TAX CONTROVERSY 360
TAX CONTROVERSY 360
McDermott Will & Schulte’s real-time tax disputes insights
TAX CONTROVERSY 360
McDermott Will & Schulte’s real-time tax disputes insights
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IRS Loses Summary Judgment In Mylan Case

by and | Mar 16, 2016 | , ,

On March 10, 2016, Tax Court Judge Laro denied the Internal Revenue Service’s (IRS) motion for summary judgment in Mylan’s challenge of the IRS’s determination that approximately $372 million should be treated as ordinary income.  See Mylan Inc. and Subsidiaries v. Commissioner of Internal Revenue, T.C.M. 2016-45.  In its Tax Court petition, Mylan seeks a redetermination of tax deficiencies related to proceeds from the sale of “all substantial rights” in a patent that Mylan treated as capital gain.  The IRS recharacterized the income as ordinary income received under a sublicense of patent rights.

Mylan entered into a number of agreements, including a 2008 agreement in the form of an “exclusive license,” that Mylan contends effectuated a sale of patent rights and entitles it to capital gain treatment.  In deciding the motion for summary judgment, the Tax Court considered whether the tax treatment should be determined based upon Mylan’s licensing agreements.  The IRS argued that pursuant to Commissioner v. Danielson, 378 F.2d 771,775 (3d Cir. 1967), taxpayers are bound by the terms of their agreements.  Mylan argued that Danielson does not apply because the Third Circuit has previously examined not only the terms of the contracts but also the intent of the parties in determining whether “all substantial rights” under a patent were transferred, relying on such authorities as Merck & Co. v. Smith, 261 F.2d 162  (3d Cir. 1958) and E.I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052 (3d Cir. 1970).

The Tax Court, however, determined that there is no inconsistency between Danielson, Merck and E.I. du Pont:

We do not see the inconsistency here.  In Danielson, a taxpayer sought to change the tax consequences of a transaction by challenging the validity of the underlying contract’s terms, specifically, allocation of consideration between the sale of stock and the covenant not to compete, because the taxpayer believed these terms did not reflect the agreement of the parties.  In Merck and E.I. du Pont de Nemours the taxpayers did not seek to alter or challenge the agreements in question.  Instead, the taxpayers disagreed with the Commissioner’s interpretation of those contracts and characterization of the related payments for tax purposes.  Here, unlike in Danielson, petitioners do not seek to change the tax consequences of the transaction by challenging the underlying agreements and reforming the contractual terms.  On the record before us, the facts here resemble those in Merck and E.I. du Pont de Nemours.  The question presented here is a question of proper tax characterization of the proceeds of valid and enforceable contracts, and we are mindful that the Commissioner and taxpayers often disagree on this issue.

 The Tax Court found that there are issues of material fact in dispute, and denied the IRS’s motion for summary judgment.

Now that the Tax Court has denied summary disposition of the case, the parties will litigate the capital vs. ordinary tax treatment of transfers of patents.  We will report back as developments occur in this hotly contested area [...]

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IRS and Taxpayers Continue Fight over Regulations Intended to Overrule Judicial Precedent

by | Mar 15, 2016 | , , ,

In March 2013, 3M filed a petition with the US Tax Court challenging the Internal Revenue Service’s (IRS) determination that additional royalty income should be allocated to 3M’s US headquarters from its Brazilian subsidiary.  See 3M Co. v. Commissioner, T.C. Dkt. No. 5186-13.  Specifically, the IRS determined that Brazilian legal restrictions on the payment of royalties to the US parent should not be taken into account in determining the arm’s-length price between 3M and the subsidiary under Treas. Reg. § 1.482-1(h)(2).  3M’s position will require the Tax Court to revisit its earlier, pre-regulations holdings on the subject and to decide whether the Supreme Court of the United States has already resolved the issue.

The parties recently submitted the case fully stipulated under Tax Court Rule 122, with simultaneous opening briefs due on March 21, 2016.  The parties will then have the opportunity to submit reply briefs responding to each other’s arguments.

More than 40 years ago, the Supreme Court in Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972), rejected the IRS’s attempt to apply section 482 where federal law prohibited the taxpayer from receiving the income the IRS was seeking to allocate to it.  Subsequent Tax Court and appellate court decisions applied the Supreme Court’s holding to restrictions under foreign and state law.  In 1994, the IRS promulgated current Treas. Reg. § 1.482-1(h)(2), which provides, in part, that “a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time.”  Although the regulation also contains a deferred income election that permits the deferred recognition of restricted income, subject to a matching deferral of deductions, it may be difficult in most situations to meet these requirements.

Whether 3M succeeds may depend on how the Tax Court applies the recent Supreme Court decision in U.S. v. Home Concrete & Supply LLC, 132 S.Ct. 1836 (2012).  There, the Supreme Court held that its prior interpretation of a statute meant that “there is no longer any different construction that is consistent with [the prior opinion] and available for adoption by the agency.”  This is an important case for all taxpayers, not just those dealing with the blocked income issue, and the Tax Court’s determination may have a broad impact on future challenges to tax regulations.



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Preparing for a Tsunami of International Tax Disputes

by and | Mar 14, 2016 | , , ,

Recently, we published a Special Report in Tax Notes International, “Preparing for a Tsunami of International Tax Disputes.”  The article can be accessed here.  While there is near-universal agreement that the number of tax disputes is going to increase, existing international tax dispute resolution processes remain in serious need of improvement. A global consensus must be reached on a process for resolving worldwide tax disputes that appeals to all stakeholders. This article focuses on recent attempts by the Organisation for Economic Development (OECD), United Nations (UN) and international tax community to achieve such a consensus.

In short, the predictability of tax base results is a serious concern for countries and multi-national enterprises alike.  The only realistic solution is to design a dependable and independent treaty-based dispute resolution process that accommodates the needs of all stakeholders. A foundation for this process has been provided by the inclusion of arbitration in both the OECD and UN model income tax treaties and its successful implementation in a few countries. Arbitration and alternative dispute resolution (ADR) have already evolved successfully in nontax government and commercial contexts. As with any such evolution, there have been both positive and negative experiences for countries and private parties. In the realm of international taxation, the development of these processes is in the early stages. It is important for all stakeholders in the tax arena to explore ways of using experiences from non-tax contexts to develop processes that can relieve emerging pressures relating to international taxation. To distinguish the international tax context from others, the new dispute resolution process could be referred to as the International Taxation Dispute Resolution Process (ITDRP), as suggested in the UN Secretariat Paper on Alternative Dispute Resolution in Taxation released on October 8, 2015.

While the development of a successful ITDRP will inevitably take time and will no doubt be contentious, significant advancements have been made in the past few months that suggest it could soon be on the horizon.  These include the initial Base Erosion and Profit Shifting (BEPS) paper on dispute resolution, the January 2015 Dispute Resolution Conference in Vienna, the OECD Action 14 Final Report (released in October 2015) and the UN Secretariat ADR Paper.

Almost all stakeholders in the international taxation community agree that: (i) the number of disputes will increase; (ii) existing dispute resolution processes are in serious need of improvement; and (iii) a global consensus must be achieved so that global tax disputes can be resolved in a way that serves the interests of all stakeholders. In this regard, it may be fortunate for the tax community that it is arriving late to the ADR processes that have evolved in other areas over the past century. As the OECD and UN processes continue to evolve, it is hoped that lessons from these other areas can be drawn upon to develop an ITDRP that serves the interests of all parties.



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Welcome to McDermott’s Tax Controversy 360 Blog!

by | Mar 9, 2016 |

McDermott Will & Emery has a leading tax controversy practice with lawyers representing clients on all aspects of federal, state and local, and international tax controversy matters, including Internal Revenue Service audits and appeals, competent authority matters and trial and appellate litigation. We regularly represent some of the world’s largest corporations on complex US, state and local, and international tax issues. Our transfer pricing team is regularly sought by major multinational enterprises to handle controversy matters, including controversy cases that other professional advisors have not been able to resolve. In addition, we represent high net worth individuals and their closely-held companies in income, estate, and gift tax controversies. Most of these tax controversy matters are successfully resolved without litigation. But when administrative settlement is not possible, we have extensive experience representing our clients in tax litigation at the trial and appellate levels, including before the US Supreme Court.

Our tax controversy group includes seasoned tax litigators, former Internal Revenue Service and US Department of Justice attorneys, and judicial clerks. We believe the insights gained from our combined tax litigation and clerking experience enhances our ability to achieve favorable resolutions for our clients.

We hope you find Tax Controversy 360 to be both interesting and helpful, and we welcome your feedback. If you have questions or topic suggestions, please let us know via the “Contact Us” form or feel free to reach out to one of the editors directly.

Todd Welty, PC
Supervisory Editor and Co-Chair, Tax Controversy Practice



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Introducing McDermott’s Blog Series on LB&I’s International Practice Units

by | Mar 9, 2016 | , ,

As part of an overall strategy and reorganization to utilize resources more efficiently, the Internal Revenue Service’s (IRS’s) Large Business and International (LB&I) Division has developed a series of International Practice Units.  These Practice Units typically consist of a set of slides explaining how agents in the field should approach a particular issue of interest in international tax or transfer pricing. A complete list of these Practice Units can be found here.

The IRS intends the Practice Units to serve as “job aids and training materials” and as “a means for collaborating and sharing knowledge among IRS employees.” The first group was published at the end of 2014, and the IRS has steadily released new Practice Units ever since.  Presently, the IRS has published over 100 practice units on a wide range of international topics.

Practice Units provide general explanations of international tax concepts, as well as information about specific types of transactions.  Practice Units are not official pronouncements of law, and cannot be used, cited or relied upon for support.  Nonetheless, they provide taxpayers with a window into the IRS’s current thinking about these issues.  Moreover, Practice Units may be helpful to anticipate the IRS’s approach relating to specific international issues.  Over the next few months, Tax Controversy 360 will unveil a series of posts highlighting individual Practice Units of special interest—please stay tuned!



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IRS Updates LB&I Examination Process Guide

by | Mar 4, 2016 | , , ,

Effective May 1, 2016, the Internal Revenue Service (IRS) will begin applying previously announced changes to the Large Business & International (LB&I) Division’s examination process.  Publication 5125 begins by setting forth expectations for the LB&I exam team and the taxpayer or its representatives.  It then addresses IRS expectations regarding refund claims.  Finally, the publication discusses the three stages of the LB&I examination process—planning, execution and resolution—and how the IRS and taxpayers should conduct themselves during each stage.

The IRS had previously released draft publication 5125 in November 2014, which concerned some taxpayers, particularly with respect to the statement that informal refund claims would only be accepted within 30 days of the opening conference.  Final Publication 5125 retains the 30-day period for making informal refund claims, but provides that LB&I will not require a formal claim after the 30-day period if an issue has been identified for examination (unless IRS published guidance specifically requires a formal claim).  Exceptions may also be granted by LB&I senior management.

Publication 5125 also made changes to the examination process based on the recent shift to an issue-based audit approach.  The case manager will have overall responsibility for the case, which may be beneficial to taxpayers involved in recent audits where domestic and international personnel appeared to share responsibility for the conduct of the audit.  Factual and issue development are also heavily stressed, with an emphasis on the information document request (IDR) process and a focused and useful examination plan.  The publication also states that IRS team members are expected to seek the taxpayer’s acknowledgment of the facts and to resolve any disputes prior to the issuance of Form 5701, Notice of Proposed Adjustment.

Taxpayers should review Publication 5125 to familiarize themselves with the current audit process and to ensure that IRS team members are following the guidance.  To the extent an IRS team member is not following the guidance, taxpayers should not hesitate to discuss the matter with the team manager.



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New Post-Validus Revenue Ruling Applies to Foreign Reinsurance Transactions

by and | Feb 24, 2016 | , ,

In mid-2015, the United States Court of Appeals for the District of Columbia Circuit affirmed (although on narrower grounds) the decision of the United States District Court for the District of Columbia in Validus Reinsurance, Ltd. v. United States.  In Validus, 786 F.3d 1039, the D.C. Circuit ruled that there was no statutory authority for the imposition of a so-called “cascading” federal excise tax (FET) to foreign retrocession transactions – a transaction involving a policy of reinsurance issued by a foreign reinsurer to another foreign reinsurer.

The D.C. Circuit relied on two principles in rejecting the application of a “cascading” FET to foreign retrocession transactions:  (1) the presumption against extraterritoriality and (2) FET should not be imposed more than once on the same transaction (that is, on the same premium amounts).  The D.C. Circuit declined, however, to specifically speak on the issue of foreign reinsurance transactions – a transaction involving a policy of reinsurance issued by a foreign reinsurer to another foreign insurer (rather than reinsurer) – despite the fact that both principles might equally apply to these transactions as well.

However, the recently released Revenue Ruling 2016-03 specifically notes that “the IRS will no longer apply the one-percent excise tax imposed by section 4371(3) to premiums paid on a policy of reinsurance issued by one foreign reinsurer to another foreign insurer or reinsurer ….”  (emphasis added).  Thus, under Revenue Ruling 2016-03, there is no distinction between foreign retrocession and foreign reinsurance transactions.  For those taxpayers with foreign reinsurance transactions, who have been stuck in limbo after the Validus decision, Revenue Ruling 2016-03 may provide relief from an IRS examiner’s inappropriate imposition of a “cascading” FET.



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Generic IRS Publication Fails to Satisfy the Advance Notice Requirement for Third Party Contacts

by | Feb 15, 2016 | ,

In Baxter v. United States, No. 4:15-cv-04764 (ND Cal. 2016), the Internal Revenue Service (IRS) issued a third-party summons for the petitioner’s 2011 tax year to the California Supreme Court seeking documents relating to payments made to the petitioner for his legal representation of capital defendants.  The petitioner brought a timely petition to quash the 2011 third-party summons in federal district court.  The court granted the petition to quash the 2011 third-party summons because the IRS failed to provide advance notice to the petitioner pursuant to Internal Revenue Code (IRC) section 7602(c)(1), which requires advance notice by the IRS of third party contacts.  Importantly, the court rejected the government’s contention that the advance notice requirement could be satisfied by providing a taxpayer with the generic notice in IRS Publication 1, which states that the IRS will “sometimes talk with other persons if [they] need information that [the taxpayer] have been unable to provide.”

To enforce a summons or dismiss a petition to quash a summons, the government must first establish a prima facie case of good faith by making a showing that: (1) the underlying investigation is for a legitimate purpose, (2) the inquiry requested is relevant to that purpose, (3) the information sought is not already in the government’s possession and (4) the administrative steps required by the IRC has been followed.

The district court found that the government has met its burden as to the first three requirements, but it failed to establish that the administrative steps required by the IRC had been followed.  The government admitted that the IRS did not provide advance notice to the petitioner of its intent to make a contact with the California Supreme Court, but instead contended that the IRS satisfied the advance notice requirement in IRC section 7602(c)(1) by transmitting a publication about the audit process generally.  In finding this argument unpersuasive, the court reasoned that the implementing regulations (301.7602-2(f)(1)(i)(B)) contemplate notice for each contact either orally or in writing.

Having quashed the summons, the court went one step further (and perhaps beyond its jurisdiction) and ordered that any new summons issued by the IRS to the California Supreme Court seeking information regarding payments made to petitioner “shall direct the California Supreme Court to first deliver the summonsed documents to the Court for an in camera review to determine whether the documents contain any privileged attorney-client communications.”

Practice Note:  At the beginning of the IRS examination, the taxpayer or his representative should request that the IRS agent provide in writing the names of each person that the agent intends to contact.    



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LB&I Practice Units: Know Your EOI Programs

by | Feb 10, 2016 | , , , ,

On January 20, 2016, the Large Business and International (LB&I) Division released a Practice Unit entitled Overview of Exchange Information Programs and Types of EOI Exchanges, defining and describing the Internal Revenue Service (IRS) Exchange of Information (EOI) programs. These EOI Practice Units specify what types of exchanges are covered by EOI programs and what types of information the IRS can seek through each type of EOI exchange.

The IRS breaks down the avenues for international information exchange into several categories:

  • Specific Requests involve requests for information pertaining to a specific taxpayer under examination or investigation for a specific period.
  • Spontaneous Exchanges involve the transmission of taxpayer information by one member of an EOI agreement that is deemed potentially of interest to a foreign partner even though no specific requests have been initiated by the foreign partner.
  • Automatic Exchanges involve the transmission of taxpayer information that foreign partners have agreed to exchange on a regular and systematic basis without individualized specific requests. The most common example includes information relating to dividends, interest, rents, royalties, salaries and annuities earned in one partner country by residents of the other partner country.
  • Industry-Wide Exchanges involve the sharing of trends, policies and operating practices in a particular industry or economic sector and do not implicate specific taxpayer information.
  • The Simultaneous Examination Program coordinates strategies and the development of technical issues between the United States and a foreign partner if it is determined a common interest exists between the respective taxing authorities. These discussions are intended to facilitate the exchange of relevant taxpayer information with the foreign partner in furtherance of the separate independent examinations of a taxpayer by each jurisdiction.
  • Joint Audits take place when the United States and one or more of its foreign partners collaborate to conduct a single examination of a taxpayer or a related taxpayer within their jurisdictions.
  • The Simultaneous Criminal Investigation Program operates through the EOI provisions of bilateral tax agreements and fosters the coordination of separate criminal investigations conducted concurrently by the United States and the foreign partner.
  • The Mutual Legal Assistance Program relates to an agreement that authorizes a partner country to secure evidence for use by the requesting country in criminal judicial proceedings of the taxpayer.
  • The Mutual Collection Assistance Request Program is intended to utilize the collection assistance provisions of tax treaties, enabling one partner state to collect taxes covered by the treaty on behalf of the other contracting state. These collection provisions appear in a limited number of current United States treaties.

The Practice Units provide a short general overview of each method and—of particular usefulness—describe what government office or department is responsible for executing requests in each category. Thus, the Practice Units may be a good “first line of defense” for information-gathering when you believe the IRS is pursuing or has received an international EOI request related to your client.

In future posts, we will discuss how these tools are utilized in practice, [...]

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Substantial Changes to Auditing Partnerships

by | Feb 2, 2016 | , ,

On November 2, 2015, the Bipartisan Budget Act of 2015 was signed into law, and which instituted significant changes to the rules governing the federal tax audits of partnerships for tax years after 2017.  In the absence of affirmatively electing partner-level adjustment, the new rules impose entity-level tax liability for Internal Revenue Service (IRS) audit adjustments to partnerships.  The new rules are a significant departure from what has historically been merely pass-through treatment of partnerships for US federal income tax issues.

There is a small partnership exception to elect out of the new audit rules.  This election may apply to partnerships with 100 or fewer partners, each of which is an individual, a C corporation, an S corporation or an estate of a deceased partner.  However, any tiered partnership – partnerships that have partnerships as partners – are ineligible for the exception.

The new rules determine IRS audit adjustments at the partnership level for items of partnership income, gain, loss, deduction or credit.  The taxes owed on those adjustments are calculated at the maximum statutory tax rate, and assessed and collected from the partnership in the year that the audit or any judicial review is completed.  Additionally, the partnership is liable for all associated penalties and interest.

Alternatively, the partnership can elect out of the entity-level tax, but must furnish to every partner for each year under examination a statement of the partner’s share of any tax adjustments.  Under this election, each partner will be responsible for paying its taxes, penalties and interest related to the adjustment.

The new rules also change who speaks to the IRS on behalf of the partnership.  Instead of the “tax matters partner,” the new rules provide for a “partnership representative.”  The partnership representative, who no longer must be a partner, has sole power to act on behalf of the partnership during the audit.  Moreover, the partnership representative can bind both the partnership and the partners with respect to the IRS examination and adjustments.

The new partnership audit regime applies to partnership returns filed for tax years beginning after December 31, 2017.  Because the new rules make fundamental changes to the way that partnerships were audited in the past, we are hopeful that the delayed effective date will give taxpayers time to consider the potential effects of the new rules on their partnerships and operative agreements.  The new rules leave open numerous issues, and we expect the IRS to issue substantial guidance in the future.



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