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

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

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

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

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

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

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

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

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

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

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Taxpayer Loses Claim for Research Credit

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

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


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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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With the IRS, Mail Delivery Counts!

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

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

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

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

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

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

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

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

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

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IRS Proposes New Regulations to Settle Supervisory Approval of Penalties Requirements

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

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

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

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

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

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

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

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