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Sixth Circuit Sides with Taxpayer in APA Challenge to Reportable Transaction Regime

We previously posted about the US Supreme Court’s opinion in CIC Servs., LLC v. IRS, which allowed a pre-enforcement challenge to the Internal Revenue Service’s (IRS) “reportable transaction” regime. In that post, we noted the district court opinion in Mann Construction, Inc. v. United States, No. 1:20-cv-11307 (E.D. Mich. 2021), holding that an IRS Notice requiring disclosure of listed transactions was not subject to the Administrative Procedure Act’s (APA) notice-and-comment requirement, and identified unanswered questions and potential future disputes over IRS enforcement strategies.

The US Court of Appeals for the Sixth Circuit has now reversed the district court in Mann Construction, holding that the IRS’s process for issuing Notice 2007-83—which designates certain employee-benefit plans featuring cash-value life insurance policies as listed transactions—violated the APA. Specifically, the court found that Notice 2007-83 was a legislative rule under the APA because it had the force and effect of law. The Sixth Circuit relied on CIC Services, explaining that Notice 2007-83 “defines a set of transactions that taxpayers must report, and that duty did not arise from a statute or a notice-and-comment rule…failure to comply comes with the risk of penalties and criminal sanctions, all characteristics of legislative rules.” The court further found that Congress did not expressly exempt the IRS from the APA’s notice-and-comment requirements with respect to the reportable transaction regime. The Sixth Circuit explained that there was an absence of any express deviation from the APA’s notice-and-comment procedures, and “any exceptions to the sturdy protections established by the APA’s notice-and-comment requirements must come from Congress, not us and not the IRS.”

What now? Mann Construction is a heavy blow to the IRS’s reportable transaction regime, and similar APA attacks are underway against other Notices imposing non-statutory reporting obligations. One example is Notice 2017-10, which identifies certain syndicated conservation easement transactions as listed transactions subject to disclosure to the IRS.

Practice Point: In 2011, the Supreme Court announced in Mayo Found. for Med. Educ. & Rsch. v. United States, that “we are not inclined to carve out an approach to administrative review good for tax law only.” The last 10 years have seen numerous APA challenges in the tax world, some successful and others unsuccessful. CIC Services and Mann Construction are two important cases for taxpayers subject to non-statutory reporting obligations. Taxpayers and practitioners should carefully consider the impact of these cases in similar reporting situations in determining whether to initiate APA challenges.




Supreme Court Denies Review of QinetiQ

We have previously written about QinetiQ U.S. Holdings. Inc.’s (QinetiQ) fight to apply the Administrative Procedure Act (APA) to notices of deficiency issued by the Internal Revenue Service (IRS). (See below for our recent coverage.)

In short, the Tax Court and the US Court of Appeals for the Fourth Circuit rejected QinetiQ’s argument that a one-sentence reason for a deficiency determination contained in a notice of deficiency violated the APA because it was arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” Undeterred, QinetiQ filed a petition for certiorari seeking review from the Supreme Court. Alas, the saga ends for QinetiQ as the Supreme Court denied the petition this morning.

Practice Point:  Although QinetiQ was not successful in its APA arguments, other APA arguments in the tax law have gained considerable traction in recent years. We will be posting soon on the recent order out of the Western District of Texas invaliding Treas. Reg. § 1.7874-8T on the grounds that this temporary regulations was unlawfully issued without adherence to the APA’s notice-and-comment requirements. Additionally, as we previously noted, other procedural arguments exists when a notice of deficiency contains a minimal explanation, such as potentially shifting the burden of proof to the IRS.

See past coverage:

 




APA Challenge to Notice of Deficiency: QinetiQ Requests Supreme Court Review

On April 4, 2017, QinetiQ U.S. Holdings, Inc. petitioned the US Supreme Court to review the US Court of Appeals for the Fourth Circuit’s decision that the Administrative Procedure Act of 1946 (APA) does not apply to the Internal Revenue Service (IRS) Notices of Deficiency. We previously wrote about the case (QinetiQ U.S. Holdings, Inc. v. Commissioner, No. 15-2192) here, here, here and here. To refresh, the taxpayer had argued in the US Tax Court that the Notice of Deficiency issued by the IRS, which contained a one-sentence reason for the deficiency determination, violated the APA because it was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The APA provides a general rule that a reviewing court that is subject to the APA must hold unlawful and set aside an agency action unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing court. The Tax Court disagreed, emphasizing that it was well settled that the court is not subject to the APA and holding that the Notice of Deficiency adequately notified the taxpayer that a deficiency had been determined under relevant case law. The taxpayer appealed to the 4th Circuit, which ultimately affirmed the Tax Court’s decision. (more…)




Final Section 385 Regulations May Pose Compliance Burdens and Raise Potential Challenges

On November 2, 2016, we participated in a panel discussion at TEI’s Houston Global Tax Symposium regarding the effects of the newly-finalized section 385 regulations. Of interest from a controversy perspective, we discussed the potential compliance burdens and privilege concerns raised by the new documentation requirements in the rules, and the potential problems with the non-rebuttable per se presumption in the transaction rules. We also discussed how the Internal Revenue Service has endeavored, in the regulations’ lengthy preamble, to address potential procedural challenges by responding to public comments and by providing justifications for the regulations, particularly in light of recent challenges to other regulations under the Administrative Procedure Act. It remains to be seen how the new 385 rules will affect businesses in practice, and how the IRS intends to apply them, consistent with its statutory mandate.




APA Challenge to Notice of Deficiency: QinetiQ Oral Arguments

On October 26, 2016, the US Court of Appeals for the Fourth Circuit heard oral argument in QinetiQ U.S. Holdings, Inc. v. Commissioner, No. 15-2192. We previously wrote about the case here and here. To refresh, the taxpayer had argued in the US Tax Court (Tax Court) that the notice of deficiency issued by the Internal Revenue Service (IRS), which containing a one-sentence reason for the deficiency determination, violated the Administrative Procedure Act (APA) because it was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The APA provides a general rule that a reviewing court that is subject to the APA must hold unlawful and set aside an agency action unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing court. The Tax Court disagreed, emphasizing that it was well settled that the court is not subject to the APA and holding that the notice of deficiency adequately notified the taxpayer that a deficiency had been determined under relevant case law. The taxpayer appealed to the Fourth Circuit.

The substance of the oral argument focused on two issues: (1) whether the IRS’s notice of deficiency in this case violated the APA and was invalid; and (2) whether, on the merits, the taxpayer was entitled to a particular deduction. We focus on the former issue here.

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3M Company, IRS File Reply Briefs in “Blocked Income” Case; Tax Court Orders Oral Argument

As discussed in an earlier post, 3M Co. v. Commissioner, T.C. Dkt. No. 5816-13, involves 3M Company’s (3M) challenge to the Internal Revenue Service’s (IRS) determination that Brazilian legal restrictions on the payment of royalties from a subsidiary in that country to its US parent should not be taken into account in determining the arm’s-length royalty between 3M and its subsidiary under Treas. Reg. § 1.482-1(h)(2). The case has been submitted fully stipulated under Tax Court Rule 122. We discussed the parties’ opening briefs, filed on March 21, 2016, here. Reply briefs were filed on June 29, with the IRS filing an amended reply brief on August 18.

3M returns to its argument that Treas. Reg. § 1.482-1(h)(2) is “procedurally invalid” because Treasury and the IRS failed to satisfy the requirements of section 553 of the Administrative Procedure Act (the APA) when they promulgated the regulations. 3M notes that the IRS completely ignored this argument in its opening brief. Citing the Supreme Court’s recent opinion in Encino Motorcars, discussed in more detail here, 3M points out that Treasury and the IRS made significant changes to the regulation, but offered no explanation for the changes. This, 3M argues, renders the regulation invalid. 3M observes that compliance with the two-step Chevron test would not save a regulation that is procedurally invalid, noting that such compliance is “a necessary but not a sufficient condition for a regulation to be upheld.”

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Offshore Voluntary Disclosure Update

The Internal Revenue Service (IRS) currently offers non-compliant US taxpayers several different relief programs in which to report foreign assets and/or income and become compliant with US rules related to the disclosure of foreign assets. One option is the Offshore Voluntary Disclosure Program (OVDP).  Another is the Streamlined Filing Compliance Procedures (SFCP).  SFCP is further bifurcated into two sub-programs—one for US residents (Streamlined Domestic Offshore Procedures or “SDOP”) and one for non-US residents (Streamlined Foreign Offshore Procedures or “SFOP”).  Each program has its own set of tailored procedures and eligibility requirements.

The critical differences between OVDP and SFCP are: (1) the non-willfulness requirement; (2) the look-back period; and (3) the amounts of penalties the US taxpayer must pay.  Specifically, OVDP does not require the US taxpayer to certify that his or her failure to disclose foreign assets was non-willful.  On the other hand, SFCP requires the US taxpayer to certify that his or her failure to disclose foreign assets was non-willful and to also include a narrative explaining such non-willful conduct.  The incentive to demonstrate non-willfulness can be significant.  In general, US taxpayers who enroll in OVDP must pay a 27.5 percent penalty (and in some cases a 50 percent penalty) of the highest aggregate value of undisclosed foreign assets for the OVDP disclosure period (eight years).  However, US taxpayers who enter SDOP must only pay a five percent penalty of undisclosed foreign assets during the disclosure period (three years), and US taxpayers who enter SFOP pay no penalty. (more…)




Law School Professors File Amicus Briefs in Support of Commissioner’s Position in Altera

Two groups of law school professors have filed amicus briefs with the US Court of Appeals for the Ninth Circuit in support of the government’s position in Altera Corp. v. Commissioner, Dkt Nos. 16-70496, 16-70497. Read more on the appeal of Altera here and the US Supreme Court’s opinion addressing interplay between the Administrative Procedure Act (APA) procedural compliance and Chevron deference here. Each group argues that Treas. Reg. § 1.482-7 represents a valid exercise of the Commissioner’s authority to issue regulations under Internal Revenue Code (Code) Section 482 and that the US Tax Court (Tax Court) erred in finding the regulation to be invalid under section 706 of the APA.

One group of six professors (Harvey Group) first notes its agreement with the arguments advanced by the government in its opening brief. In particular, the Harvey Group concurs with the argument that “coordinating amendments promulgated with Treas. Reg. § 1.482-7(d)(2) vitiate the Tax Court’s analysis in Xilinx that the cost-sharing regulation conflicts with the arm’s-length standard.” It then goes on to note its agreement with the government’s argument that “the ‘commensurate with the income’ standard … contemplates a purely internal approach to allocating income from intangibles to related parties.”

Having thus supported the government’s commensurate-with income-based arguments, the Harvey Group argues that the regulation in question is, in any event, consistent with the general arm’s-length standard of Code Section 482. It does so based principally on the proposition that “[s]tock-based compensation costs are real costs, and no profit-maximizing economic actor would ignore them.” However, that said, “there are material differences between controlled and uncontrolled parties’ attitudes, motivations and behaviors regarding stock-based compensation.” Thus, according to the Harvey Group, the Tax Court erred when it concluded that “Treasury necessarily decided an empirical question when it concluded that the final rule was consistent with the arm’s-length standard,” because “[n]o empirical finding that uncontrolled parties do, or might, share stock-based compensation costs is required to support Treasury’s regulation.” Accordingly, the Tax Court’s reliance on State Farm and the cases following it was a “key misstep” by the Tax Court.

The Harvey Group also proposes that, should the Ninth Circuit find that the term “arm’s length standard” or the meaning of the “coordinating regulations” is ambiguous, the government’s interpretation embodied in Treas. Reg. § 1.482-7 should be afforded Auer deference. Read more on deference principles in tax cases and the unique challenges of Auer deference. Auer deference is a special level of deference that can apply when an agency interprets its own regulations, although there are several limitations on its use.  Finally, if the Ninth Circuit decides that the regulations “have an infirmity,” the Harvey Group argues that “[t]he best remedy is to remand to Treasury for further consideration.”

A second group of nineteen professors (Alstott Group) similarly agrees with the government’s arguments to the Ninth Circuit. The Alstott Group argues that the 1986 addition of the “commensurate with income” standard [...]

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Update on APA Challenges to Notice of Deficiency

In an earlier blog post, we discussed the US Tax Court’s ruling in QinetiQ U.S. Holdings, Inc. v. Commissioner, No. 14122-13 (Dec. 27, 2013). The taxpayer had argued that the Internal Revenue Service’s (IRS’) notice of deficiency containing a one-sentence reason for the deficiency determination violated the Administrative Procedure Act (APA) because it was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The Tax Court disagreed, emphasizing that it was well settled that the court is not subject to the APA. To refresh, the APA provides a general rule that a reviewing court that is subject to the APA must hold unlawful and set aside an agency action unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing court. (more…)




3M Company, IRS File Opening Briefs in “Blocked Income” Case

As noted in an earlier post, 3M Co. v. Commissioner, T.C. Dkt. No. 5816-13, involves 3M’s challenge to the Internal Revenue Service’s (IRS’s) determination that Brazilian legal restrictions on the payment of royalties from a subsidiary in that country to its US parent should not be taken into account in determining the arm’s-length royalty between 3M and its subsidiary under Treas. Reg. § 1.482-1(h)(2). The case has been submitted fully stipulated under Tax Court Rule 122, and the parties’ simultaneous opening briefs were filed on March 21, 2016.

Citing First Sec. Bank of Utah and cases following it, 3M first argues that “[c]ase law consistently holds that the Commissioner cannot employ section 482 to allocate income that the taxpayer has not received and cannot receive because a law prevents its payment or receipt.” Under this line of authority the IRS’s proposed allocation of royalty income to 3M is precluded by Brazilian law. This result is not changed by Treas. Reg. § 1.482-1(h)(2) because that regulation is invalid.

The regulation is “procedurally invalid,” 3M argues, because Treasury and the IRS failed to satisfy the requirements of § 553 of the Administrative Procedure Act (APA) when they promulgated the regulation. They did not respond to significant comments criticizing the proposed regulation; nor did they articulate a satisfactory justification or explanation for the regulation. They thus did not engage in the “reasoned decisionmaking” required by the APA and case law such as State Farm and Altera when an agency issues regulations. (more…)




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