresses the applicable protections, the type of information subject to protection, and what may effectuate a waiver of those protections.

Additionally, the report analyzes the practices and trends of each local taxing authority with respect to information gathering and sharing. This report also includes a summary table comparing these 17 countries on several key intricacies of their respective tax laws.

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The Ninth Circuit Holds Equitable Recoupment Not Time-Barred

In a taxpayer win, the Ninth Circuit recently reversed the Tax Court and held equitable recoupment was not time barred.  Revah v. Comm’r, No. 11-70211 (9th Cir. Sept. 17, 2014) (unpublished opinion).  Relying on longstanding precedent, the Ninth Circuit held the taxpayers were not statutory barred from applying for equitable recoupment because it’s permitted even with respect to an untimely refund claim.  Thus, even though the taxpayers failed to timely file their refund claims, “untimeliness is not a ground upon which the tax court may deny equitable recoupment.”  Id.

Equitable recoupment is a judicial doctrine that applies where one transaction or event is subject to two taxes based on inconsistent theories.  The equitable recoupment doctrine “allows a litigant to avoid the bar of an expired statutory limitation period” and “prevents an inequitable windfall to a taxpayer or to the Government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event affecting the same taxpayer or a sufficiently related taxpayer.”  Menard, Inc. v. Comm’r, 130 T.C. 54, 62 (2008).  To establish equitable recoupment a taxpayer must prove: (1) the overpayment or deficiency for which recoupment is sought by way of offset is barred by an expired period of limitation, (2) the time-barred overpayment or deficiency arose out of the same transaction, item, or taxable event as the overpayment or deficiency before the Court, (3) the transaction, item, or taxable event has been inconsistently subjected to two taxes, and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.  Id. at 62-63.  In practice, taxpayers often have difficulty mounting arguments of equitable recoupment against the IRS, although the Government typically has more success in this area.

The IRS audited and made adjustments to the Revahs’ 1999 and 2000 tax returns related to inventory and bad debt, and resulting in a decrease in the net operated losses the taxpayers reported on their 1997 and 1998 returns.  The taxpayers accepted the adjustments assuming that, as the examiner acknowledged, they would be able to reduce income in 2001 through amended returns.  After the exam and in 2005, the taxpayers filed amended returns in accordance with the examiner’s adjustments, but the refund claims were denied as untimely.  The taxpayers petitioned the Tax Court for relief asserting the equitable recoupment doctrine.  The Tax Court (Judge Cohen) found the taxpayers’ inability to use the NOLs to reduce tax liabilities was not the result of the inequitable application of inconsistent theories of taxation contemplated by the equitable recoupment doctrine, and thereby denied the petition.  The Ninth Circuit reversed and remanded in favor of the doctrine’s application, illustrating that there is hope for future taxpayers seeking to offset current IRS liabilities with past credits under the doctrine.

Sixth Circuit Sharpens Ford’s Focus on Payment of Overpayment Interest

While it appears that Ford’s petition for certiorari to the Supreme Court yielded Ford some of the answers it was looking for, Ford is still without the approximately $470 million in what it argues is overpayment interest.  As we discussed in a previous article, the Supreme Court asked the Sixth Circuit to address the question of proper venue.  The Government had previously argued that the Tucker Act (28 U.S.C. § 1491(a)) is the only general waiver of sovereign immunity regarding overpayment interest.  As such, the Government urged a district court would not have jurisdiction under 28 U.S.C. § 1346(a)(1) as Ford was not seeking to recover money that was already paid.  In an opinion dated October 1, the Sixth Circuit denied the Government’s claim that refund claims for overpayment interest, as opposed to claims for tax, penalties, and interest on tax and penalties, must exclusively be brought in the Court of Federal Claims rather than an appropriate federal district court.  This issue had previously been decided by the Sixth Circuit in Scripps Co. v. United States, 420 F.3d 589 (6th Cir. 2005).  In Scripps, the Sixth Circuit held that a suit to obtain overpayment interest includes a “recovery” of money as is described in 28 U.S.C. § 1346(a)(1).  The Sixth Circuit, in seeing no reason to revisit the Scripps decision, declined to revisit the issue and held against the Government’s jurisdiction claim.

Once the Sixth Circuit confirmed proper jurisdiction of the case, it then turned to the merits of the case.  The Sixth Circuit initially addressed whether Section 6611 (relating to overpayment of interest) constitutes a “waiver of sovereign immunity that must be strictly construed,” which would, in turn, require a narrow reading of the term “overpayment.”  The Government argued that Section 6611 constitutes a waiver of sovereign immunity, and as such, the term “overpayment” should be subject to the strict construction canon.  Ford argued that 28 U.S.C. § 1346(a)(1) was the appropriate waiver of sovereign immunity, and that Section 6611 was instead a substantive right underlying the claim.  The Sixth Circuit found that, during the years at issue, any distinction between overpayments of “deposits in the nature of a cash bond” and “advance tax payments” had been made by the Service and not by Congress.  As such, the Sixth Circuit held that the any distinction between deposits and advance tax payments are substantive only, and do not implicate sovereign immunity.

Next, the Sixth Circuit turned to the “date of overpayment,” and whether such date is properly determined as the day that Ford remitted deposits or, alternatively, the date that on which such deposits were converted into advance tax payments.  The Sixth Circuit determined that this issue turns on whether the payments were made by Ford “for the purpose of discharging its estimated tax obligations.”  The Sixth Circuit looked to the “tradeoffs” presented in Rev. Proc. 84-85 (which had been in effect during the years at issue).  In essence, the Sixth Circuit determined that in order for Ford to stop the accrual of underpayment interest, Ford had the ability to either (i) remit a cash-bond deposit which would not pay Ford potential overpayment interest, but which could be returned upon Ford’s demand, or (ii) make an advance tax payment, which would allow Ford to recoup interest with respect to an overpayment, but would deny Ford the immediate ability to recoup the funds.  The Sixth Circuit viewed the form of the remittances, either as a cash-bond deposit or an advance tax payment, as dispositive of the purpose of the payment.  As such, since Ford initially remitted cash-bond deposits, the Sixth Circuit found that Ford “did not remit those deposits to discharge its estimated tax deficiency.”  Thus, the Sixth Circuit held for the Government and found that the remittances were cash-bond deposits that were not entitled to overpayment interest, and that the “date of overpayment” did not begin until the date the payments were converted to advance tax payments.

While Ford received favorable rulings from the Sixth Circuit regarding both proper venue and whether Section 6611 constitutes a separate waiver of sovereign immunity, Ford ultimately lost regarding when an “overpayment” begins.  Ford now has the ability to file yet another petition for certiorari to the Supreme Court.  While any potential petition remains to be seen, it appears that the case at hand is finally narrowed down to the sole issue of when an “overpayment” begins.

First Shoe Drops for Corporate Inversions

Notice 2014-52, released by the US Treasury Department on September 22, 2014, is intended to disrupt, and in some cases prevent, so-called corporate inversion transactions that have not been completed prior to the notice’s release.

Although the notice includes very detailed rules, it very generally takes a two-pronged approach to discourage inversions after September 21, 2014.

Dentons’ Tax team explores the implications of Notice 2014-52 on cross-border acquisitions or mergers.

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German Federal Fiscal Court Ruling Potentially Provides Reduced Withholding Rates to Certain US Entities

In a decision dated June 26, 2013 (Doc No I R 48/12, original available here), the German Federal Fiscal Court (a court of last resort in Germany over tax and custom matters) was tasked with determining whether an “S” corporation (a US corporation that is a pass-through for US tax purposes but not for German tax purposes) is considered a US resident under the 2006 protocol of the German-US income tax treaty (the “Treaty”).  Article 10, Paragraph 2 of the Treaty provides in part that if a German company pays a dividend to a US resident, German withholding tax imposed on the receipt of such dividend shall not exceed (i) 5% if the beneficial owner of the dividend is a company that directly owns at least 10% of the voting stock of company paying the dividend, or (ii) 15% in all other cases.  Article 1, Paragraph 7 of the Treaty generally states that if “an item of income, . . . derived by or through a person that is fiscally transparent” pursuant to US or German law, then “such item shall be derived by a resident of a State to the extent that the item is treated for the purposes of the taxation law of such State as the income, profit or gain of a resident.”

In the case, the S corporation, a 50% shareholder of a German company, received dividends from the German company.  The German court held that the S corporation was considered a US resident for purposes of the Treaty and thus subject to a reduced withholding tax rate of 5%.  In interpreting Article 1, Paragraph 7 of the Treaty, the German Federal Fiscal Court determined that the two references to “resident” did not necessarily imply the same resident.  The German Federal Fiscal Court determined that the income may be considered derived by “a resident of a State” (here, the S corporation) so long as the income is treated by the US as “profit or gain of a resident” (i.e., the shareholders of the S corporation).  The German court reasoned that, because, under US federal income tax law, income derived by an S corporation is “income, profit or gain” of its shareholders, such items of income derived by or through the S corporation should be considered derived by a US resident.  Accordingly, the German Federal Fiscal Court held that the S corporation was a “US resident” for purposes of Article 1, Paragraph 7.

Additionally, the German court had to decide whether the S corporation is the beneficial owner of the respective dividends although under US federal income tax law, the respective income is attributed to the shareholders of the S corporation. The withholding tax reduction to 5% under Article 10, Paragraph 2 of the Treaty is only granted if (inter alia) the beneficial owner of the dividends is a company. The German court came to the conclusion that the term “beneficial owner” is not defined in the Treaty and, hence, has to be determined under German law. Under German law, the S corporation, irrespective of its tax treatment in the US, qualifies as a corporation so that income of the S corporation must under German law be attributed to the S corporation itself – not to its shareholders. Therefore the dividends were paid to a US resident corporation as beneficial owner (i.e., the S corporation). As a consequence, the withholding tax reduction to 5% was granted.

Whether this case could be extended to other US entities is unclear.  For example, a limited liability company provides corporate-like limited liability for its shareholders, but is fiscally transparent for US federal income tax purposes (unless a check-the-box election is filed for the LLC).  Therefore, the holding of this case may apply to an LLC if German tax law classifies a US LLC as a corporation, which mainly depends on the content of the articles of association of the respective US LLC.  However, this case should not apply to an entity that is a US partnership for state law purposes as, under Article 3, Paragraph 1 of the Treaty, a partnership is generally not treated as a “body corporate” and thus is not treated as the beneficial owner of dividends.

While in the case it was clear that the S corporation itself (and not its shareholders) could file for the refund, a recent change in German tax law enacted in 2013 may have changed this. However, the new provision in German tax law was not intended for cases such as US S corporations and the German tax authorities have not yet issued clear guidance on whether the S corporation or its shareholders should apply for the refund. For now it is therefore advisable for both the S corporation and its shareholders to file refund claims simultaneously to avoid a potential statute of limitations issue in the event that the German tax authorities interpret its refund provisions in a different manner.

Michael Graf, a partner in Dentons’ Frankfurt office specializing in Taxation, co-authored this article.

The Tax Court Rejects the IRS’s Section 6901 Analysis

On May 29, 2014, the Tax Court, in a division opinion, decided another transferee liability case in favor of the taxpayers.  See Swords Trust v. Commissioner, 142 T.C. No. 19 (2014). In Swords, the taxpayers (which were four separate trusts) together owned all the outstanding shares of stock in a C corporation, Davreyn.  Davreyn was a personal holding company that owned a substantial amount of stock in Reynolds Metal (which produced the popular aluminum foil brand, Reynolds Wrap).  Prior to the transaction at issue, Reynolds Metal merged with Alcoa, Inc., another aluminum company, and Davreyn’s existing Reynolds Metal stock was converted into shares of Alcoa stock.

Sometime in 2000, the taxpayers’ accountant learned about an opportunity for shareholders of a personal holding company to sell their appreciated stock to a financial buyer in a tax-efficient manner.  The taxpayers eventually agreed to enter into such proposed stock sale and on February 15, 2001, the taxpayers executed a stock purchase agreement wherein the taxpayers sold all of their stock in Davreyn to Alrey Trust (an entity that was affiliated with the investment banking firm, Integrated Capital Associates or ICA).  Unbeknownst to the taxpayers, Alrey Trust immediately liquidated Davreyn and then sold the Alcoa stock.  On its tax return, Alrey Trust reported a substantial gain on the subsequent sale of the Alcoa stock and offset such gain with an artificial loss that was generated from a Son-of-Boss transaction.

After assessing substantial tax liabilities against Alrey Trust and Davreyn—both to no avail—the IRS proceeded to attempt to collect Davreyn’s unpaid tax liability from the taxpayers, as transferees of Davreyn’s assets.  The IRS argued that a two-step analysis applies in determining whether the taxpayers, as transferees, are liable under Section 6901 for Devreyn’s unpaid taxes:  (1) analyze whether the subject transactions are recast under Federal law, which in Swords was primarily the Federal substance over form doctrine, and then (2) apply State law to the transactions as recast under Federal law.  Of course, to anyone familiar with transferee liability cases, this argument should not come as a surprise—it has functioned as the constant mantra of the IRS in several prior transferee liability cases.  Even though the First, Second and Fourth Circuit Courts had all recently rejected this argument, the IRS found itself once again in front of the Tax Court reiterating its Section 6901 argument.  See Diebold Found., Inc. v. Commissioner, 736 F.3d 172, 184-185 (2d Cir. 2013); Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597, 604-605 (1st Cir. 2013); Starnes v. Commissioner, 680 F.3d 417, 428-429 (4th Cir. 2012).  This time though, the Tax Court explicitly rejected the IRS’s proposed two-step analysis.  As the Fourth Circuit held in Starnes, the question of whether a transfer occurred for purposes of Section 6901 is separate from the question of whether the transfer was fraudulent for state law purposes.  See Starnes, 680 F.3d at 428-429.  Accordingly, the Tax Court found that Section 6901 requires that the court apply state (rather than Federal) law to determine whether a transaction is recast under a substance over form (or similar) doctrine.

The IRS argued alternatively that the applicable state law, Virginia, has a substance over form doctrine that applies to recast the series of transaction as one transfer between each of the taxpayers and Davreyn.  Again, the Tax Court disagreed, finding that the IRS “has left us unpersuaded that the Supreme Court of Virginia would apply a substance over form analysis to the present setting.”  Swords, 142 T.C. *15.  The IRS had not identified an adequate Virginia case wherein the court applied a substance over form or similar doctrine.  Moreover, even if such an analysis would apply in Virginia, the Tax Court was unpersuaded that the taxpayers or their representatives had the requisite actual or constructive knowledge of Alrey Trust’s plans to sell the Alcoa stock and to illegitimately avoid any resulting tax liability.  The Tax Court concluded that the transaction was in form and substance a sale of stock and that the transaction should not be recast as a sale of assets followed by a liquidating distribution.  After analyzing the transaction in light of Virginia’s actual fraud statute, constructive fraud statue and trust fund doctrine, the Tax Court found that the IRS failed to establish an independent basis under Virginia state law for holding the taxpayers liable for Davreyn’s unpaid tax.  Accordingly, Section 6901 did not apply to this case.

Thouron v. United States: Third Circuit Holds Reliance on Counsel may Relieve Penalties for Late Payment of Taxes.

In Thouron v. United States, No. 13-1603 (3d Cir. May 13, 2014) the Court of Appeals for the Third Circuit held that reliance on tax advice may establish a reasonable cause defense to failure to pay penalties.  (Slip. Op. at 9.) 

This case arises out of estate taxes originally due in 2007.  In his will, the decedent appointed a friend as executor of the estate and the friend hired a tax attorney to advise the estate on tax matters.  Relying on the advice of the attorney, the estate timely filed an extension for time to file the estate return and remitted a partial payment, but did not file for an extension to pay the remainder of the tax due.  The estate claimed its attorney advised it that the extension to pay was not due until the return was filed and that the tax due would be deferred under I.R.C. section 6166 because the bulk of the estate’s assets were illiquid.  The estate further claimed that the attorney advised it that no penalty would be imposed.  The IRS assessed the mandatory penalties of I.R.C. section 6651 and the estate filed a refund claim in district court asserting reasonable cause and reliance on its tax expert as a penalty defense.

The district court for the District of Pennsylvania held that reliance on the tax adviser was not reasonable cause for the late payment of the estate taxes and granted summary judgment in the government’s favor.  To support its conclusion, the lower court relied heavily on United States v. Boyle, 469 U.S. 241 (1985), a Supreme Court decision holding an estate could not rely on its attorney for the ministerial task of timely filing a return.  The district court read Boyle to preclude any finding of reasonable cause based on reliance on an expert or other agent in failure-to-file and failure-to-pay cases.

The Third Circuit reversed and remanded.  The court first established that the holding of Boyle, though a late-filing case, was applicable to failure-to-pay cases because of the similarity in the language in the statutes.  The Third Circuit held, however, that the district court misapplied Boyle to the facts at issue.  Distinguishing Boyle because it involved reliance on an adviser for merely the ministerial task of filing, the court noted the distinction drawn in Boyle between relying on an expert’s clerical action and relying on the expert’s advice: “taxpayers may rely on the advice of an expert but may not, for purposes of completing their statutory duty, rely on an agent to perform the task of filing and paying.”  (Slip. Op. at 9).

Ultimately, the Third Circuit held there was a material question as to whether the estate relied on the advice of counsel in not paying the tax due and remanded the case for that factual determination.  The court noted that the estate must also show either an inability to pay or undue hardship from paying at the deadline.  The court offered no insight as to how the estate can make such showing.

Are You Ready for FATCA?

July 1, 2014, marks the date when withholding under the US Foreign Account Tax Compliance Act (FATCA) first begins to apply. Aimed at addressing perceived tax evasion and avoidance by US persons through the use of offshore accounts, FATCA has a wide-ranging impact on non-US entities that receive, directly or indirectly, many types of US-source income. Additionally, US entities that make payments of many types of US-source income to non-US persons are also affected by the new rules.

In the video interview, Tax partner John Harrington, former international tax counsel for the Department of Treasury, provides an overview of FATCA. In the video, John explains why companies should be actively preparing for the new compliance provisions, even if 2014 and 2015 are considered a “transition period” by the IRS. More specifically, he examines:

  • The broad impact of FATCA and intergovernmental agreements (IGAs);
  • The importance of planning for FATCA’s series of compliance deadlines; and
  • New reporting requirements and expectations under the global information automatic exchange.

Opportunity to Claim Refund on WHT Overpayment on Dividends Received by Non-EU Investment Funds from Europe – Update

In a recently reported Emerging Markets Series of DFA Investment Trust Company case (C -190/12) the European Court of Justice confirmed that investment funds based outside EU should benefit from the free movement of capital rule regarding investments in Europe (see link for more details). This judgment opens up the opportunity for non-EU investors to claim withholding tax refunds in some EU jurisdictions (in particular Germany, Poland, Spain and the Czech Republic). Follow-up information on selected EU jurisdictions is set out below.

Czech Republic
Czech law imposes a favorable tax regime on certain investment funds established in the EU, Norway and Iceland. It offers investment funds the opportunity to claim tax refunds, which should be of particular interest to non-EU investment funds achieving capital gains or income derived from their Czech-based immovable property.

Peter Varga
peter.varga@dentons.com

France
Since 2012, further to the judgment in Santander Asset Management and others ruling (joined cases 338/11 to 347/11), non-resident undertakings for collective investment in transferable securities (UCITS) are no longer required to pay withholding taxes on dividends received from France. Any withholding taxes collected at source should open up the right to claim refunds under certain conditions.

This ECJ judgment could trigger a legislative response from France which is currently difficult to predict. It could mean the enactment of a specific tax for French UCITS and a specific withholding tax for non-French UCITS. This was in fact the route taken by France after the High Court ruled in 2009 that French WHT  charged on unearned income achieved by non-resident nonprofit organizations (where French nonprofit organizations were tax exempt) was illegitimate. The tax was set at 15%, instead of the original 25% rate that only applied to non-resident nonprofit organizations.

Jessie Gaston
jessie.gaston@dentons.com

Germany
Certain non-German investment funds investing in German companies should also benefit from this decision. German Investment Tax Act provides for a full WHT refund in case of capital income of the fund, but only for those established in Germany and not for comparable funds established abroad. Whether or not non-German funds can be considered comparable to German funds in terms of tax treatment needs a case-by-case analysis. The requirements for the applicability of the German Investment Tax Act changed recently due to the implementation of the AIFM Directive.

Thomas Voss
thomas.voss@dentons.com

Poland
A case was initiated by a Polish court which gives solid grounds for non-EU investors to claim refunds of overpaid WHT. Polish regulations offer income tax exemptions for domestic investment funds and funds based in the EU/EEA and there are exchange of tax information mechanisms with a number of jurisdictions. If tax has been paid on dividends from a Polish company, it should be analyzed if there are conditions for preferential treatment based on the EU principles of freedom of establishment and the free movement of capital.

Rafał Mikulski
rafal.mikulski@dentons.com

Romania
The principles of the case and their applicability are certain to be assessed on a case-by-case basis. It definitely sheds new light on European investments and should be explored especially in conjunction with the new Romanian law on exemption of tax for re-invested profits.

Delia Dragomir
delia.dragomir@dentons.com

Spain
Application of the case in Spain, along with other ECJ precedents (i.e. ECJ joined cases 338/11 to 347/11) would allow to investment funds located outside the EU/EEA to claim refunds of the withholding taxes paid on their Spanish sourced dividend income, on the amount exceeding the 1% tax rate applicable to Spanish resident investment funds. Chances of success would depend on fulfilling the requirements set by the ECJ in the case at hand.

Jose Ramon Vizcaino
joseramon.vizcaino@dentons.com

UK
As the UK does not impose withholding tax on dividends (other than REIT dividends), the impact of the case in the UK is limited.

Jeremy Cape
jeremy.cape@dentons.com

Cross-border exchange of information procedures

In this issue of Vox Tax, we analyze the recent wave of information sharing among national tax authorities.

As tax regimes around the world place an increased emphasis on transparency and international cooperation to combat tax evasion, a host of new laws, rules and regulations have been enacted.

In the report, lawyers from Dentons’ Global Tax Team examine the practices and policies in 15 countries across North America, Europe and Central Asia. Learn about the type of information that may be shared among nations, and what that means for your capital and tax strategies. For your reference, this report also includes a table comparing these 15 countries on several key intricacies of their respective tax laws.

Read the complete analysis

Circuit Split In Summons Procedures

As part of the examination process, the IRS has wide latitude to obtain documents, records, or other information from a taxpayer.  The IRS normally requests and receives information informally.  Other times, however, the IRS resorts to a more forceful tact—an administrative summons.  This approach has teeth, as the federal district courts have statutory authority to compel compliance.

To have a summons enforced in federal district court, the IRS generally must satisfy four prima facie requirements established fifty years ago by the Supreme Court in United States v. Powell.  Those requirements are: (1) the investigation must be conducted for a legitimate purpose; (2) the summons must be relevant to that purpose; (3) the IRS must not already have the information sought; and (4) the IRS must have followed the administrative steps required by the Internal Revenue Code.

Recently, in Jewell v. United States, the Court of Appeals for the Tenth Circuit focused on the fourth requirement.  Code section 7609(a)(1) provides special administrative procedures for third-party summonses (e.g., the IRS summons person A regarding person B).  One of these specified procedures provides that “notice of the summons shall be given to any person identified [person B in the example above] . . . no later than the 23rd day before the day fixed in the summons as the day upon which such records are to be examined.” (emphasis added).  In Jewell, the government admitted that the taxpayer had not received the statutorily-prescribed notice.  Thus, as the Tenth Circuit phrased it, “[t}he resulting question is whether we are free to disregard the statutory requirement.”

The Tenth Circuit’s inquiry focused first on the interpretation of the section 7609(a)(1) 23-day notice requirement.  Was notifying the taxpayer mandatory?  The Tenth Circuit rejected the government’s arguments to the contrary, concluding that Congress intended to require mandatory notice.  The court noted that the authority cited by the government “did not disturb the age-old precept that ‘shall’ means ‘shall'”.

The Tenth Circuit’s inquiry then focused on whether the notice requirement was an “administrative step” under Powell.  Looking at the common meaning of the term, the court concluded that the 23-day notice provision was an administrative step, as contemplated by Powell.  The court concluded that the summonses at issue should be quashed.

Although the 23-day requirement and the Powell requirements both seem rather straightforward—and we agree that the Tenth Circuit is correct—the Tenth Circuit’s opinion created a circuit split.  As the court acknowledged, five other circuit courts have declined to apply Powell in the same manner.  The First Circuit has acknowledged that the IRS must comply with all required administrative steps, but allowed enforcement of a summons where only 21 days of notice was provided.  The Second, Sixth, and Eleventh Circuits are willing to excuse the notice defect where the taxpayer is not prejudiced.  And the Fifth Circuit has allowed enforcement of a summons to avoid elevating “form over substance.”

With such disparate approaches being taken by different circuits, this issue could find its way to the Supreme Court next term.

Opportunity to Claim Withholding Tax Overpayment on Dividends Received by Non-EU Investment Funds from Europe

In its verdict in Case C-190/12 (Emerging Markets Series of DFA Investment Trust Company), the European Court of Justice (ECJ) confirmed that investment funds based outside the EU should benefit from the EU’s free movement of capital rule regarding investments in Europe.

Dentons’ global Tax team discusses the implications of this verdict in Europe.

Read more

Karina Furga-Dąbrowska, Cezary Przygodzki, and Rafał Mikulski, all members of Dentons’ Tax practice in Poland, co-authored this article.

Automatic Information Exchange: Did the Dog Just Catch the Bus?

John Harrington recently published an article in Tax Notes Today (available through the Lexis paywall) regarding eight potential challenges presented by an international automatic exchange system. 

On February 13, the OECD released details of its proposed common reporting standard, or CRS.  With the release of this report, the OECD and G-20, like the dog intent on catching a bus that it has long chased and finally caught, now have to figure out what do to with the prize they have captured.  Harrington discusses how an automatic information exchange could affect taxpayers, financial intermediaries, and governments.

IRS issues guidance regarding the Windsor decision’s application to qualified retirement plans

The US Internal Revenue Service (IRS) has issued much anticipated guidance on qualified plan requirements related to same-sex marriage. Last summer’s Supreme Court decision to invalidate the Defense of Marriage Act definition of marriage under Federal law left plan sponsors and administrators uncertain how, and importantly when, to apply the holding of the Court’s decision with respect to their employee benefit plans.

Dentons’ Pension, Benefits, and Executive Compensation lawyers discuss the IRS guidance provided since the Court’s decision offering insight about what affected plans must say and by when.

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Katharina E. Babich, Pamela Baker, and Martin J. Moderson, members of Dentons’ Pensions, Benefits, and Executive Compensations practice, co-authored this article.

IRS Granted Considerable Latitude to Delay Payment of Tax Refunds

A recent Fifth Circuit opinion, El Paso CGP Co., L.L.C. v. United States, illustrates that the IRS’s authority under the Code’s mitigation rules is, at least in the Fifth and Third Circuits, construed broadly.  Acknowledging the general rule that a closing agreement with the IRS prevents the IRS from reopening a year included in that agreement, the Fifth Circuit’s opinion—overall, favorable to the IRS—turns upon the exceptions to this general rule found in the Code’s mitigation rules, which allow the IRS to reopen a closed tax year through an assessment within one year of a closing agreement.  However, the Fifth Circuit offered a taxpayer-friendly interpretation of the variance doctrine, which generally provides that in a refund suit, a taxpayer may not raise a ground for recovery which was not previously set forth in the taxpayer’s administrative refund claim.

As is the case in many tax cases, this dispute involved a much earlier tax year—here, 1986.  On a company’s 1986 tax return, the company claimed various tax credits, which exceeded the allowable amount for that year.  As a result, the company carried some of those credits forward to 1987 through 1990.  After an IRS audit of the 1986 tax return, the IRS disallowed some of the credits and increased the company’s liabilities for 1986 – 1990, which the company later paid.

Several years later, the IRS and the company executed a Form 870-AD (“Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment”), in which the company agreed to the assessment and collection of a tax deficiency for 1986 but reserved the right to file a claim for refund.  The company later exercised this right and filed an approximately $18 million refund claim, primarily attributable to replacing the disallowed tax credits with other tax credits which the company originally had carried forward to later years.  This action, however created tax deficiencies for 1987 through 1990.

In July 2005, the IRS and the company agreed on the amounts of liability owed or refund due for each of the 1986 through 1990 taxable years and entered a “Closing Agreement”.  Pursuant to the Closing Agreement the company was owed a refund for 1986 and had deficiencies for 1987 – 1990.

In September 2005, the IRS made only a partial payment of the agreed-upon refund due for 1986.  The IRS asserted that the remaining portion would be used to satisfy the deficiencies for 1987 – 1990.  In August 2006, the company sought from the IRS a refund the remaining amount for 1986, asserting that the IRS had failed to assess deficiencies within the applicable one-year statute of limitations.  The company further asserted that the IRS was precluded from collecting deficiencies from 1987 – 1990 because the IRS failed to follow the mitigation rules.  The IRS denied the refund claim, and the company filed a refund suit in district court.

The district court granted summary judgment to the Government.  First, the district court held that it lacked jurisdiction because the refund suit was not based on a valid administrative refund claim.  The district court reasoned that the administrative refund claim was disposed of by the Closing Agreement.   As another basis for holding that it lacked jurisdiction, the district court concluded that the refund suit violated the variance doctrine because the grounds for recovery in the refund suit varied from the grounds in the original administrative refund claim.  The company appealed.

Stating that courts “have not always been so dogmatic in applying” the variance doctrine, the Fifth Circuit disagreed with the district court and concluded that it had jurisdiction over the refund suit.  The Fifth Circuit noted that there is an exception from the variance doctrine where, as in this case, the Government’s “unilateral action creates the substantial variance.”  The court further stated that the Government “cannot use the variance doctrine to straightjacket the taxpayer when the Government unexpectedly changes its litigation strategy.”

It was not all bad news for the Government though.  Although the court concluded that the IRS had failed to assess tax within the applicable period of limitations, the court concluded the IRS had complied with the mitigation rules (i.e., which allowed the IRS to reopen the closed tax years).

The court rejected a contention from the company that each tax year must be treated separately and followed an approach taken by the Third Circuit.  Pursuant to that approach, the court reasoned that the separate-tax-year concept should not apply where the parties reach an agreement, such as the Closing Agreement, that permits the IRS to pay out or recover a sum attributable to multiple years.  Accordingly, the court held that when a taxpayer enters into a closing agreement with the IRS, the IRS can comply with the mitigation rules by “assessing and collecting” any net deficiency from the years covered by the Closing Agreement (or, alternatively, by  “refunding or crediting” a net overpayment).

This approach essentially allows the IRS to take a piecemeal approach to resolving a taxpayer’s liability after entering a Closing Agreement and affords the IRS another “bite at the apple,” even after statutes of limitations for assessment are arguably closed—which could substantially delay closure of a tax dispute and payment of a refund.

Tax Court Signs Off on Homebuilder Tax Deferral

A large family-owned homebuilding business recently prevailed in Tax Court to the tune of millions of dollars of tax deferral.

The Shea family, over the course of about 40 years, built one of the largest private homebuilder businesses in the United States.  The family operated their business through several entities (collectively, the “companies”).  These companies built, developed, marketed, and sold homes in planned communities, replete with amenities ranging from meditation gardens to golf courses.  The communities’ amenities represented a large portion of the companies’ overall costs.  The Tax Court dispute centered on the proper interpretation of an accounting method for reporting the companies’ taxable income.

Pursuant to Code section 460, taxpayers who receive income from contracts that are not completed in the year in which they are entered into generally must recognize income and expenses throughout the duration of the contract (known as the “percentage of completion method of accounting”).  Different rules, however, apply for home construction contracts.  These rules focus on income recognition when a contract is completed.  The statute does not define completion, but Treasury regulations provide two tests for determining whether a contract is completed.

Under the first test, a contract is completed when the customer is able to use the subject matter of the contract for its intended purpose and at least 95% of the total contract costs attributable to the subject matter have been incurred by the taxpayer (the “use and 95% completion test”).  Treas. Reg. § 1.460-1(c)(3)(i)(A).  Under the second test, the contract is completed upon final completion and acceptance of the subject matter of the contract (the “final completion and acceptance test”).  Treas. Reg. § 1.460-1(c)(3)(i)(B).  Although these regulations might seem facially straightforward, the IRS and the companies disagreed about how these regulations should be interpreted.

In particular, the parties disagreed about what constituted the subject matter of each purchase and sales contract.  Per the IRS, the subject matter of each contract was merely the home and lot upon which it sat.  Under the IRS’s interpretation, the companies would be required to report income when each home in the planned communities was sold.  The companies and the Tax Court, in an opinion authored by Judge Robert Wherry, disagreed.

The court concluded that, despite integration clauses which seemingly limited the subject matter of the contract to that which was provided in the contract, the relevant “contract” for purposes of the regulatory analysis was much broader.  The court found it important that homebuyers were contracting not merely for a home, but for the “entire lifestyle of the development and its amenities”, on which the companies focused their marketing efforts.  The court also rejected as “simplistic and short sighted” an IRS argument that certain state law legal definitions relating to real estate contracts should govern the analysis.

The court similarly dismissed the IRS’s interpretation of the relevant regulations.  The court concluded that, contrary to an IRS contention, the plain meaning of the phrase “subject matter of the contract” also included common improvements.  The court noted that the regulations explicitly state that “to determine whether final completion and acceptance of the subject matter of the contract have occurred, a taxpayer must consider all relevant facts and circumstances.”  Accordingly, the court concluded that the companies were entitled to defer income from their contracts until 95% of the total contract costs were incurred or the development (or phase of a development) was completed and accepted.

The court recognized that the “clearly articulated exception for homebuilders . . . reflects a deliberate choice by Congress that home construction contracts should be treated differently and accorded the more generous deferral of the completed contract method.”

In a concluding footnote, the court warned taxpayers from extending the rationale of the case to create “extremely long, almost unlimited deferral periods”.  The court noted that such efforts would likely fail.   That said, similarly-situated taxpayers should consult their tax advisors to determine whether they are on the correct method of accounting and whether their taxable income has been reported consistently with this opinion.  If not, they may be entitled to significant tax deferral.   Note, however, that the IRS generally must approve changes to taxpayers’ methods of accounting.

US Treasury Releases Substantial FATCA Guidance

Continuing its implementation of the Foreign Account Tax Compliance Act (FATCA), the US Treasury Department recently released a package of proposed and temporary regulations.

According to a fact sheet released by the US Treasury Department along with a preliminary version of the temporary regulations on February 20, 2014, this is “the last substantial package of regulations necessary to implement [FATCA].”

Dentons’ tax lawyers analyze the latest on FATCA in this article.

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Recent Amendments to the Federal Rules of Appellate Procedure Include Changes to Procedures for Appeals from Tax Court

On December 1, 2013, amendments to the Federal Rules of Appellate Procedure went into effect.  Several of these amendments relate to appeals from decisions of the U.S. Tax Court.  The amended Rules provide needed clarity on two issues–the procedures applicable to interlocutory appeals from Tax Court, and the Tax Court’s status an independent court, not an administrative agency.

Rules 13 and 14, as previously written, did not address the right to an interlocutory appeal (i.e., an appeal of a trial court ruling that occurs before the entire trial court case has concluded).  Code section 7482(a)(2), however, provides a right to permissive interlocutory appeals from the Tax Court.

Pursuant to section 7482(a)(2), the Tax Court judge presiding over a case essentially must allow for an interlocutory appeal to occur.  Specifically, the Tax Court judge must include with the order to be appealed a statement that a controlling question of law is involved with which there is a substantial ground for a difference of opinion, and that an immediate appeal from that order may materially advance the conclusion of the litigation.  If this statement is included, the U.S. Court of Appeals to which the order is appealable (see section 7482(b)) has discretion to permit an appeal taken from such order.  In addition, Tax Court proceedings are not stayed unless ordered by a judge of the Tax Court or the U.S. Court of Appeals having jurisdiction over the appeal.

As amended, the previously-written Rule 13 became Rule 13(a), and the permissive interlocutory appeal provision was inserted as Rule 13(b).

Rule 13(b) states that an appeal by permission is governed by Rule 5.  Rule 5 provides the general procedural requirements (e.g., to whom the petition for permission to appeal must be filed, the contents of the petition, the page length, etc.) for filing a petition for permission to appeal.

Rule 14 was amended to conform with other rules by specifying that rules (other than Rule 24(a), relating to Leave to Proceed in Forma Pauperis (discussed below)) referring to the “district court and district clerk”  are to be read as referring to the Tax Court and its clerk.

Also modified was Rule 24, “Proceeding in Forma Pauperis”, which in Latin translates closely to “proceeding in the form of a pauper”.  This rule relates to the procedures for seeking waiver of court fees if a party cannot afford these fees.  The amendments to Rule 24 were mostly stylistic.  Per the drafters of the amendments, the language in the previous version of the rule created a false impression that the Tax Court was an agency within the executive branch, rather than an independent court.  The rule previously referred to an appeal from “an administrative agency, board, commission, or officer (including for the purpose of this rule the United States Tax Court)”.  Now, the rule has separate clauses for “an appeal from the United States Tax Court” and “an appeal or review of a proceeding before an administrative agency, board, commission, or officer”.

Managing Claims for ERISA Benefits

Very few areas involve more tax rules and more controversies (with many more opponents than just the Internal Revenue Service) than the area of employee benefits.  You may know this better as the realm of ERISA and ERISA plans.  Occasionally, I will be contributing posts to this blog from the perspective of controversies, tax and otherwise, involving ERISA matters.  This is my first.

There are a variety of ways that an ERISA plan can end up in court.  ERISA provides three basic jurisdictional paths to the courthouse, the most commonly used of which is a suit by a participant or beneficiary for benefits payable by an ERISA-covered benefit plan under section 502(a)(1)(B) of ERISA, 29 USC section 1132(a)(1)(B).  The jurisprudence governing suits of this nature is long and surprisingly complex, and it will provide grist for this blog on multiple occasions in the future.

The U.S. Supreme Court recently addressed a recurring problem area in the jurisprudence under section 502(a)(1)(B) of ERISA in a 9-0 opinion released on December 16, 2013.  In that opinion, the Court determined that a statute of limitations written into a plan document can be enforceable.   Heimeshoff v. Hartford Life & Accident Insurance Co.,  571 U.S. ___ , 2013 WL 6569594 (S. Ct. Dec. 16, 2013).

Julie Heimeshoff was covered under a long term disability plan  insured by Hartford and sponsored by Wal-Mart Stores, Inc.  On August 22, 2005, she filed a claim for LTD benefits under the plan.  For a lot of valid reasons, the final denial of her benefits was not issued until November 26, 2007.  Ms. Heimeshoff then filed suit for the unpaid benefits on November 18, 2010, almost three years to the day after the final denial was issued.  Experienced lawyers among you would look at a claim first asserted in 2005 and at a suit filed on that claim more than 5 years later and think, there has to be a statute of limitations defense in these facts.  You would be correct, but not as clearly as you might suspect.

ERISA has a statute of limitations provision for some lawsuits, but has no stated statute of limitations for actions brought under section 502(a)(1)(B) of ERISA.  The courts have developed a process for providing a statute of limitations for these suits to fill this statutory void.  Like many of its counterparts, the Wal-Mart LTD plan also had reacted to the void by creating its own statute of limitations for these suits.  It contained a provision that stated:  “Legal actions cannot be taken against The Hartford … [more than] 3 years after the time written proof of loss is required to be furnished according to the terms of the policy.”  Ms. Heimeshoff’s lawsuit was filed more than three years after proof of loss was required, but within three years (barely) after the date of the last denial in the plan’s internal administrative review process under section 503 of ERISA.  The question answered by the U. S. Supreme Court was whether after considering these plan terms, Ms. Heimeshoff’s suit was filed too late.  The answer was, yes, it was filed too late.  This three year statute of limitations (that accrued on the date written proof of loss was required) was enforceable so long as the length of the limitations period was “reasonable” and there was no controlling statute to the contrary.

Here are some potentially intriguing action items for consideration:

(1) Seriously consider reviewing any of your existing ERISA plan terms that create a contractual statute of limitations for claims under section 502(a)(1)(B) of ERISA for that statute’s compliance with the requirements of Heimeshoff.  Be sure that during your review, you are differentiating between the plan’s deadline for initially filing a claim for benefits under the plan and the plan’s deadline for filing a lawsuit to attempt to recover unpaid, denied benefits. Only the latter has been affected by Heimeshoff.   Your plan’s new statute may overlap with the period of time needed to exhaust the plan’s administrative remedies under section 503 of ERISA, but it must leave time afterwards for filing suit, so integrate your plan’s new statute of limitations carefully with its internal administrative review procedures and time frames.  The fact that three years was a reasonable length for the statute does not mean that three years or fewer will always be reasonable or that longer than three years will always be unreasonable.  The fact that 9 Justices agreed that three years was reasonable in these circumstances provides no small amount of comfort that three years ought to be reasonable again.

(2)  In cases where it does not already exist in your ERISA plans, seriously consider adding a plan-based statute of limitations for suits brought under section 502(a)(1)(B) of ERISA to seek benefits under your ERISA plan.  In doing so, be careful to select an accrual date trigger (a start date) that will yield consistent results in a variety of circumstances, is as objective and easily discernable by a participant and court as possible and will be viewed by a disinterested trier of fact as being a reasonable way to begin the statute’s running.  For some insured plans, the trigger accrual date used in Heimeshoff – the “time written proof of loss is required” – will work for some insured plans, but not in all such plans, and it is more troublesome as an accrual date for an ERISA plan that is not funded with insurance.

(3)  Heimeshoff said that if the results from applying a plan’s statute of limitations were viewed as too harsh, equitable principles could be used to mitigate the impact.  Not too long ago, the U.S. Supreme Court said in U.S. Airways v. McCutchen that ERISA plans could by their terms limit the application of equitable principles to the plan.  Should your ERISA plan take up the invitations of Heimeshoff and McCutchen and revise its plan terms accordingly?

(4) Consider whether Heimeshoff can be extended to allow your ERISA plan to add and enforce a statute of limitations for suits brought under section 502(a)(3) of ERISA.

IRS Issues PFIC Regulations: A New Start to an Old Beginning

On December 30, 2013, the US Treasury Department (the “IRS”) published a package of proposed, temporary, and final regulations relating to Passive Foreign Investment Companies (“PFICs”) and their shareholders. The most significant component of the package is its guidance on the new annual filing requirements for PFIC shareholders, but the package also includes other, generally minor, changes to existing rules governing PFICs and their shareholders.

The IRS issued the regulations just in time to meet a self-imposed year-end deadline: the IRS wanted the new reporting rules to become effective before 2013 ended so that the new reporting rules would apply during the next filing season. Still, the package includes good news for some PFIC shareholders since the new regulations eliminate a retroactive filing requirement for 2011 and 2012 taxable years that had been threatened in a 2011 IRS notice.

The new regulations address in a limited way a package of technical PFIC regulations originally proposed by the IRS in 1992. Because the new package includes, in a modified form, a small portion of the 1992 proposed regulations, the new package withdraws that portion of the 1992 proposed regulations. The remaining (and outstanding) portion of the 1992 proposed regulations includes provisions that have been severely criticized. So, US investors and tax practitioners must await further IRS action to clarify the status of those proposed provisions and the interpretation of the applicable statutory rules.

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2014 Will Ring in Uncertainty for Many US Taxpayers

When 2013 ends, so will more than 50 US tax provisions. Nearly all of these expiring tax provisions have suffered this fate before, only to be extended retroactively after months of uncertainty for affected taxpayers.

Included among the list of expiring tax provisions are some widely used incentives, such as the research and experimentation tax credit and 50 percent “bonus” depreciation. The list of expiring tax provisions also contains a raft of energy incentives, including the production tax credit for wind energy, incentives for alternative and renewable fuels and credits for energy-efficient appliances and houses. Provisions important to individuals—such as the deduction for out-of-pocket expenses for teachers, higher exclusions for mass-transit benefits and the deduction for state and local sales taxes—will sunset at the end of this year. The same is true for provisions important to US companies with cross-border activities (for example, the “active financing exception” and the subpart F exception for dividends, interest, rents and royalties paid between related controlled foreign corporations) and businesses operating in certain designated or distressed areas. Despite their diversity, these expiring tax provisions have one thing in common: Taxpayers who use them are about to enter months of uncertainty as to their availability.

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Sander Lurie, a member of Dentons’ Public Policy and Regulation practice, co-authored this article.

Companies May be Able to Deduct Settlement Payments Made to Resolve Potential Health Care Fraud Liability

Is there any silver lining when your company settles a False Claims Act suit with the government?  Possibly, in the form of a tax deduction.  In general, a taxpayer may deduct their ordinary and necessary business expenses.  A taxpayer may also deduct, as an ordinary and necessary business expense, a payment made in settlement of a claim.  A taxpayer may not, however, deduct any fine or penalty paid for a violation of the law.  Treasury Regulations provide that compensatory damages paid to the government do not constitute a fine or penalty.

The False Claims Act currently provides for a civil penalty of between $5,000 and $10,000 plus triple the amount of damages which the Government sustains because of the person’s actions.  In general, the damages (i.e., the losses sustained by the government) are considered compensatory, and the $5,000 to $10,000 penalty plus the triple damages (excluding the actual damages) are considered punitive.  For example, let’s say the government suffered a $100,000 loss due to healthcare fraud and imposed a $5,000 penalty plus $300,000 multiplied damages.  Under the general rule, one may think that $100,000 should be considered compensatory, whereas $205,000 would be considered punitive.  The current state of the law, however, is much more nuanced.

In 1976, when a prior version of the False Claims Act which authorized only double damages was in effect, the Supreme Court characterized the damages provision as “necessary to compensate the government completely for the costs, delays, and inconveniences occasioned by fraudulent claims.”   Sixteen years later, with the current triple damages provision in effect, the Supreme Court stated that the “damages multiplier has compensatory traits along with the punitive.”  A case-by-case determination is necessary to determine the portion of punitive and compensatory damages.

In Fresenius Medical Care Holdings, Inc. v. United States, 111 A.F.T.R. 2d 2013-1938 (D. Mass. 2013), the U.S. District Court for the District of Massachusetts (“District Court”), analyzed the deductibility of settlement payments made to the government to resolve a dialysis company’s potential liability under the False Claims Act (i.e., relating to allegations of Medicare and Medicaid fraud) and other causes of action.

During the 1990s, whistleblowers brought qui tam civil actions against an entity that later became a subsidiary of the dialysis company.  The dialysis company, to resolve its potential criminal liability, agreed to pay a substantial penalty.  To resolve its potential civil liability, the dialysis company agreed to pay the government approximately $385 million –of which approximately $66 million was to be paid to the whistleblowers.  The settlement agreement provided that the dialysis company agreed that nothing in the agreement was “punitive in purpose or effect.”  After paying the agreed-upon settlement, the company deducted the entire civil settlement payments as ordinary and necessary business expenses.  The IRS, after an audit, determined that only $193 million (i.e., approximately half) of the settlement payments were compensatory and thus properly deductible.  The dialysis company disagreed with the IRS’s determination that only half of the settlement was compensatory and filed an administrative appeal.  On appeal, the IRS agreed that the approximately $66 million paid to the whistleblowers was deductible, but maintained that approximately $127 million was not deductible.  The dialysis company paid all tax that the IRS said was due, and filed suit to recover the disallowed portion.  After a trial, a jury concluded that an additional $95 million was deductible (i.e., $353 million of the $385 million settlement was deductible).  The dialysis company moved for entry of final judgment.

Stating that “a factfinder must determine to what extent ‘multiple’ damages are, in fact, compensatory”, the District Court made clear that the IRS or taxpayers cannot unilaterally characterize payments.  The District Court found it reasonable for the jury to conclude that pre-judgment interest, which was not included in the settlement agreements, was necessary to make the government whole.  In addition, the District Court found it reasonable for the jury to conclude that the criminal settlement payment was intended to cover the bulk of punitive damages.  The District Court granted the dialysis company’s motion.

Key Takeaway: If you are negotiating with the government to negotiate a False Claim Act settlement you should consider the tax effects.  You may be entitled to a substantial tax benefit.

Notice 2013-78: IRS Proposed Significant Changes to Competent Authority Procedures

U.S. tax treaties generally permit taxpayers to request assistance from the U.S. government to alleviate double taxation or taxation otherwise inconsistent with tax treaties.  The component of a government that handles these requests is typically known as the “competent authority”.   Competent authority provisions are usually contained in a particular treaties’ Mutual Agreement Procedure (“MAP”) article.

The IRS, on November 22, 2013, released Notice 2013-78, proposing a revenue procedure (to supersede Rev. Proc. 2006-54) and providing updated guidance related to requesting U.S. Competent Authority (“Competent Authority”) assistance.  The proposed revenue procedure is also intended to “improve clarity, readability, and organization” and reflect IRS structural changes that have occurred since 2006.  The changes contained within the notice are, in some cases, substantial.

One of the key changes is that, in certain situations, a taxpayer seeking Competent Authority assistance must file a “pre-filing memorandum”.  These situations include, but are not limited to, certain issues relating to a foreign-initiated adjustment of more than $10 million, a taxpayer-initiated position (e.g., a request for refund), the taxation of intangibles, and requests for discretionary limitations of benefits relief.  The pre-filing memorandum must, in the case of a foreign-initiated adjustment, explain the factual and legal basis of the action and describe the steps undertaken in the foreign country and any communications with the foreign competent authority regarding the matter.  Additionally, the pre-filing memorandum must state whether the taxpayer wishes to have a pre-filing conference with the Competent Authority and propose at least three possible dates for such a conference, whether or not the taxpayer wishes to have a conference.

That is, the Competent Authority could require a pre-filing conference–something not provided for in current guidance.  Pre-filing conferences could, however, prove helpful to taxpayers, because the Competent Authority can provide preliminary advice, although such advice is advisory only.

The proposed guidance also greatly expands the Competent Authority’s ability to expand the scope a matter.  Under current guidance, a taxpayer may use a procedure known as the Accelerated Competent Authority Procedure (“ACAP”) to request the expansion of a matter to subsequent taxable periods, if the same issues exist in those periods.  Current guidance also requires the consent of the IRS field office with jurisdiction over the matter.  Under the proposed guidance, however, the Competent Authority is not required to obtain IRS field office consent or even wait for a taxpayer’s request for an expanded scope.  Instead, the proposed guidance permits the Competent Authority to seek to include other years where it is “feasible, practicable, and in the interest of sound tax administration to do so.”  The proposed guidance further provides that the Competent Authority may expand the scope of issues because of its “strong interest in resolving all potential .. . issues in a timely manner”.

Under the proposed guidance, taxpayers must think far in advance whether they wish to seek Competent Authority assistance.  If the IRS memorializes in writing an examination resolution (e.g., a resolution with IRS Examination that is memorialized in a Fast Track Settlement Session Report, a Form 870 waiver, a Form 870-AD offer, a closing agreement, or any other similar agreement) relating to a U.S.-initiated adjustment, it may be too late.  The Competent Authority will accept a request for its assistance relating to U.S.-initiated adjustment memorialized in a such a resolution only if the terms of the resolution are agreed to by the Competent Authority, in writing, prior to its execution.  If the Competent Authority disagrees with the resolution, the Competent Authority will request that the examination team and the taxpayer amend the terms accordingly.  With respect to Fast Track Settlement proceedings, the Competent Authority will accept a MAP request relating to a U.S.-initiated adjustment only if the Competent Authority was named as a participant, and given a reasonable opportunity to participate, in the proceeding (and related IRS meetings).

The proposed guidance also shrinks the time in which a taxpayer may request IRS Appeals assistance through the Simultaneous Appeals Procedure (“SAP”).  Through SAP, as the procedure’s name suggests, IRS Appeals considers the same issues simultaneously with the Competent Authority.  Current guidance provides that a taxpayer may request IRS Appeals assistance, at any time, after filing for Competent Authority assistance.  Under the proposed guidance, a taxpayer has only 60 days after the Competent Authority accepts the taxpayer’s request for assistance.

On the whole, the proposed guidance is intended to make the Competent Authority process more efficient.  If the guidance is issued in its current form, seeking Competent Authority assistance will be more difficult for taxpayers as they will have to decide earlier to request Competent Authority assistance.  Lastly, the Competent Authority would be granted substantially greater powers such as requiring pre-filing conferences and expanding the scope of its assistance to other years or issues.

SCOTUS Vacates and Remands Ford Decision to Determine Proper Jurisdiction

Did Ford commit a venue foot-fault?  The Government thinks so.  An opinion from the Supreme Court last week gives lawyers yet another illustration of the principle that jurisdictional challenges may be raised at any time – even in a court of last resort. In response to Ford Motor Company’s petition for certiorari to recover overpayment interest of approximately $470 million in deposits in the form of cash bonds remitted to the IRS before Ford converted them to payments (see our previous post), the Supreme Court of the United States vacated the Sixth Circuit’s judgment and remanded to the Sixth Circuit.  The opinion can be found here.  The Supreme Court is asking the Sixth Circuit to determine whether the district court lacked jurisdiction under 28 U.S.C. § 1491(a) (the “Tucker Act”), which requires claims against the U.S. founded insofar as relevant upon any Act of Congress be brought in the Court of Federal Claims.  Essentially, the Government argues that refund claims for overpayment interest, as opposed to claims for tax, penalties, and interest on tax and penalties, must exclusively be brought in the Court of Federal Claims rather than an appropriate federal district court.  To explain why it was raising this novel argument for the first time before the Supreme Court, the Government argued that it had failed to previously raise the issue due to controlling circuit precedent holding that 28 U.S.C. § 1346(a)(1) grants original jurisdiction over claims for overpayment interest both to district courts and the U.S. Court of Federal Claims.  Under this precedent, an award of overpayment interest is typically considered to be an essential component of the relief sought under a tax or penalty refund claim and is interpreted to fall within a district court’s refund jurisdiction under 28 U.S.C. § 1346.    

The Supreme Court determined that, because it is a court of “final review” and not one of “first view,” the Sixth Circuit should be the initial court to consider the Government’s claim.  The Supreme Court also urged the Sixth Circuit to consider if such determination impacts whether or not Section 6611 of the Internal Revenue Code (relating to overpayment interest) is a waiver of sovereign immunity that should be narrowly construed.  Interestingly, if the Sixth Circuit again determines that Section 6611 of the Code is the provision that waives sovereign immunity for claims of overpayment of interest, then presumably Ford is in the same place it was before the Supreme Court vacated and remanded the Sixth Circuit’s decision: seeking certiorari and “arguing that the Sixth Circuit was wrong to give [Section] 6611 a strict construction.”  Alternatively, if the Government is correct regarding its interpretation of the Tucker Act, and if the case cannot be transferred to the Court of Federal Claims, Ford may be time-barred from filing a claim for refund, potentially losing its claim to $445 million – an important reminder of the importance of choice of venue when filing suit.

Anticipate Litigation, Check. Anticipate Communications Between a Testifying Expert and Parties Other than the Taxpayer or the Taxpayer’s Attorney, Ch…Wait, What? To Involve Counsel, Or Not To Involve Counsel Is the Question.

Taxpayers continually find themselves facing decisions that will end up being scrutinized during future IRS examinations, and courts have repeatedly found that such concern, coupled with other factual indicia, can satisfy the “anticipation of litigation” requirement for work product protection under Federal Rule of Civil Procedure (“FRCP”) 26(b)(3).  (For a seminal case on this topic, please see United States v. Adlman, 134 F.3d 1194 (2d. Cir. 1998)).  The U.S. District Court for the District of Delaware recently grappled with this issue in a Government action to enforce several IRS summonses related to an examination of a $4.5 billion worthless stock deduction claimed by Vivendi S.A.’s U.S. subsidiary, Veolia Environment North American Operations, Inc. (the “Taxpayer”), during the 2006 tax year. See United States v. Veolia Environment N. Am. Operations, Inc., D. Del., No. 1:13-mc-03 (Oct. 25, 2013).  The taxpayer previously provided 600,000+ pages of bates-stamped documents to the Government in response to more than 25 summonses and hundreds of Information Document Requests during the examination of the Taxpayer’s 2004-2006 tax years.  Approximately 300 withheld documents remained at issue.

In Veolia, the Court found the Taxpayer adequately established their anticipation of litigation during the transaction’s 2006 planning stages.  The Court was specifically persuaded by the Taxpayer’s 2006 retention of outside counsel to advise on litigation possibilities, a Private Letter Ruling request on certain aspects of the transaction, the Taxpayer’s participation in a pre-audit program for the IRS to review the transaction, the Taxpayer’s audit history, and the amount of the claimed deduction.  Interestingly, the Court even opined that if the government’s contention that the Taxpayer had a history of engaging in similar transactions in the ordinary course of business was true, work product protection could still apply given the facts of the case.  This was all consistent with aspects of the established case law on the anticipation of litigation issue.

Unfortunately for the Taxpayer, the Government’s claims and the court’s analysis did not stop there.  During 2006, the Taxpayer retained a French valuation firm to provide a risk exposure analysis on the transaction and identify and supervise U.S. valuation experts that could prepare valuation reports to substantiate the claimed deduction.  One firm was retained in 2006 and produced a pre-transaction valuation report that supported the claimed position and another firm was retained in 2007 to provide a second valuation report to buttress the argument.  These reports were prepared independently and both were ultimately provided to the Government to support the claimed position.

The Government argued that the Taxpayer’s provision of the two valuation reports made their preparers testifying experts under FRCP 26(b)(4) and any communications that relayed factual data to the testifying experts were not protected according to FRCP 26(b)(4)(C)(ii). The first point was not heavily disputed, and the Taxpayer appears to have provided significant amounts of information to the Government during the examination.  Regarding the second issue, the Court focused on the privilege log and held that some of the documents presented therein appear to be factual communications to testifying experts that are not protected under the work product doctrine.  Importantly, the Court also stated that FRCP 26(b)(4)(C) and its protections did not extend to parties other than the Taxpayer or the Taxpayer’s attorneys.  That final point may have been moot in Veolia, given the court’s indication that the referenced communications constituted facts and data; however, it raises an important aspect of the rule to be mindful of.

The number of litigated summons cases involving privilege and work product claims continues to increase.  And the pace of new cases may continue to grow given the IRS’s new IDR policy, which promises to increase significantly the numbers of summonses that are issued.  For taxpayers and tax advisors, this is an area of concern that should be closely monitored.

Can the IRS Circumvent U.S. Law by Issuing a Treaty Request?

Shortcuts to identifying the “soft spots” of a tax return have long tempted the IRS. Those shortcuts are generally quite controversial and have included the aggressive use of penalties to force a reasonable cause defense and the resulting disclosure of privileged materials and, as another example, transparency programs such as Schedule UTP that arguably strain the credibility of the IRS’s policy of restraint with regard to tax accrual workpapers. More recently, with the increasing prevalence of complex, cross-border transactions having multi-jurisdictional tax consequences, there is often a paper trail of tax analysis strewn around the world that is providing the IRS with a new temptation. Would the IRS be tempted to quietly make a treaty request in an attempt to circumvent U.S. privilege protections and obtain the materials without the fuss of a privilege fight? Unfortunately, the IRS and foreign taxing authorities have succumbed to this temptation, and it is something that practitioners should be aware of. The propriety of any such request must be carefully scrutinized and the appropriate interventions should be considered.

Indeed, the IRS has used treaty requests in lieu of following the administrative summons process (as well as its own internal directives) in order to bypass procedural safeguards for the taxpayer to attempt to obtain privileged and protected documents that would otherwise be unavailable to the IRS under U.S. law. This premature and improper use of treaty requests violates two core principles contained in most bilateral tax treaties, and in articles 18-26 of the Convention on Mutual Administrative Assistance in Tax Matters and article 26 of the OECD Model Tax Convention and its Commentary.

First, the issuance of a treaty request to circumvent domestic law is improper and objectionable because the requested nation is not obligated to employ procedures or obtain information that is at variance with or not obtainable under the laws of either country. This means that, for example, where the U.S. issues a treaty request, the same procedural safeguards that exist in the U.S. would also effectively be available with respect to the request. Additionally, the privileges and protections that exist in the requested country also apply. Under U.S. law, the IRS has broad authority to issue a summons for the production of documents or testimony relevant to the purpose of ascertaining the correctness of a return or determining the liability of any person or any internal revenue tax. But the IRS is subject to specific limitations. Significantly, pursuant to United States v. Powell, 379 U.S. 48 (1964), a summons is not enforceable unless it is (1) issued for a legitimate purpose; (2) the material sought is relevant to that purpose; (3) the information sought is not already within the possession of the IRS; and (4) the administrative steps required by the Internal Revenue Code have been followed. Further, the IRS is limited to materials in the possession, custody, and control of the summonsed party and is not entitled to documents that are privileged or protected under U.S. law, including the attorney-client privilege, attorney work product protection, and the privilege against self-incrimination. A requested nation will not employ measures to circumvent these U.S. laws. As noted in the OECD Commentary, one nation cannot take advantage of its treaty partner’s information system merely because it is wider than its own. Thus, a treaty request at variance with the U.S. law, including those discussed above, should be denied.

Second, the issuance of a treaty request before exhausting domestic measures is a clear violation of the international authorities and is grounds for rejection of a request. Under U.S. law, a summons is not self-enforcing. Instead, if the summonsed party fails to comply with the summons, the U.S. government must bring an enforcement action in the appropriate federal district court. And, both the taxpayer and the recipient of a summons have the right to protest the enforcement of a summons by filing a petition to quash in federal district court. The administrative summons procedures thereby provide the prerequisite mechanisms for a court to review the legitimacy of the summons and/or whether the claims of privilege are well-founded. The IRS cannot circumvent a taxpayer’s privileges or right to have a court review these claims by simply pursuing the documents through a treaty request because a request made prior to exhausting the domestic administrative summons procedures should be denied.

The premature and improper issuance of a treaty request merely shifts the burden of potentially protracted and costly disputes to a foreign nation, attempting to force the foreign nation to interpret and decide U.S. law. In addition to the potentially resulting prejudice against the rights of the taxpayer, this shifting aspect is itself clearly an inappropriate imposition on a treaty partner. See article 26 of the OECD Model Tax Convention and its Commentary. Treaty partners are usually quite receptive to these arguments by the objecting taxpayer in intervention proceedings.

Cross-border tax structuring: Is there a common denominator for substance requirements?

Dentons is launching the next phase of  Vox Tax, a series of Dentons global reports dedicated to the most pressing tax matters facing CEOs, CFOs, general counsel and tax directors. Issued periodically throughout the year, Vox Tax reports will focus on a key current topic in the areas of international tax law and tax planning.

Vox Tax’s first report, authored by Dentons’ global Tax group, covers tax structuring in jurisdictions around the world. “Cross-border tax structuring: Is there a common denominator for substance requirements?” examines 14 nations and discusses critical current tax topics, such as treaty shopping and substance. The report was prepared in collaboration with Loyens & Loeff, a Dutch law firm which contributed a chapter on the Netherlands.  To access a digital version of the report, click here.

The Vox Tax report will be accompanied by three upcoming cluster webcasts, each focused on a different region. These brief, interactive seminars are designed to help practicioners reduce risks and optimize tax operations.

Webcast Schedule
Thursday, November 21, 2013
Western Europe: UK, Spain, France, Germany
Time: 9:00 AM PST / 12:00 PM EST / 17:00 GMT / 18:00 CET

Tuesday, November 26, 2013
Central and Eastern Europe / CIS:
Poland, Czech Republic, Slovakia, Romania, Ukraine, Russia
Time: 9:00 AM EST / 14:00 GMT / 15:00 CET

Thursday, December 5, 2013
North America: Canada and the US
Time: 9:00 AM PST / 12:00 PM EST / 17:00 GMT / 18:00 CET

To RSVP, click here.

US Treasury Department Releases Latest Round of FATCA Guidance

Notice 2013-69, released on October 29, 2013, is the latest effort by the US Treasury Department to provide guidance to US and foreign entities that will be subject to the new reporting and withholding rules imposed by the so-called Foreign Account Tax Compliance Act, or “FATCA.” For information on previous guidance issued by the US Treasury Department and background on FATCA, please see our previous alerts titled US Government Announces 6-Month Delay in Certain FATCA Rules and US Issues Final FATCA Regulations.

Notice 2013-69 basically does three things:

  1. publishes the draft Foreign Financial Institution (“FFI”) agreement with which participating FFIs and Model 2 FFIs must comply,
  2. provides updated information about the responsibilities of participating FFIs and Reporting Model 2 FFIs and the FATCA registration process, and
  3. announces the intent to make limited changes to the recently issued FATCA regulations and to other reporting regulations to coordinate with FATCA reporting.

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Jerome Walker, a member of Dentons’ Corporate practice, co-authored this article.

Ford Attempts to Catch the Ear of SCOTUS in Pursuit of Approximately $470 Million

Approximately five years after its Detroit counterparts received billions of dollars from the federal government, Ford Motor Company is attempting to recoup approximately $470 million in overpayment interest it believes it is owed from the federal government.  Ford has petitioned the Supreme Court of the United States claiming that the Sixth Circuit improperly extended the “narrow construction” of a waiver of sovereign immunity to a narrow construction of Section 6611 of the Internal Revenue Code (relating to interest on overpayment of taxes).  In arguing that certiorari is warranted, Ford noted that there is confusion among the circuit courts over the application of the strict construction canon to waivers of sovereign immunity.  The Supreme Court docket for Ford’s case can be found here, and the petition for certiorari is here.

Originally, for the tax years 1983-1989, 1992, and 1994, the IRS determined that Ford had underpaid its taxes.  In an effort to toll potential interest charges on its potential underpayment, Ford took advantage of a special rule in Rev. Proc. 84-58 that allowed it to make additional payments as a cash bond (i.e., a deposit), which had the effect of stopping the accrual of underpayment interest.  Years later, Ford converted the deposit into an “advance payment” to satisfy further tax liabilities.  However, the IRS subsequently determined that Ford had overpaid its taxes for the years in question.  Ford then received from the IRS the amount of the overpayment, plus interest.  The parties agree on the amount of the overpayment, but disagree as to when the overpayment interest should begin to accrue.

Ford argued, unsuccessfully, that the date of overpayment began once Ford had submitted the deposit.  The government argued that since the payments must be made with respect to a tax liability, the date of overpayment did not begin until Ford requested that the IRS treat the cash bonds as “advance payments” to satisfy further tax liabilities.   The district court agreed with the government, holding that Ford was not entitled to overpayment interest until it converted the deposit into an advance payment.  Ford Motor Co. v. United States, 105 A.F.T.R.2d 2010-2775 (E.D. Mich. 2010) (available through PACER and major commercial reporting services).

On appeal, the Sixth Circuit, acknowledging that Ford’s interpretation of Code Section 6611 was “strong,” applied a strict construction canon to Code Section 6611 and affirmed the holding of the district court.  Ford Motor Co. v. United States, 508 Fed. Appx. 506 (6th Cir. 2012) (not recommended for publication).  The Sixth Circuit found that that Code Section 6611 is the provision that waives sovereign immunity for claims of overpayment interest and that the canon of narrow construction should apply to resolve the interpretation of Code Section 6611 in the government’s favor.

Ford is now asserting that 28 U.S.C. § 1346(a)(1) is the provision that waives the government’s sovereign immunity with respect to overpayment interest, and Code Section 6611 is the provision that confers the substantive right underlying the claim for overpayment interest.  As such, and consistent with Supreme Court precedent, Code Section 6611 should not, Ford argues, be subject to the strict construction canon.  In Ford’s petition for certiorari, it argued that “in direct conflict with [the Supreme] Court’s precedents, the Sixth Circuit invoked the strict construction canon to construe not the waiver of sovereign immunity, but instead the separate, substantive provision.”  If the Supreme Court rules in Ford’s favor (and sends the case back to the Sixth Circuit on remand), the Sixth Circuit’s seemingly sympathetic view of Ford’s reading of Code Section 6611 may ultimately lead to a decision that could lead to some taxpayers seeking additional interest on overpayments.   However, in 2004 Congress enacted Code Section 6603, which provides, in general, that if a taxpayer follows certain procedures pursuant to a deposit made after October 22, 2004, interest may accrue from the date of the deposit so long as the deposit is with respect to a “disputable tax.”  Thus, even if Ford were to prevail, taxpayers that follow the requirements of Code Section 6603 (and corresponding Revenue Procedure 2005-18) will not have to rely on the Ford case.

Another Instance Where Relying on a Tax Expert Does Not Excuse Penalties Imposed On A Taxpayer

Although it seems reasonable for a taxpayer to assume that by soliciting the advice or services of a tax expert the taxpayer would be insulated from any tax penalties stemming from a mistake made by the tax expert, unfortunately, case law does not always support that assumption.  Specifically, the Ninth Circuit recently ruled that a taxpayer was liable for a penalty for filing a late estate tax return even though the taxpayer relied on a certified public accountant (CPA), who incorrectly advised him about the extended filing deadline.  See Knappe v. United States, 713 F.3d 1164 (9th Cir. 2013).

In Knappe, the taxpayer was named as the executor of an estate.  Because the taxpayer had no prior experience serving as an executor or filing an estate tax return, the taxpayer enlisted the help of a CPA.  The CPA correctly informed the taxpayer that the deadline for filing the estate tax return was nine months after the decedent’s date of death.  In need of additional time to prepare the return, the taxpayer sought advice from the CPA about requesting an extension of the filing deadline from the IRS.  The CPA mistakenly told the taxpayer that he could obtain a 12-month extension of both the filing and payment deadlines.  Acting on the erroneous advice, the taxpayer filed the estate tax return several months late and the IRS assessed a 20% late filing penalty, amounting to $196,414.60.

The taxpayer argued that his reliance on the CPA constituted “ordinary business care and prudence” such that the taxpayer had an apt defense to the penalty—the failure was due to reasonable cause and not due to willful neglect.  The Ninth Circuit, however, disagreed.

The Ninth Circuit addressed the familiar Supreme Court case, Boyle, which involved a taxpayer who delegated the task of filing a tax return to an expert, only to have the expert file the return late.  Boyle v. United States, 469 U.S. 241 (1985).  In contrast to Boyle, the taxpayer here did not delegate the task of filing the return to an expert.  Rather, the taxpayer personally filed the return after the actual deadline, but within the time that the CPA erroneously told him was available.  In fact, the Supreme Court in Boyle expressly declined to address the precise question posed in Knappe.

In Boyle, the Supreme Court drew a sharp distinction between substantive tax advice, on which taxpayers may reasonably rely, and non-substantive tax advice, on which taxpayers may not rely.  The Supreme Court explained that determining the filing date for a tax return is a non-substantive matter.  Although determining the date for a filing extension is different from simply determining a filing deadline, the Ninth Circuit found that it was not different enough.  That is, similar to the question of the determining the filing deadline of a tax return, the question of when the estate tax return was due once an extension had been obtained is also a non-substantive question.  Accordingly, the Ninth Circuit concluded that the taxpayer did not exercise ordinary business care and prudence when he relied on the CPA’s advice regarding the extended deadline.

Interestingly, the Ninth Circuit cited another tax case that treated the question of whether multiple filing extensions were available to the taxpayer as a substantive question, thus, absolving the taxpayer of tax penalties.  It seems there’s a very fine line separating substantive tax advice from non-substantive tax advice.

SCOTUS Struggles with TEFRA Jurisdiction: Oral Arguments in United States v. Woods

On October 9, 2013, the U.S. Supreme Court heard oral arguments in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562).  The original question presented to the Court by petitioner was whether the 40% gross valuation misstatement penalty applies to transactions that lack economic substance.  When the Court granted the certiorari petition, however, it expressly asked the parties to brief and argue the additional question of whether the district court had jurisdiction in the case under I.R.C. section 6226 to consider the substantial valuation misstatement penalty at issue.  And it was this jurisdictional question that dominated oral argument before the Court.

Both the parties and the Court focused on the statutory language granting a court jurisdiction at the partnership level.  Specifically, I.R.C. section 6226(f) grants a court jurisdiction to determine “all partnership items . . . and the applicability of any penalty . . . which relates to an adjustment to a partnership item.”  Justice Kagan attempted to narrow the issue to whether the penalty was directly or indirectly “related to” a partnership item, and accused both parties of adding something to the statute: the taxpayer requiring the penalty “directly” relate, and the government asking the Court to read the statute to include any penalties “indirectly” relating to a partnership item.  Counsel for the taxpayer-Respondent explained that Congress separately defined an “affected item”, which includes outside basis, and could have explicitly expanded the statute to include penalties related to the partnership item and affected items, but it did not.  Respondent later reminded the Court that tax penalties are strictly construed in favor of the taxpayer and that any ambiguity must be resolved in the taxpayer’s favor.

On the merits, Respondent’s counsel focused on Congress’ intent and the context of the statute, arguing that the statute deals with a different situation than the one before the Court: the statute addresses a misstatement of value, not an entirely disallowed transaction.  Respondent explained the distinction by analogy, “if I donate a painting that I say that is worth $1 million to a church and I put that on my return, but, in fact, it turns out that I didn’t donate the painting, I may have committed a fraud . . . but I haven’t made a valuation misstatement, nor have I misstated my basis.”  As multiple Justices recognized, Congress enacted a new statute in 2010 to directly address that problem, in a noneconomic substance penalty.  See I.R.C. § 7701(o).  Both parties before the Court agreed that the noneconomic substance penalty would apply to the current case had that penalty been on the books at the time of the transaction.

Neither advocate had much time to argue the merits of the case, and, interestingly, the Justices asked few questions during those parts of the arguments.  On the other hand, questions from the bench commanded the jurisdictional arguments.  While tax practitioners may be hoping for a decisive answer to the question on the merits, it is possible the Court will issue a more narrow ruling that it lacks jurisdiction in this case to answer that question.  Of course, predictions based on oral arguments alone are like writing in the wind and the running water.  It is difficult to predict whether the Justices will rule on the merits of the case, much less what that ruling may be.

Adam Pierson, a member of Dentons’ Litigation practice, co-authored this article.

Jurisdiction to Dispute Penalties: Partner v. Partnership-Level Proceedings

The U.S. Supreme Court recently heard oral arguments in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562).  In addition to the heavily-disputed circuit split regarding the gross misstatement penalties, the Court may rule on a complicated jurisdictional question implicated in TEFRA partnership proceedings.  Although neither party nor the lower courts raised the issue, the Court directed the parties, without further detail, to brief and argue whether the district court had jurisdiction under I.R.C. § 6226 to consider the substantial misstatement penalty for an underpayment “attributable to” an overstatement of basis.  Accordingly, the Court may address the issue of whether penalties related to the overstatement of outside basis must be resolved in a partnership proceeding or must be raised in a subsequent partner-level claim.  It is possible that the Supreme Court may resolve the Woods case on jurisdictional grounds, without addressing the substantive circuit split on whether the 40% gross valuation misstatement penalty applies to transactions that lack economic substance, though most believe that it will also address the circuit split on the gross valuation misstatement penalty.

In either event, the fact that the Supreme Court directed the parties to brief and argue the jurisdictional issue is a pointed reminder that the TEFRA partnership audit procedures are outdated and in desperate need of a fix.  In fact, TEFRA jurisdictional issues have generated huge amounts of litigation about partnership tax procedure, often without addressing the underlying merits of a tax dispute.  So the Supreme Court’s guidance in Woods on TEFRA jurisdiction may have far reaching impact and either confirm or cast doubt on a whole series of ad hoc TEFRA procedural decisions over the past ten years.

In Woods, the particular TEFRA partnership procedures at issue involves penalties.  When TEFRA was originally enacted, penalties were not partnership items and had to be resolved in individual partner-level proceedings after the completion of the partnership audit and any resulting tax litigation.  In 1997, congress amended TEFRA to provide that penalties are determined at the partnership level without reclassifying penalties as partnership items.  As a result, significant confusion arose as to whether all or only a portion of the penalty issues (e.g., everything except the reasonable cause defense to penalties as this is specific to an individual partner’s state of mind) can be determined in a partnership proceeding.  Also, significant issues arose as to whether a court has jurisdiction in a partnership  proceeding over penalties if the underlying adjustment resulting in a partner-level underpayment of tax is itself not a partnership item.

Many courts have found that the reasonable cause defense to penalties is jurisdictionally appropriate at the partnership level when the defense involves the conduct and state of mind of the partnership’s managing member or when the defense is not personal to the partners or dependent on their separate returns.  Where the penalties imposed require a determination of non-partnership items, however, courts have found the defense properly raised at the partner level.  Thus, several courts have found no jurisdiction in a partnership-level proceeding when the penalties related to the outside bases of the individual partners because outside bases are generally not partnership items and must determined at the partner level.  It is this last point that the Supreme Court in Woods has focused its jurisdictional analysis on, even though the parties to the case did not raise jurisdictional questions.

After being directed to brief the issue, the taxpayers in Woods rely heavily on Tax Court decisions Jade Trading and Petaluma to argue that the district court lacked jurisdiction to impose the penalty because it relates to a nonpartnership item, i.e., the partner-by-partner determination of the partners’ outside (or tax) bases in the partnership interests.  See Petaluma FX Partners LLC v. Comm’r, 591 F.3d 649, 655-56 (D.C. Cir. 2010), on remand 135 T.C. 366; Jade Trading v. United States, 80 Fed. Cl. 11, 60 (2007), aff’d in part and vacated in part, 598 F.3d 1372 (Fed. Cir. 2010).  In contrast, the government argued that the district court had jurisdiction to impose the penalty because the issue was a partnership item.  Interestingly, the government previously conceded that its argument was wrong.  See Brief for Respondents, United States v. Woods, 133 S. Ct. 1632, 2013 WL 3816999, *21-24 (July 19, 2013) (citing Logan Trust v. Comm’r, No. 12-1148 (D.C. Cir. Oct. 25, 2012) (“We agree that outside basis is an affected item, not a partnership item . . .”)).

Hopefully, the Supreme Court’s jurisdictional decision in Woods clarifies—instead of further confuses—TEFRA jurisdictional rules.  Given the current political environment in Washington, D.C., it is unlikely that congress would take up a statutory fix to TEFRA, much less agree on what that fix should look like.  The current case-by-case, and often conflicting, judicial resolution of TEFRA issues is maddening to lawyers, judges, and especially taxpayers who simply want the merits of their tax cases decided.

Did the Tax Court Enforce Retroactive Penalties?

Taxpayers and practitioners alike were unsettled by recent language from a Tax Court opinion suggesting that retroactive penalties may be enforced.  See Soni v. Comm’r, T.C. Memo. 2013-30.   In Soni, the Tax Court summarily stated “[t]his Court has decided previously that taxpayers may be liable for a penalty arising from a transaction entered into before the penalty was enacted.”  Id. at *8.  In support, the Court cited Patin v. Comm’r, 88 T.C. 1086, 1127 n.34 (1987), aff’d without published opinion, 865 F.2d 1264 (5th Cir. 1989), and aff’d without published opinion sub nom. Hatheway v. Comm’r, 865 F.2d 186 (4th Cir. 1988), and aff’d sub nom. Skeen v. Comm’r, 864 F.2d 93 (9th Cir. 1989), and aff’d sub nom. Gomberg v. Comm’r, 868 F.2d 865 (6th Cir. 1989) (all available through major commercial case reporting services); McGehee Family Clinic, P.A. v. Comm’r, T.C. Memo. 2010-202, slip op. at 6.

Retroactive penalties conflict with Congress’ express recognition that taxpayers, as a general matter, should not be penalized if their tax return filing position is successfully challenged by the IRS if—at the time the return was originally filed—the taxpayer took the position reasonably and in good faith.  The primary exception to this fundamental proposition is the new and arguably strict liability penalty for transactions lacking economic substance.  Some would argue, and the IRS routinely does in fact argue, that if a transaction lacked economic substance, it necessarily was not entered into reasonably and in good faith.  Obviously, we disagree with this argument given the ever-shifting and vague economic substance doctrine.  Nonetheless, what to make of Soni and the cases it relied upon?

A close review of the facts and holding of Soni reveals that the Tax Court did not impose retroactive penalties.  In summary, the court enforced penalties arising from transactions entered into before the transaction was subject to penalty—not before the penalty was enacted.  This is a fine, but significant, distinction.

In Soni, the taxpayers engaged in a certain transaction beginning in 2001.  In a revenue ruling issued three years later, the IRS “listed” the transaction as an abusive tax shelter, arguably putting the taxpayer on notice that the transaction could not be entered into in good faith. (Obviously, this line of reasoning ignores the fact that the IRS has “delisted” certain transactions that it previously considered abusive.)  Even after the transaction was listed, the taxpayer continued to engaged in it.  For the taxable year ending after the revenue ruling was effective, the IRS sought to impose a penalty under I.R.C. section 6662A (for understatements with respect to reportable transactions) on the taxpayers for engaging in the listed transaction at issue.

Part of the taxpayers’ defense to the penalty was that they relied upon a favorable IRS determination letter issued in 2002, before the revenue ruling was issued.  In upholding the penalty, the court found that the revenue ruling should have put the taxpayers on notice that they could no longer rely upon such determination letter and that the transaction was now a listed transaction—“[i]gnorance of the law is no excuse for noncompliance with the applicable law.”  Id. at *10.

None of the cases cited by the court in Soni (listed above) actually applied penalties retroactively or stand for the proposition that a penalty can be applied prior to the enactment of the penalty statute.  In fact, in McGehee, the court explicitly stated that the penalty was not being applied retroactively and was applicable only to tax years ended after the date of enactment of the penalty at issue.  See McGehee, T.C. Memo. 2010-202.  So, despite the loose language in Soni, the Tax Court did not open the floodgates to retroactive penalties.

IRS Clarifies Renewable Energy Construction Requirements

The IRS released Notice 2013-60 (the “Current Notice”) last week which clarifies the beginning of construction requirements for the renewable energy production tax credit(PTC) or the investment tax credit (ITC). A taxpayer will be eligible to receive the PTC under Section 45 of the Code, or the ITC under Section 48 of the Code in lieu of the PTC, with respect to a facility if construction of such facility begins before January 1, 2014. As you may know, the IRS released Notice 2013-29 in April, 2013 (the “Prior Notice”), which provides the taxpayer with two methods for establishing the beginning of construction: starting physical work of a significant nature (the “Physical Work Test”); or paying or incurring five percent or more of the total cost of the facility (the “Safe Harbor”).

The Current Notice provides a method for taxpayers to satisfy the continuous construction or continuous efforts tests, clarifies that the master contract rules apply to the Safe Harbor, and clarifies that a taxpayer may transfer a facility after construction has begun.

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The Eighth Circuit Weighs in on Whether Outside Basis is an Affected Item at the Partner Level

As a part of the continuing TEFRA partnership audit proceeding litigation saga, the Eighth Circuit in Thompson v. Comm’r, (No. 12-1725) (Sept. 9, 2013), weighed in on the question of whether outside basis can be decided at the partnership level, or whether it is an affected item that must be determined subsequently at the partner level.  In Thompson, after partnership-level proceedings involving a SON-of-BOSS transaction were decided in favor of the government, the IRS issued a notice of deficiency to the partners explaining several adjustments made to their individual returns and imposing a 40% accuracy-related penalty.  When the taxpayers filed a petition in Tax Court to challenge the notice of deficiency, the IRS moved to dismiss for lack of jurisdiction and argued that the notice was issued in error and that the deficiency procedures of I.R.C. § 6230(a)(1) were inapplicable.  The Tax Court agreed with the IRS and dismissed the partners’ petition.  Writing for the majority, Judge Wherry held that computing the partners’ deficiency arising from the adjustments finalized in the partnership-proceeding did not require any partner-level determinations since the partnership activities “constituted an economic sham” that “foreclosed [the partners] from claiming any loss on liquidating a partnership interest in a disregarded partnership.”  On appeal, the Eighth Circuit reversed, holding that the Tax Court erred in determining that it lacked jurisdiction over the petition.

The Eighth Circuit’s focus, interestingly, was on whether the Tax Court actually made a determination of the partners’ outside basis in the partnership-level proceeding.  The Eighth Circuit held that because the Tax Court did not determine the partners’ outside basis in the partnership, the notice deficiency procedures were applicable and the Tax Court had jurisdiction to consider the taxpayers’ petition.  But, as Judge Gruender noted in his concurring opinion, the question is not whether the Tax Court made the determination; Judge Gruender argued that the Tax Court did in fact make a determination that the partners’ outside basis in the partnership was zero, but that this determination must be “determined at the partner level.”

In holding the Tax Court had jurisdiction, the Eighth Circuit agreed with other circuits to have addressed the question, citing Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010) and Petaluma FX Partners, LLC v. Comm’r, 591 F.3d 649 (D.C. Cir. 2010).

The United States Supreme Court may rule on this issue in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562), where, on its own initiative, the Court directed the parties to brief and argue whether the district court had jurisdiction to consider the substantial misstatement penalty for an underpayment “attributable to” an overstatement of basis.

US Government Announces 6-Month Delay in Certain FATCA Rules

Recognizing the practical and logistical problems faced by US withholding agents and foreign financial institutions (“FFIs”), and the uncertainty faced by many FFIs and foreign governments about whether an intergovernmental agreement (“IGA”) will be in effect by January 1, 2014, US tax authorities on July 12, 2013, issued Notice 2013-43. Notice 2013-43 states that the US Treasury Department and US Internal Revenue Service (“IRS”) will postpone by six months, to July 1, 2014, the start of withholding required by the so-called Foreign Account Tax Compliance Act, or “FATCA,” and make corresponding adjustments to various other time frames provided in the final regulations. The Notice states that its goal is to allow for a more orderly implementation of FATCA. The Notice gives affected entities more time to adjust to FATCA; it generally does not, however, relax the long-term, substantive withholding and reporting obligations imposed by FATCA.

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Jerome Walker, a member of Dentons’ Corporate practice, co-authored this article.

Major Deadline Approaching to Minimize Exposure for Unclaimed Property Liability

Delaware corporations and other business entities have a limited opportunity to minimize and liquidate exposure to Delaware unclaimed property liability by enrolling in Delaware’s Voluntary Disclosure Agreement Program. The VDA program permits companies not under audit to voluntarily disclose and pay the amount of unclaimed property without interest or penalties. To obtain the maximum benefit of the VDA program—a waiver of all interest and penalties on reported property from transactions in 1996 and later, and an exclusion of property arising from transactions that took place prior to 1996—a company must enroll by June 30, 2013. An audit could otherwise subject a company to liability for transactions that took place as far back as 1981, plus interest and penalties which could double the amount due.

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Kate F. Buckley and Sara R. Werner, members of Dentons’ Corporate practice, co-authored this article.

US Senate Passes Marketplace Fairness Act

On May 6, 2013, as anticipated when the Senate recessed last week, the US Senate passed the Marketplace Fairness Act of 2013 (S. 743). The bill’s passage was the culmination of a flurry of action by the Senate in recent weeks, including an April 25th procedural vote that ended debate on the bill and sent the bill to the floor of the Senate which passed the bill by an overwhelming majority.

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Sander Lurie and John R. Russell IV, members of Dentons’ Public Policy and Regulation practice, co-authored this article.

Changes Proposed to US Tax Reporting Rules for “Outbound” Transfers

On January 30, 2013, the US Treasury Department (IRS) proposed amendments to existing gain recognition agreement (“GRA”) regulations that apply to US persons who transfer stock of a US corporation or a foreign corporation to a foreign corporation. The proposed changes to the GRA regulations address the consequences to US persons for failing to file GRAs and related documents (failure to file), to comply in any material respect with the terms of, or rules governing, GRAs (failure to comply), or to satisfy other reporting obligations. The proposed changes would affect not only future reorganizations and contributions of stock to foreign corporations, but also prior transfers that continue to be subject to GRA reporting. The proposed changes also provide similar failure to comply rules with respect to liquidating distributions to foreign corporations and certain other document filing requirements arising with a US person’s transfer of stock or assets to certain foreign corporations.

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US Issues Final FATCA Regulations

On January 17, 2013, the US Treasury Department (IRS) released final regulations to implement the US reporting and withholding rules originally enacted in 2010 and frequently referred to as the Foreign Account Tax Compliance Act, or FATCA. Beginning on January 1, 2014, the FATCA rules generally impose a 30 percent withholding tax on many types of payments of US-source income to a foreign entity (“withholdable payments”) unless the foreign entity reports certain information about any US account holders or owners it possesses. The FATCA rules apply directly to withholding agents, foreign financial institutions (FFIs) and non-financial foreign entities (NFFEs), but their indirect impact is far broader and often affects unsuspecting parties.

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Jerome Walker, a member of Dentons’ Corporate practice, co-authored this article.

Scuffling at the Edge of the Fiscal Cliff

On December 31, 2012, a host of tax and spending provisions were scheduled to expire. On January 2, 2013, substantial cuts to defense programs and to domestic discretionary spending also were scheduled to commence. Negotiations in Washington regarding these provisions had been taking place for weeks without resolution, with a sequence of different negotiating partners seeking, and failing, to reach agreement. Finally, on New Year’s Eve, Senate Minority Leader McConnell and Vice President Biden were able to work out a compromise package, and in an unusual New Year’s Eve session that stretched well into New Year’s Day, the Senate overwhelmingly passed the package. In an even more unusual New Year’s Day session, the House of Representatives passed the Senate package unchanged, with House Democrats voting overwhelmingly for it while a majority of House Republicans voted against it. The package, entitled the “American Taxpayer Relief Act of 2012,” now goes to the President who has stated that he will sign the bill.

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Michael E. Zolandz and Gary L. Goldberg, members of Dentons’ Public Policy and Regulation practice, co-authored this article.

IRS Updates FATCA Guidance

On October 24, 2012, the US Internal Revenue Service (“IRS”) issued Announcement 2012-42 along with a table (reproduced below) that summarizes certain Foreign Account Tax Compliance Act (“FATCA”) due diligence deadlines. The changes announced are limited, but they demonstrate that the IRS and the US Treasury Department continue to make modifications to the FATCA withholding and reporting rules in response to comments, especially comments focused on practical problems encountered by entities trying to implement and comply with FATCA.

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Jerome Walker, a member of Dentons’ Corporate practice, co-authored this article.

IRS Clarifies and Tightens New “Anti‑Inversion” Regulations

On June 7, 2012, the US Treasury Department (the “IRS”) issued new regulations interpreting the US tax rules that apply to “expatriated entities.” An expatriated entity, sometimes referred to as an “inverted company,” is a US company (usually the parent company of a group of US and foreign affiliates) that seeks to become a lower-taxed foreign company rather than a higher-taxed US company. In 2009, the IRS issued temporary regulations that were scheduled to expire on June 8, 2012 (the “2009 temporary regulations”), and the regulations released on June 7 were issued shortly before the 2009 temporary regulations lapsed.

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Looming Tax and Spending Changes Cause Mounting Uncertainty

It has been given different names: “fiscal cliff,” “taxmageddon,” all of which sound like the name of bad screenplays written by a tax lawyer or accountant.

However, the pending expiration of tax and spending provisions, implementation of across-the-board spending cuts, and need to raise the federal debt limit are real and will come to a head in the United States within the next several months.

This alert summarizes the possible consequences of these issues, especially the effect of their confluence, and analyzes possible outcomes.

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Mike McNamara and Michael E. Zolandz, members of Dentons’ Public Policy and Regulation practice, co-authored this article.

Fighting Back: Taxpayers Challenge State Tax Assessments Based on Contingent-Fee Transfer Pricing Audits

In today’s economic environment, it is no secret that many states face significant budget shortfalls. In response to these circumstances, certain state treasury departments have begun to propose new income tax assessments based on transfer pricing studies that they have “outsourced” to third-party audit firms, often on contingent-fee terms. These arrangements, however, have left many taxpayers concerned. A state department of revenue’s combination of broad powers to propose adjustments and enjoyment of significant deference from state trial courts has traditionally been tempered by an expectation that the department will carefully exercise its discretion in making its assessment. But taxpayers are left wondering whether this powerful check on what otherwise might be arbitrary or capricious assessments is effectively abandoned where that state turns to a third-party, operating without transparency and on a contingent-fee basis, to pursue assessments under a highly technical area of the law (i.e., transfer pricing) with which the state department of revenue may, itself, have only limited experience.

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US Treasury Department Issues Final “Bank Deposit” Interest Reporting Regulations

On April 17, 2012, the US Treasury Department released final regulations and a revenue procedure setting forth the requirements for US offices of certain financial institutions to report on the interest earned by nonresident individuals. Although the regulations, and the multiple sets of proposed regulations that preceded them, are often referred to as the “bank deposit” interest regulations, the preamble to the regulations notes that they will affect commercial banks, savings institutions, credit unions, securities brokerages, and insurance companies that pay interest on deposits. The new reporting rules apply to interest paid on or after January 1, 2013.

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New Foreign Tax Credit Regulations Issued

On February 14, 2012, the US Treasury Department (“IRS”) published in the Federal Register regulations dealing with two separate but related foreign tax credit issues. One set of regulations, which are proposed and temporary, provide guidance to taxpayers on how to interpret section 909 of the US Internal Revenue Code which denies a foreign tax credit for certain “foreign tax credit splitting events.” The other set of regulations, which are final, provide guidance on which person is considered to pay a foreign tax and is therefore eligible to claim a credit for the foreign tax paid.

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US Department of the Treasury Releases Proposed Regulations Implementing FATCA

On February 8, 2012, the US Department of the Treasury (the “Treasury Department”) issued detailed proposed regulations to implement the withholding and reporting rules commonly referred to as the “Foreign Account Tax Compliance Act” or “FATCA.” The proposed regulations supplement and, in some cases, modify the rules the Treasury Department previously announced in a series of notices. The release of the new rules provide an opportunity, in advance of the implementation dates, for foreign financial institutions (“FFIs”) to, among other things, determine the impact of the reporting and withholding requirements on their operations, including how much due diligence is required, whether the FFI systems must be enhanced, whether FFI records are currently readily retrieveable, whether the current number of customer files require that due diligence commence now, whether the FFI has sufficient staffing levels, whether FFI staff is sufficiently trained to implement FATCA, and whether third party assistance is required.

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Edward Hickman and Jerome Walker, members of Dentons’ Corporate practice, co-authored this article.

IRS Announces Third Special Offshore Voluntary Disclosure Initiative

The Internal Revenue Service (IRS) announced on January 9, 2012 that it has reopened its voluntary disclosure initiative for the third time, in response to the US government’s continuously widening investigation of foreign banks relating to unreported offshore accounts of US persons. This third special disclosure initiative follows the IRS’s 2009 and 2011 Offshore Voluntary Disclosure Programs (OVDPs) and is available to those taxpayers who did not file in time for the 2009 or 2011 OVDPs. As in the past the OVDPs are designed to bring offshore money back into the US tax system and help individuals with undisclosed income from hidden offshore financial accounts get current with their taxes. This program allows individuals with previously unreported foreign financial accounts to significantly reduce their exposure to substantial civil tax penalties and, in many cases, to eliminate the possibility of criminal prosecution. Foreign accounts include assets held in offshore trusts, foundations, corporations and other entities.

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Specified Foreign Financial Assets: New Form Must Be Filed With US Tax Return

The US Department of the Treasury (the “IRS”) recently released temporary and proposed regulations (the “Temporary Regulations”), effective December 19, 2011, to implement the provisions of the Hiring Incentives to Restore Employment (HIRE) Act that require individuals to report specified foreign financial assets (“SFFAs”) to the IRS. The Temporary Regulations apply to individuals required to file Form 1040, “US Individual Income Tax Return,” and to certain individuals required to file Form 1040-NR, “Nonresident Alien Income Tax Return.” The reporting required under the Temporary Regulations must be made on Form 8938, Statement of Specified Foreign Financial Assets.

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“Strategies for Managing Parallel Proceedings with Fifth Amendment Implications,” Inside the Minds: Strategies for Criminal Tax Cases

The DOJ Tax Division has long recognized the efficacy of parallel criminal and civil proceedings and actively pursues them in its current endeavor at increased enforcement. Parallel proceedings often present complicated issues that create additional challenges for taxpayers and their attorneys. When a parallel proceeding is pending, the invocation of the Fifth Amendment by either the taxpayer, a tax advisor, or other non-party witness can create adverse implications in a subsequent proceeding.  Taxpayers and their attorneys must carefully navigate the risk of an adverse inference against the taxpayer under the circumstances of the particular case.  The well-informed attorney can prepare to face all of these issues and effectively navigate the specific facts of his or her case.  The following discussion will explain and analyze: the effect of a party’s invocation in independent proceedings, the effect of a party’s invocation in parallel proceedings, the implications of a non-party’s invocation, and whether an invoker can waive the privilege and later testify.

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The Erosion of the Fifth Amendment Privilege

“You’d have to be living in a hole not to know that the U.S. government is really focused on offshore tax evasion,” IRS Commissioner Shulman told Bloomberg News earlier this year. The Bank Secrecy Act of 1970 (“BSA”) permits civil and criminal penalties for U.S. taxpayers who fail to report interests in foreign financial accounts. In the past, however, civil and criminal enforcement was rare; between 1996 and 2002 only twelve indictments were reported. In 2001, heightened financial reporting requirements were enacted under the Patriot Act, which is expressly designed to help prosecute international crimes. The government’s formal declaration of war on foreign tax evasion was commemorated in 2008 when a district court authorized the IRS’s John Doe Summons on Swiss bank UBS, demanding documents identifying U.S. taxpayers with unreported accounts. This order followed the indictments and guilty pleas of a high-profile UBS customer and his private UBS banker. In 2009, the DOJ charged UBS with aiding U.S. taxpayers in tax evasion. The bank avoided prosecution by paying $780 million and disclosing account data. Shulman promised severe penalties as the government pursued “criminal avenues” for these targeted individuals. Criminal charges have since been filed against numerous taxpayers, bankers, financial advisers, and lawyers linked to the data. Still, earlier this year, the IRS threatened offshore bank account holders with the increasing risks of criminal prosecution.

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Qualified Offers and the Recovery of Administrative and Litigation Costs from the IRS

Taxpayers and taxpayers’ counsel may be able to proactively fit within the net worth requirements set forth in 28 U.S.C. § 2412(d)(1)(B), which sets forth the standard applicable to both recovery of litigation costs and shifting the burden of proof to the government in tax cases. For example, a taxpayer may be able to successfully fit within net worth requirements by making distributions at any time before the date the case is filed. The following discussion provides a summary of this taxpayer position in recent litigation, the government’s opposition to this position, and the taxpayer’s appropriate—and successful—reply. In addition, relevant portions of the court’s holding and the case law the Government relied upon is also attached for the convenience of the reader. This discussion contains excerpts from Southgate Master Fund, LLC v. United States651 F. Supp. 2d 596 (N.D. Tex. 2009).

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