Legal Alert: The 2013 Tax Litigation Year in Review: Important Events

As we look forward to 2014, we take a look back at the top 10 important tax controversy issues making the news in 2013 that may have continuing importance in the future.

1. Woods – Court Rules on Valuation Misstatement

On December 3, 2013, the U.S. Supreme Court unanimously reversed the Fifth Circuit’s holding that the 40% gross valuation misstatement penalty applied when a taxpayer claimed an outside basis in a partnership interest that exceeded the actual basis of zero. United States v. Woods, 134 S.Ct. 557 (2013). The Supreme Court first determined that there was jurisdiction, abrogating two prior Court of Appeals cases holding otherwise. Proceeding to the merits, the Court resolved a split among the Fifth and Ninth Circuits on one side and the First, Third, Seventh and Eleventh Circuits on the other, in holding that the valuation misstatement penalty applies when the basis misstatement is inextricably linked to a finding that the underlying transaction lacked economic substance. The Court further rejected the argument that the valuation misstatement penalty was intended to apply only to factual errors and not to overstatements of basis that result from different legal interpretations of the tax law.

For a more detailed analysis of the Woods opinion, click here.

1. Wells Fargo – Court Clarifies Work Product Doctrine for UTP Regime

In an opinion issued on June 4, 2013, the U.S. District Court for the District of Minnesota issued an important ruling clarifying how the work product doctrine applies to documents prepared in connection with the new uncertain tax position (UTP) regime. Wells Fargo & Co. v. United States, No. 10-57, 2013 WL 2444639, 112 A.F.T.R.2d 2013-5380 (D. Minn. 2013). In the opinion, the taxpayer was ordered to disclose: information subject to disclosure, including the identification of UTPs; historical facts underlying the taxpayer’s federal UTPs (including, specifically, the transactions associated with the UTPs); the taxpayer’s process for identifying its federal UTPs; and other opinions and materials generated by the taxpayer’s accounting firm regarding the UTPs, as well as opinions and materials generated by any other non-lawyer, unless the information incorporates the legal analysis of the taxpayer’s attorneys.

After an in camera review, the court ruled that recognition and measurement analysis contained in the taxpayer’s tax accrual workpapers was protected opinion work product. Holding that the IRS did not demonstrate extraordinary circumstances for the release of the opinion work product, the court ordered that information be specifically redacted, including: FIN 48 analysis determining whether it is more likely than not that the tax benefit derived from the tax position will be sustained upon examination; the measurement of the largest amount of tax benefit that is greater than 50% likely to be realized upon settlement with the tax authority; regarding specific UTPs, the qualification of the monetary amount that the taxpayer recorded as a reserve; information regarding the units of account under FIN 48; and other materials containing legal analysis, such as the taxpayer’s discussions of settlement positions or its accounting firm’s restatement and approval of the taxpayer’s settlement analysis.

In addition to the opinion work product, the court also held that certain e-mails between attorneys and the taxpayer concerning draft versions of the tax accrual workpapers were privileged even though the final drafts were eventually disclosed to an accounting firm, concluding that the disclosure of a final draft of a document does not erase attorney-client privilege with respect to earlier versions.

For a more detailed analysis of the 100-plus page Wells Fargo opinion, click here.

1. Administrative Procedures for Appeals, Conference and Settlement Procedures, Collections and Summons Issuance and Enforcement – IRS Modifies Its Approach with the AJAC Project and the Issuance of Directives in June and November

On July 18, 2013, the IRS issued a directive describing the implementation of the first phase of the recommendations under the Appeals Judicial Approach and Culture (AJAC) Project. The purpose of AJAC is to return Appeals to a “quasi-judicial approach” in handling cases. The July 18 directive outlines changes that will be made to the Internal Revenue Manual concerning Appeals Procedures, Conference and Settlement Procedures, Collections Due Process, Offers-in-Compromise and the Collections Appeals Process.

On November 4, 2013, the IRS issued directives to LB&I examiners concerning the issuance and enforcement of Information Document Requests (IDR) that became effective as of January 2, 2014. According to the IRS, these new directives are designed to make the IDR process “more effective and transparent.” The new procedures require agents to draft one IDR for each issue and to communicate with the taxpayer about the issue, the information sought and the timeline for responding to IDRs. They also set forth mandatory steps for the IRS audit team to follow when responses are not received by the response date. Those steps contemplate the institution of summons enforcement proceedings if a response is not received within 49 days from the IDR response date. This 49-day process is broken into three steps: (1) the issuance of a Delinquency Notice 10 days after the response date requiring a response within 15 days; (2) the issuance of a Pre-Summons Letter within 14 days of the Delinquency Notice response date requiring a new response date within 10 days; and (3) the issuance of the Summons.

Whether the changes outlined in the directives will survive 2014 intact is in question. The employee union representing IRS employees, NTEU, filed a national institutional grievance challenging the IRS’s implementation of its new procedures on November 19, 2013. On January 7, 2014, the IRS acknowledged that the implementation of the procedures without completing bargaining with the NTEU was premature and committed to negotiations with the NTEU on the procedures. The IRS’s commitment to engage in negotiations concerning the new procedures will likely delay their implementation, and the negotiations may alter their content.

Another development on the IRS administrative practice front to follow in 2014 is the Supreme Court’s decision to grant certiorari in United States v. Clarke, 517 Fed.Appx. 689 (11th Cir. 2013), cert. granted, 82 U.S.L.W. 3131 (U.S. Jan. 10, 2014). The case is expected to clarify the circumstances when a taxpayer is entitled to a hearing when there is an issue as to the IRS’s motives for issuing an administrative summons. The case under review from the Eleventh Circuit involved a taxpayer claim that the IRS issued summonses for the illegitimate purpose of extending the applicable limitations period. Id.

For an up-to-date discussion of the changes happening in IRS Appeals and Compliance areas, tune in to Sutherland’s Webinar, Current Update on IRS Appeals Division and Other Acronyms, Including AJAC, RAP, ADR and NII, on February 20, 2014. Click here for a link to register for the webinar.

1. STARS Transactions – Bank of New York, Salem Financial, and Santander Holdings

In 2013, courts reviewed three cases involving the tax consequences of the so-called “STARS” transactions. SeeBank of New York Mellon v. Commissioner, 140 T.C. 15 (2013) (“BNY I”); Salem Financial, Inc. v. United States, 112 Fed. Cl. 543 (2013); Santander Holdings USA, Inc. v. United States, -- F.Supp.2d --, 2013 WL 5651414 (D. Mass. 2013). Generally, in these cases, a U.S. bank formed a UK trust by transferring income-generating assets to the trust. At the same time, Barclays Bank PLC (Barclays), also an owner in the trust, made a loan to the U.S. bank. Under the arrangement, a series of payments were made between the trust, the U.S. bank and Barclays, including a payment in connection with the interest on the loan, which was reduced by an amount from Barclays equal to a portion of the UK taxes to be paid by the trust (Bx payment). As a result of the transaction, the U.S. bank paid UK and U.S. taxes on the trust income and Bx payments, and the U.S. bank claimed foreign tax credits for the UK taxes.

The U.S. Tax Court in BNY I and the U.S. Court of Federal Claims in Salem Financial held that the transactions lacked economic substance and disregarded the transactions, finding: (1) the trust had no economic activity other than to circulate income between itself and Barclays; (2) the loan was an unnecessary and separate part of the transaction; and (3) the Bx payments were effectively rebates and therefore tax items. In contrast, the U.S. District Court for the District of Massachusetts in Santander Holdings reached the opposite conclusion, determining that the Bx payments were private payments between the parties and could not be considered a “tax item” as characterized by the BNY I and Salem Financial courts. Consequently, the court determined that the payments should be included as pre-tax profit for purposes of the objective economic substance test and found that the transaction had economic substance.

The conflicting decisions in Santander Holdings, BNY I and Salem Financial set the stage in 2014 for potential appeals in three circuits: Santander Holdings is appealable to the First Circuit, BNY I to the Second Circuit and Salem Financial to the Federal Circuit.

1. Chemtech Royalties – Debt Versus Equity Challenges As the New Economic Substance Trump Card

One of the most noteworthy developments of 2012 was the significant uptick in the number of cases in which the IRS challenged taxpayer classifications of investments as “debt” or “equity.” This trend continued into 2013 with the District Court’s opinion in Chemtech Royalty Associates, L.P. v. United States, No. 05-944, 2013 WL 704037, 111 A.F.T.R.2d 2013-953 (M.D. La. Feb. 26, 2013). In Chemtech Royalty, the District Court upheld the IRS’s disallowance of $1 billion of deductions claimed by Dow Chemical in relation to two special limited investment partnership (SLIPS) transactions. The court devoted a significant section of its opinion to the question of whether the foreign banks held true equity interests in the partnerships or whether their interests were more like debt.

For a more detailed discussion of the Chemtech Royalty opinion, click here.

The Chemtech Royalty opinion aligns more closely with the complicated structured tax cases in which courts held for the IRS: TIFD III-E, Inc. v. United States, 666 F.3d 836 (2d Cir. 2012) (Castle Harbor); Hewlett-Packard Co. v. Commissioner, 103 T.C.M. (CCH) 1736 (2012); Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012); and H&M, Inc. v. Commissioner, 104 T.C.M. (CCH) 452 (2012). In these cases, the courts were skeptical of the bona fides of transactions involving elaborate structures. In contrast, where cases involve straightforward business transactions, e.g., genuine debt instruments, the U.S. Tax Court has shown that it is generally favorable towards taxpayers. SeeNA General Partnership & Subsidiaries v. Commissioner, 103 T.C.M. (CCH) 1916 (2012) (ScottishPower); PepsiCo Puerto Rico, Inc. v. Commissioner, 104 T.C.M. (CCH) 322 (2012). For a more detailed analysis of these opinions, click here.

1. The LILO/SILO Transactions –ConEdison,UnionBanCal and John Hancock

Opinions issued by the Federal Circuit, Court of Federal Claims and Tax Court in 2013 mark the final group of opinions concerning LILO/SILO transaction cases. See Consolidated Edison Co. of New York, Inc. v. United States, 703 F.3d 1367 (Fed. Cir. 2013), UnionBanCal Corp. v. United States, 113 Fed.Cl. 117 (2013), and John Hancock Life Insurance Co. v. Commissioner, 141 T.C. No. 1, 2013 WL 3984621 (2013). These courts determined that the transactions were shams because they involved a complicated series of agreements in which the taxpayer was insulated from risk and never held the benefits and burdens of ownership of the assets they purportedly purchased. Given the specific findings of these cases, the opinions are likely of limited value to taxpayers, but the cases serve as an example where the level of complexity in a structured transaction affects the taxpayer’s chances in court.

1. Quality Stores – The U.S. Supreme Court Set to Decide Whether Supplemental Unemployment Compensation Benefits are Subject to FICA

On September 7, 2012, the Sixth Circuit held that certain types of severance payments (referred to as supplemental unemployment compensation benefits or “SUB payments”) are not taxable wages under FICA. In re Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012). In so holding, the court declined to follow the Federal Circuit’s contrary decision in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008). In May 2013, the Supreme Court granted certiorari to resolve the conflict, and the Supreme Court heard oral arguments on January 14, 2014. The Supreme Court’s decision will resolve this important issue, which when combined with other refund claims is estimated by the government to be in excess of $1 billion.

1. PPL Corporation – Supreme Court Reaffirms that Substance and Not Form Should Govern Tax Characterizations

On May 20, 2013, the U.S. Supreme Court handed taxpayers a win and reaffirmed the principle that substance—not form—should determine the characterization of a given tax transaction. PPL Corporation v. Commissioner, 133 S.Ct. 1897 (2013). In PPL Corporation, the Court provided some welcome clarity for taxpayers and practitioners holding that a U.S. taxpayer was entitled to claim a foreign tax credit on its share of a “windfall tax” imposed on the taxpayer’s United Kingdom (UK) subsidiary. Applying a “commonsense approach that considers the substantive effect of the tax,” the Court found the windfall tax creditable because its “predominant character” “is that of an excess profits tax, a category of income tax in the U.S. sense.”Id. at 1899-1900.

While this is a welcome development for taxpayers, the repercussions of the opinion have yet to be seen. The Treasury may amend its regulations to address questions raised in the concurring opinion by Justice Sotomayor—including whether the “predominant character” test requires that a tax have the same character for all taxpayers in order to satisfy the test—or may promulgate new regulations specifically addressing excess profits taxes as a subset of income taxes. Moreover, this result will likely affect the IRS’s position on the creditability of certain other foreign taxes commonly paid by U.S. taxpayers, including the Puerto Rican Excise Tax and the Mexican impuesto empresarial a tasa única (IETU) tax.

For a more detailed discussion of the PPL Corporation opinion and its potential ramifications, click here.

1. Windsor – Court Rules that Validly Married Same-Sex Couples Are Married for Federal Tax Purposes

On June 26, 2013, the Supreme Court held that the definition of “marriage” under the Defense of Marriage Act (DOMA) was unconstitutional because it constituted a deprivation of the very liberty protected by Due Process and the Fifth Amendment. United States v. Windsor, 133 S. Ct. 2675 (2013). In accordance with the Court’s ruling, taxpayers validly married under state law must be recognized as married for federal tax purposes. Although Windsor was a case in which the taxpayer sought a refund for federal estate tax purposes, the holding has ramifications for all federal tax statutes.

The Windsor opinion will lead to changes to the treatment of same-sex couples in connection with tax procedures and policies relating to tax return filing requirements, FICA and employee benefits plans. Under Revenue Ruling 2013-17, same-sex married couples whose marriage was valid in the state performed are deemed validly married for federal tax purposes even if the marriage is not valid where the couples reside. Rev. Rul. 2013-17, 2013-38 I.R.B. 201. In the aftermath of Windsor, the IRS issued administrative guidance concerning claims for refunds of FICA taxes and procedures for income tax withholding. See Rev. Rul. 2013-17; Notice 2013-61, 2013-44 I.R.B. 432. On January 6, 2014, the IRS issued procedures concerning the treatment of same-sex couples under employee benefit plans, including cafeteria plans, flexible spending accounts and health savings accounts. Notice 2014-1, 2014-2 I.R.B. 270.

For more detailed analysis concerning the ramifications of Windsor to employee benefits matters, click on the following links: Top 10 Considerations for Employee Benefit Plans After Windsor;A Marriage Made in Washington: Treasury and IRS Recognize Same-Sex Marriage for Tax Purposes;Fall of the DOMA-n Empire: Practical Employee Benefits Implications; andDOL Agrees with Treasury on Same-Sex Spouse Recognition.

1. Loving v. IRS – Court Limits IRS Ability to Regulate Tax-return Preparers

Another important decision came from the U.S. District Court for the District of Columbia, which held that the IRS was not authorized to regulate non-attorney, non-CPA tax-return preparers with Circular 230. See Loving v. I.R.S., 917 F.Supp. 2d 67 (D.C. Cir. 2013). The regulation—which required tax-return preparers to pass a qualifying exam, pay an annual application fee and take 15 hours of continuing education courses—was issued pursuant to a statute authorizing the Treasury to “regulate the practice of representatives of persons” before the IRS. Id. at 73. Finding that a tax-return preparer does not “present a case” to the IRS when filing a tax return, the court held that a tax-return preparer did not “represent” persons before the IRS within the meaning of the statute. The decision was appealed, and the D.C. Circuit heard oral arguments on September 24, 2013. See Loving v. I.R.S., No. 13-5061 (D.C. Cir.). The resolution of this issue will potentially affect the businesses of non-attorney, non-CPA tax preparers hired to assist people with filing their tax returns and the people who hire them. The D.C. Circuit’s opinion is one to watch for this year.