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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  Revah v. Comm’r, No. 11-70211 (9th Cir. Sept. 17, 2014) (unpublished opinion).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.

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.

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.

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.

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.