On June 15, 2017, the California state Legislature voted to pass a comprehensive reform of the State Board of Equalization (BOE), known as the Taxpayer Transparency and Fairness Act of 2017 (AB 102).[i]  As passed by both the Assembly and Senate, this legislation was signed by Governor Jerry Brown on June 27, 2017 as part of the 2017-18 budget trailer package.

The Taxpayer Transparency and Fairness Act of 2017 strips the BOE, which currently administers over thirty tax and fee programs, of most of its powers and instead establishes a new agency: the California Department of Tax and Fee Administration (DOT).   The new DOT will be under the control of a director appointed by the Governor and subject to Senate confirmation.  This is a change from the BOE, which is governed by five elected Board members and is the nation’s only elected tax commission.[ii]

The enactment of this new legislation comes on the heels of a March 2017 report by the Department of Finance, which performed an evaluation of the BOE, including its sales and use tax resource utilization, outreach activities, and sales and use tax reporting.[iii]  The Department of Finance’s evaluation found that “certain board member practices have intervened in administrative activities and created inconsistencies in operations, breakdowns in centralized processes, and in certain instances result in activities contrary to state law and budgetary and legislative directives.”[iv]  State Controller Betty T. Yee stated on Thursday that the “sweeping reform passed today takes the duties of BOE down to the studs and structurally remodels to ensure more consistent, fair, transparent, and efficient administration of California’s tax laws and appeals.”[v]

Beginning July 1, 2017, the BOE will remain responsible for only (1) the review, equalization, or adjustment of property tax assessments; (2) the measurement of county assessment levels and adjustment of secured local assessment rolls; (3) the assessment of certain pipelines and related responsibilities; (4) the assessment of taxes on insurers; and (5) the assessment and collection of excise taxes on alcohol.

The Taxpayer Transparency and Fairness Act of 2017 also establishes a new Office of Tax Appeals, which will create tax appeal panels, each consisting of three administrative law judges, with offices in Sacramento, Fresno and Los Angeles. Each administrative law judge is required by statute to have been an active member in the State Bar of California for at least five years immediately preceding his or her designation to a tax appeals panel, and possess knowledge and experience with regard to the administration and operation of the tax and fee laws of the United States and of California. As such, the administrative law judges must be active, experienced tax lawyers in the state of California.

The Office of Tax Appeals will handle all appeals currently handled by the BOE (other than those relating to the responsibilities retained by the BOE), including petitions for redetermination, administrative protests, claims for refund, and appeals from an action of the Franchise Tax Board. The new Office of Tax Appeals will begin conducting appeals on or after January 1, 2018.

The tax appeals panels are required to publish a written opinion for each appeal decided by each tax appeals panel within 100 days after the date upon which a tax appeals panel’s decision becomes final. Taxpayers may be represented on an appeal by any authorized person or persons, at least 18 years of age, of the person’s choosing, including, but not limited to, an attorney, appraiser, accountant, bookkeeper, employee, business associate, or other person.

Decisions of the tax appeals panel are appealable to the California Superior Court subject to a de novo standard of review. In most California tax disputes (other than for determinations regarding a taxpayers residency status), the underlying liabilities are required to be paid and matters proceed to Superior Court litigation on the basis of a complaint for refund.

Internally, the BOE has a Settlement Section and the FTB has a Settlement Bureau, that were created to provide an administrative resolution of tax disputes on a “hazards of litigation” basis in a manner somewhat similar to the IRS Office of Appeals. Most experienced practitioners would likely conclude that these settlement procedures led to a realistic resolution of an administrative tax dispute often overcoming the need to present a matter to the members of the BOE.

It remains to be seen how this transition will impact taxpayers with cases currently pending before the BOE. Procedurally, although transfer of the administrative duties of the BOE is to occur by July 1, those duties will mostly be handled by the current administrative personnel of the BOE. As such, one might anticipate some, but not much, of an interruption in the examination and collection of taxes from California taxpayers.

Whether six months is a sufficient amount of time for the selection and training of qualified administrative law judges for the Office of Tax Appeals will remain to be seen. However, the requirement for published decisions should be helpful in the administration of future tax disputes within the settlement functions of the DOT (assuming the BOE Settlement Section is to continue) and the FTB. Historically, practitioners were disadvantaged by the inability to determine how other similarly situated tax disputes were resolved and how similar, or not, certain decisions of the BOE may be to an underlying dispute. Transparency in the administration of tax law is, from every perspective, is good for all.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] AB-102 The Taxpayer Transparency and Fairness Act of 2017: California Department of Tax and Fee Administration: Office of Tax Appeals: State Board of Equalization.(2017-2018), available at https://leginfo.legislature.ca.gov/faces/billCompareClient.xhtml?bill_id=201720180AB102.

[ii] http://www.boe.ca.gov/info/about.htm.

[iii] http://www.dof.ca.gov/Programs/Osae/documents/Board_of_Equalization_Evaluation_March-2017.pdf

[iv] Evaluation, California State Board of Equalization Sales and Use Tax Reporting Retail Sales Tax Fund Adjustment, prepared by Office of State Audits and Evaluations, California Department of Finance, March 2017 at iv.

[v] Press Release, “CA Controller Cheers Passage of Tax Board Overhaul,” 6/15/2017, available at http://sco.ca.gov/eo_pressrel_18545.html.

Plea agreements in criminal tax cases normally have a section containing the calculation of the agreed Sentencing Guideline Range. The plea agreement also typically recites that the Government will recommend a guideline range sentence as long as the defendant meets his obligations under the plea agreement, but that the court is not required to accept the Government’s sentencing recommendations or the parties’ agreements as to facts and sentencing factors.  Most defendants probably assume that in fact the Government’s recommendation is the maximum sentence that they will receive and that if the court sentences outside the Guideline range it will impose a lesser sentence.  This is not always the case, as the defendant learned in United States v. Avan Nguyen, 2016 U.S. App. LEXIS 6390 (5th Cir., April 13, 2017).

Nguyen owned a wholesale salon equipment business. He pled guilty to aiding and abetting the filing of a false and fraudulent corporate tax return.  The plea agreement recited that the Guideline range, after acceptance of responsibility was a level 13, which translates to a 12-18 month term of imprisonment, and that he would forfeit $1.1 million in seized funds.  The district court imposed a sentence of 36 months imprisonment followed by 1 year supervised release and a fine of $250,000.  The reason: the district court disagreed with the Government and Nguyen’s interpretation of certain facts.

During the investigation, the IRS determined that third parties had made almost $5 million in structured deposits into Nguyen’s business accounts. A raid on his house yielded over $3.2 million in cash, most of it wrapped in bundles of $10,000. The Presentence Report discussed the apparent structuring conduct and recommended an upward departure based on either Guidelines § 4A1.3 (underrepresented criminal history) or Guidelines § 5K2.21 (uncharged conduct).  The district court did not accept the recommendation, but did consider the apparent structuring conduct in exercising its discretion under Booker v United States to make an upward variance to the maximum allowable sentence.

Although the Government took the position that there was insufficient evidence that Nguyen was involved in criminal structuring, the district court determined that Nguyen had in fact engaged in criminal structuring. The district court based its finding on several facts beyond the seizure of cash and the structured deposits.  These included that Chase Bank wrote to Nguyen that it believed that structured deposits were made to his bank account, after which he changed the name of his business and opened up a new account under the new business name.  A number of structured deposits were made to the new account.  The district court held that these facts supported a finding that Nguyen knew of the reporting obligations for deposits over $10,000 and knowingly and intentionally had structured deposits made to avoid the reporting requirements.

The court of appeals reviewed the district court’s sentence under an abuse of discretion standard. Finding that there were no procedural errors committed by the district court, that there was sufficient evidence to support its conclusion that Nguyen was engaged in criminal structuring and that the district court articulated a number of factors supporting its sentence, the court of appeals affirmed the sentence.

Criminal tax cases often involve defendants who may have engaged in other financial or tax-related offenses that are not charged. Because plea agreements in criminal tax cases often contain a litany of the defendant’s “bad acts,” this could include facts suggesting that there was uncharged criminal conduct.  From time to time an overzealous special agent may provide the probation officer with evidence about such conduct.  The decision in Nguyen is an object lesson in criminal tax cases: the district court is not bound by the plea agreement.  If presented with evidence detrimental to the defendant, a sentence about the Guideline range may be imposed.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

 

Large multinational corporations have historically been the focus of IRS transfer pricing examinations, such as the dispute between Amazon and the IRS over the amounts Amazon charged its European subsidiary for certain intangible assets that were transferred.[i]  However, IRS efforts to address potential income shifting between related entities have expanded to include smaller companies in the middle market.

Section 482. These examinations arise as a result of the IRS’s power under Section 482, which provides that in the case of two or more businesses “owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.”  This Section gives the IRS broad discretion to reallocate income so that the income reported by a taxpayer is consistent with the economics and substance of the transactions between the related entities.

The standard under Section 482 is whether a transaction is arm’s length, which is shown by comparing the results of the related party transaction to what the results of the same transaction would be if entered into by unrelated taxpayers.[ii]  The regulations under Section 482 set forth extensive rules and guidance that must be followed in determining whether a controlled transaction satisfies the arm’s length standard.

LB&I Compliance Campaigns. The IRS recently announced that one of LB&I’s new compliance campaigns is the “Related Party Transactions Campaign,” which will be implemented through issue-based examinations.[iii]  The IRS explained in the rollout of the campaign that it will focus on “transactions between commonly controlled entities that provide taxpayers a means to transfer funds from the corporation to related pass through entities or shareholders.”  The IRS specified that it is allocating resources to this issue “to determine the level of compliance in related party transactions of taxpayers in the mid-market segment.  The IRS does not state whether its focus will be on transactions involving foreign entities or whether its focus will include transactions between related domestic entities.  While one of the prime concerns for the IRS in this area is taxpayers shifting income from the U.S. to a jurisdiction with a lower tax rate using non arm’s length transactions, situations arise where taxpayers have an incentive to shift income from one domestic entity to another.  The IRS’s powers under Section 482 apply equally to transactions with a domestic entity as to transactions with a foreign entity.

The IRS also rolled out another campaign targeting specifically one type of cross-border transaction between commonly controlled entities.   The IRS’s “Inbound Distributor Campaign” focuses on U.S. distributors of goods sourced from foreign-related parties, where the U.S. distributor has incurred losses or small profits that are not commensurate with the functions performed and risks assumed by the domestic entity—in such cases, the IRS believes the taxpayer would be entitled to higher returns in arm’s-length transactions.[iv]  For this compliance campaign, which will also be implemented by issue-based examinations, the IRS has “developed a comprehensive training strategy…that will aid revenue agents as they examine this IRC Section 482 issue.”[v]

Transfer Pricing Studies. With the IRS’s expanded focus on related party transactions, it is important for taxpayers who have commonly controlled or related entities to revisit their transfer pricing policies and consider obtaining a transfer pricing study.  In addition to potential substantial or gross valuation misstatement penalties if the IRS makes a transfer pricing adjustment, taxpayers may also be subject to a strict liability penalty depending on the net amount of the adjustment if the taxpayer did not obtain a transfer pricing policy prior to filing its tax return.[vi]  In order to be in the best position in the event of a transfer pricing audit and in order to help avoid the risk of a strict liability penalty in the event of a significant adjustment, taxpayers should have documentation prior to filing their tax returns setting forth the taxpayer’s determination of the price and establishing that the method the taxpayer used was reasonable and consistent with the Section 482 regulations.[vii]

Transfer Pricing Examinations. In an examination, the IRS advises revenue agents to issue a “§6662(e) mandatory Information Documentation Request” at the beginning of an audit, which will request the taxpayer’s documentation regarding its transfer pricing determinations.[viii]  While best practice is to ensure that all related party transactions are done at arm’s length, taxpayers facing a transfer pricing examination should be aware that the regulations under Section 482 allow for a “setoff” of an IRS transfer pricing adjustment, if the taxpayer can establish that the effect of multiple transactions between the related parties, when considered together, reflect an arm’s length arrangement between the entities.[ix]  The procedures that a taxpayer must follow to claim a setoff are set forth in Revenue Procedure 2005-46.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] Amazon.com, Inc. v. Comm’r, 148 T.C. No. 8, Docket No. 31197-12, 2017 (Mar. 23, 2017).

[ii] Treas. Reg. § 1.482-1(b).

[iii] https://www.irs.gov/businesses/large-business-and-international-launches-compliance-campaigns.

[iv] Id.

[v] Id.

[vi] IRC §6662(e)(1)(B); IRC §6662(h)(2)(A)(ii)(I).

[vii] IRC §6662(e)(3)(B).

[viii] IRS Transfer Pricing Audit Roadmap, available at https://www.irs.gov/pub/irs-utl/FinalTrfPrcRoadMap.pdf.

[ix] Treas. Reg. § 1.482-1(g)(4)(i).

The IRS may soon adopt a variation on Southwest Airlines’ slogan “you are now free to move about the country.” The IRS variant “you are now not free to move about the world.”  We previously blogged about enactment of Internal Revenue Code sec. 7345, which authorizes the State Department to deny a revoke a passport of an individual if the IRS certifies that the individual owes over $50,000 in tax, penalties and interest.  See, http://www.taxlitigator.com/if-you-dont-pay-your-taxes-you-not-be-able-to-travel-by-robert-s-horwitz/.

For a passport to be revoked, the IRS must certify that the taxpayer owes $50,000 in tax, penalties and interest that have been assessed and that either 1) a notice of federal tax lien has been filed and all administrative remedies under IRC § 6320 have lapsed or been exhausted or b) levy has been issued.  Recently, the IRS posted on its website that it will soon begin to certify tax debts to the State Department.  As of early May, 2017, certifications have not been sent, but taxpayers who owe more than $50,000 in tax, penalties and interest can expect in the near future to have their passports revoked or applications for passport denied.  A taxpayer who is making payments under on an installment agreement or has not entered into an offer in compromise or settlement agreement with the IRS is not subject to certification.  Similarly, the IRS will not certify a taxpayer who has requested a collection due process hearing with respect to a notice of intent to levy or a taxpayer who has requested innocent spouse relief.

A taxpayer whose passport has been revoked or who has had a passport application denied because of past due taxes, is not without a remedy: sec. 7345(e) provides that a person who has been notified by the IRS of certification “may bring a civil action against the United States in a district court of the United States or the Tax Court to determine whether the certification was erroneous or whether the Commissioner has failed to reverse the certification.”

Aside from the wisdom of allowing the IRS to strip a citizen of his or her right to travel outside the US, the statute has a number of holes. The statute requires the IRS to notify the individual “contemporaneously” of certification and the right to bring a civil action but does provide how notice is to be given. This is in contrast with other IRC sections requiring notice, such as notices of deficiency (IRC 6212), collection due process notices (IRC 6320 & 6330), summonses (IRC 7603 & 7609) and worker classification notices (IRC 7436), which require at a minimum written notice by certified or registered mail. The IRS website states it will send taxpayers notice by regular mail on Notice CP 508C.  This may not be as good a way as certified mail to ensure that the taxpayer receives notice and pays attention to it, but it is probably sufficient to pass Constitutional muster. Although many people consider the right to travel outside the U.S. as fundamental, the Supreme Court views it as “no more than an aspect of the ‘liberty’ protected by the Due Process Clause of the Fifth Amendment.” Califano v. Gautier Torres, 435 U.S. 1, 5 n.6 (1978) (per curiam).

There are other holes in the statute.   The statute does not provide whether the taxpayer or the Government has the burden of proof. It does not indicate what issues can be considered: can the merits of the assessment be contested or only whether the IRS correctly calculated the amount owed. It does not indicate whether a taxpayer is entitled to a trial on the merits or just summary review by the court. Whether failure to pay tax justifies restricting a citizen’s right to foreign travel has not been decided, but given that several appeals courts have upheld the statute authorizing denial of a passport for unpaid child support, Eunique v Powell, 371 F.3d 971 (9the Cir. 2002); Weinstein v. Albright, 261 F.3d 127 (2nd Cir. 2001), courts will probably uphold the constitutionality of sec. 7345.   It may be several years before we know the answers, however, since these issues will need to be decided in litigation

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

 

In Keller Tank Services II Inc. v. Commissioner, 848 F.3d 1251 (10th Cir. 2017), the Tenth Circuit affirmed the Tax Court’s holding that a taxpayer could not challenge a Section 6707A penalty during a collection due process hearing or in a subsequent Tax Court proceeding because it already challenged the penalty with the IRS Appeals Office.

This holding illustrates how challenges to IRS liabilities that are not subject to the familiar tax deficiency procedures may have multiple pathways to IRS Appeals, but not all of those pathways allow for the Appeals determination to be further appealed to the Tax Court. Two liabilities that present this issue are assessable penalties (i.e. Section 6707A in Heller) and interest.

As set forth in Keller, after the IRS proposes a Section 6707A penalty, the taxpayer has 30 days to agree to or protest the penalty to the Appeals Office. Keller filed such a protest with IRS Appeals to seek rescission of the penalty under Section 6707(d).  Keller received a telephonic conference with an Appeals Officer, but the penalty was ultimately sustained and the Appeals Officer closed the case.  Congress did not provide for this type of determination in appeals be further appealed by filing a Petition the Tax Court.  While there could be benefits to this type of appeal, namely a pre-collection opportunity to have a second independent IRS employee review the same issue, this may be the end of the road for disputing the substantive liability.  Contrast this with the taxpayer in Yari v. Commissioner, Yari, were the taxpayer first appealed an IRC Section 6707A Penalty in the context of a CDP proceeding instead of through an administrative appeal.  See Yari v. Comm’r, 143 TC 157 (2014), affd without discussion of this issue, 118 AFTR 2d 2016-6096 (9th Cir. 2016).  In Yari, unlike in Keller, the Tax Court had jurisdiction to review the dispute of the underlying liability.

Similarly, after the IRS assesses interest, if the taxpayer wishes to seek interest abatement for IRS delays in the audit or the IRS improperly computes interest suspension, a statutory right to appeal exists in IRC Section 6404. Despite this appeal right being present, the taxpayer should still consider waiting to dispute the liability in a CDP Appeal so that they are not faced with a dead end appeal if they exceed the net worth limitations set forth in IRC Section 6404.

In practice, presenting arguments to or negotiating with a final decision maker presents a different dynamic than making an argument to someone who can be overruled as a matter of law (or for abusing their discretion in collection situations). As such, a taxpayer should be well informed so that the taxpayer does not take an appeal pathway that results in a dead end with no further pre-collection appeal rights to the Tax Court.

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state civil and criminal tax controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at www.taxlitigator.com

Large multinational corporations have historically been the focus of IRS transfer pricing examinations, such as the dispute between Amazon and the IRS over the amounts Amazon charged its European subsidiary for certain intangible assets that were transferred.[i]  However, IRS efforts to address potential income shifting between related entities have expanded to include smaller companies in the middle market.

Section 482. These examinations arise as a result of the IRS’s power under Section 482, which provides that in the case of two or more businesses “owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.”  This Section gives the IRS broad discretion to reallocate income so that the income reported by a taxpayer is consistent with the economics and substance of the transactions between the related entities.

The standard under Section 482 is whether a transaction is arm’s length, which is shown by comparing the results of the related party transaction to what the results of the same transaction would be if entered into by unrelated taxpayers.[ii]  The regulations under Section 482 set forth extensive rules and guidance that must be followed in determining whether a controlled transaction satisfies the arm’s length standard.

LB&I Compliance Campaigns. The IRS recently announced that one of LB&I’s new compliance campaigns is the “Related Party Transactions Campaign,” which will be implemented through issue-based examinations.[iii]  The IRS explained in the rollout of the campaign that it will focus on “transactions between commonly controlled entities that provide taxpayers a means to transfer funds from the corporation to related pass through entities or shareholders.”  The IRS specified that it is allocating resources to this issue “to determine the level of compliance in related party transactions of taxpayers in the mid-market segment.  The IRS does not state whether its focus will be on transactions involving foreign entities or whether its focus will include transactions between related domestic entities.  While one of the prime concerns for the IRS in this area is taxpayers shifting income from the U.S. to a jurisdiction with a lower tax rate using non arm’s length transactions, situations arise where taxpayers have an incentive to shift income from one domestic entity to another.  The IRS’s powers under Section 482 apply equally to transactions with a domestic entity as to transactions with a foreign entity.

The IRS also rolled out another campaign targeting specifically one type of cross-border transaction between commonly controlled entities.   The IRS’s “Inbound Distributor Campaign” focuses on U.S. distributors of goods sourced from foreign-related parties, where the U.S. distributor has incurred losses or small profits that are not commensurate with the functions performed and risks assumed by the domestic entity—in such cases, the IRS believes the taxpayer would be entitled to higher returns in arm’s-length transactions.[iv]  For this compliance campaign, which will also be implemented by issue-based examinations, the IRS has “developed a comprehensive training strategy…that will aid revenue agents as they examine this IRC Section 482 issue.”[v]

Transfer Pricing Studies. With the IRS’s expanded focus on related party transactions, it is important for taxpayers who have commonly controlled or related entities to revisit their transfer pricing policies and consider obtaining a transfer pricing study.  In addition to potential substantial or gross valuation misstatement penalties if the IRS makes a transfer pricing adjustment, taxpayers may also be subject to a strict liability penalty depending on the net amount of the adjustment if the taxpayer did not obtain a transfer pricing policy prior to filing its tax return.[vi]  In order to be in the best position in the event of a transfer pricing audit and in order to help avoid the risk of a strict liability penalty in the event of a significant adjustment, taxpayers should have documentation prior to filing their tax returns setting forth the taxpayer’s determination of the price and establishing that the method the taxpayer used was reasonable and consistent with the Section 482 regulations.[vii]

Transfer Pricing Examinations. In an examination, the IRS advises revenue agents to issue a “§6662(e) mandatory Information Documentation Request” at the beginning of an audit, which will request the taxpayer’s documentation regarding its transfer pricing determinations.[viii]  While best practice is to ensure that all related party transactions are done at arm’s length, taxpayers facing a transfer pricing examination should be aware that the regulations under Section 482 allow for a “setoff” of an IRS transfer pricing adjustment, if the taxpayer can establish that the effect of multiple transactions between the related parties, when considered together, reflect an arm’s length arrangement between the entities.[ix]  The procedures that a taxpayer must follow to claim a setoff are set forth in Revenue Procedure 2005-46.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] Amazon.com, Inc. v. Comm’r, 148 T.C. No. 8, Docket No. 31197-12, 2017 (Mar. 23, 2017).

[ii] Treas. Reg. § 1.482-1(b).

[iii] https://www.irs.gov/businesses/large-business-and-international-launches-compliance-campaigns.

[iv] Id.

[v] Id.

[vi] IRC §6662(e)(1)(B); IRC §6662(h)(2)(A)(ii)(I).

[vii] IRC §6662(e)(3)(B).

[viii] IRS Transfer Pricing Audit Roadmap, available at https://www.irs.gov/pub/irs-utl/FinalTrfPrcRoadMap.pdf.

[ix] Treas. Reg. § 1.482-1(g)(4)(i).

A Court of Appeals recently decided that an innocent spouse who relied on the IRS’s bad advice and filed suit in Tax Court too late, couldn’t get “equitable tolling” of the filing deadline.

Tax law allows spouses and former spouses to escape liability for joint tax debts in certain situations, including when it would be “inequitable to hold the individual liable for any . . . deficiency.” If the IRS denies so-called “innocent spouse” relief, then the taxpayer can petition the United States Tax Court to get a judge to rule on the requested relief.    Taxpayers don’t have to pay the tax first and sue for a refund in Tax Court, as they would in U.S. District Court, so missing out on Tax Court could mean the end of the case, particularly for taxpayers who don’t have the money to pay the tax and sue for a refund.  Like most lawsuits, there’s a deadline to file suit in Tax Court; in this case, it’s 90 days after the IRS denies a claim for relief.

In the unfortunate case of Nancy Rubel, the IRS failed to accurately count to 90 days. In denying her claims for innocent spouse relief, the IRS helpfully told Ms. Rubel that she had a right to appeal to Tax Court.  Instead of telling her that she had 90 days to file the petition – which presumably would have led her to pull out a calendar and accurately figure out the filing deadline – the IRS unhelpfully told her an exact deadline for filing in Tax Court.  The 90-day period according to the IRS’s calendar actually was 105 days on the calendar that everyone else, including the Tax Court, uses.  Ms. Rubel filed after 90 days had expired but before the incorrect deadline told to her by the IRS.  When she got to Tax Court, the IRS moved to dismiss her appeal as untimely.  She appealed, arguing that the IRS was “equitably estopped” from arguing she was late, because all she did was rely on the IRS’s incorrect calculation of the filing deadline.  It was unfair, she argued, for the IRS to tell her she had 105 days to file and then move to dismiss because she didn’t’ file within 90 days.

The Third Circuit Court of Appeals upheld the Tax Court in Rubel v. Commissioner, finding that the statute setting the 90-day deadline was “jurisdictional.”  That means, if the taxpayer doesn’t file within 90 days, the Tax Court isn’t authorized by Congress to hear the case.  That also means, the deadline can’t be ignored through arguments such as equitable tolling that otherwise might allow a court to overlook a late filing.  Interestingly, the Third Circuit didn’t comment on the harsh result from Ms. Rubel’s decision to trust the IRS.  The court also didn’t comment on the perverse incentives resulting from its decision – that the IRS has no incentive to tell taxpayers the right filing deadline and in fact will greatly improve its position by “miscalculating” the appeal period and slipping out of Tax Court jurisdiction if the taxpayer relies on the IRS.  Hopefully the IRS will start telling taxpayers that the deadline is 90 days instead of trying to calculate 90 days for the taxpayer, as they’ve shown that they can’t even read a calendar and taxpayers suffer the consequences.

EVAN J. DAVIS – For more information please contact Evan Davis – davis@taxlitigator.com or 310.281.3288. Mr. Davis is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) handling civil and criminal tax cases and, subsequently, of the Major Frauds Section of the Criminal Division of the Office of the U.S. Attorney (C.D. Cal) handling white-collar, tax, and other fraud cases through jury trial and appeal. He has served as the Bankruptcy Fraud coordinator, Financial Institution Fraud Coordinator, and Securities Fraud coordinator for the USAO’s Criminal Division.

Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, and federal and state white collar criminal investigations. He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (OVDP, Streamlined Procedures and otherwise).

 

In a recent Division Opinion[i], the Tax Court granted petitioners a hardship waiver for an untimely IRA rollover, allowing them to exclude the amount from income and avoid an early distribution penalty.  In a broad sense, the case illustrates the pitfalls of retirement account distributions.  A closer examination of the facts, however, suggests a case where the administrative process failed, and the Tax Court was needed to get the right result.  From a distance, but as a former Counsel attorney, I find it hard to fathom why this case went all the way to trial.  Congratulations to the Fordham Clinic that handled the case.

John Trimmer retired from the NYPD after 20 years. Before retiring he had lined up a job as a security officer for the New York Stock Exchange to supplement his pension income.  After retiring, the NYSE job fell through.  Mr. Trimmer couldn’t find another job and the NYPD does not rehire retired officers.  Mr. Trimmer began suffering from major depression.  His behavior changed in all aspects of his life.

After his depression started, Mr. Trimmer received two checks totaling approximately $100,000 from his retirement accounts. The checks sat on his dresser for over a month before they were deposited into his checking account.  Mrs. Trimmer was not involved in this matter and believed her husband was handling his retirement assets.  Mr. Trimmer received a Form 1099-R indicating the distributions were taxable.  Mr. Trimmer’s accountant advised him to put the funds into an IRA, which he did shortly after.  The distribution was reported as not taxable.

The IRS issued a Notice CP2000, an automated notice, indicating the Trimmers failed to report the distribution and were liable for a 10% penalty. Mr. Trimmer responded with an eloquent letter explaining his situation, the depression he suffered, and that the tax liability would cripple his family.  The IRS sent a response indicating the taxpayers didn’t need to do anything further.  Three days later, the IRS issued a letter rejecting the requested relief.  A Notice of Deficiency was subsequently issued.

At trial the Taxpayers agreed the distribution would ordinarily be taxable, but that they qualified for a hardship waiver because of Mr. Trimmer’s depression. The IRS not only disagreed that Mr. Trimmer qualified for the hardship waiver, but argued that the examination division lacked authority to consider a hardship waiver, and that any consideration of a hardship waiver is not subject to judicial review.  The IRS further argued that the Taxpayers’ expert should be excluded.

The IRS argued that the Taxpayers failed to follow the rules in Rev. Proc. 2003-16, which provided guidance regarding hardship waivers. Specifically, it mentioned that a taxpayer needed to submit a Private Letter Ruling request and include the fee as set out in the Rev. Proc.  In 2016, the IRS revised the Rev. Proc. and made clear that exam could consider the hardship waiver.  The Court held that the exam division always had the authority to consider a hardship waiver.[ii]

The Court additionally held that it had jurisdiction to review the IRS’ determination and used an abuse of discretion standard.  The IRS argument that the Court lacked jurisdiction to review the hardship denial is yet another attempt by the IRS to limit taxpayer’s rights.  The hardship determination is fundamental to the ultimate deficiency determination.  If the hardship is granted, the distribution is not taxable.  The decision has a detailed analysis of this issue, noting that there is a strong presumption that acts of administrative discretion are subject to review.[iii]  Nothing in the statute indicated the hardship decision was not subject to review.[iv]

The IRS next tried to exclude the taxpayer’s expert witness, who was an unpaid clinical professor at Fordham with degrees in social work.[v]  Again the opinion is detailed in this section and a good primer on expert witnesses.  The Court ultimately denied all of the IRS objections.  Any flaws that the Taxpayers’ expert had seemed to stem largely from the fact that because of limited resources the Taxpayers couldn’t hire an outside expert.  The expert also came from a Fordham clinic.

After 44 pages, the Court addresses the merits of the Taxpayer’s hardship claim and grants the waiver, finding that the failure to waive the 60-day rollover requirement was against “equity or good conscience”. The Court found that the Taxpayer’s in no way profited from retaining the funds and the Mr. Trimmer suffered from a disability.

From the outside, it is hard to understand why this case didn’t settle. The deficiency was not large, the Taxpayers’ put the money in an IRA without benefitting, albeit untimely, and most of all, Mr. Trimmer suffered from depression.  The IRS tried to dispute that in part by arguing Mr. Trimmer refereed a soccer game on occasion.  This case seems to show a severe lack of empathy or perhaps a lack of understanding of mental illnesses such as depression.  Other recent cases have shown the IRS to seek restrictive interpretations of hardship as well as trying to avoid producing documents that would reduce the taxpayers liability.  The budget crunch and heavy caseload that IRS employees currently have and will likely have for the foreseeable future, don’t leave me optimistic that we can expect taxpayer friendly changes going forward.

JONATHAN KALINSKI specializes in both civil and criminal tax controversies as well as sensitive tax matters including disclosures of previously undeclared interests in foreign financial accounts and assets and provides tax advice to taxpayers and their advisors throughout the world.  He handles both Federal and state tax matters involving individuals, corporations, partnerships, limited liability companies, and trusts and estates.

Mr. Kalinski has considerable experience handling complex civil tax examinations, administrative appeals, and tax collection matters.  Prior to joining the firm, he served as a trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising Revenue Agents and Revenue Officers on a variety of complex tax matters.  Jonathan Kalinski also previously served as an Attorney-Adviser to the Honorable Juan F. Vasquez of the United States Tax Court.

[i] Trimmer v. Commissioner, 148 T.C. No. 14 (2017)

[ii] Id. at 15.

[iii] Id. at 21.

[iv] Id. at 22.

[v] Id. at 27.

Posted by: Robert Horwitz | April 28, 2017

IRS Gets Slapped Down on Penalties By Robert Horwitz

The IRS often proposes penalties in notices of deficiency. Under IRC section 7491(c), in a proceeding in court, the IRS has the burden of producing evidence to show that the taxpayer is liable for the penalty.  Under IRC section 6751(b)(1), the IRS cannot assess a penalty “unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”  There are exceptions to the need for a supervisor’s written approval, including late filing and payment penalties and penalties that are computed by electronic means.

In Chai v. Commissioner, Docket Nos. 15-1653 (2nd Cir. Mar. 20, 2017), the Second Circuit held that the IRS has the burden of proving compliance with section 6751(b). Chai also involves an interesting issue on the relationship between TEFRA partnership adjustments and deficiency proceedings and on whether a taxpayer is engaged in a trade or business, but a discussion of those issues will have to wait for a future blog.

The taxpayer in Chai received a 1099 for $2 million from his employer.  He claimed that the $2 million was a return of capital.  The IRS treated the payment as compensation.  Due to the fact that Chai was “over sheltered,” i.e., his losses from tax shelters exceeded all of his reported income plus the $2 million, he could not have an income tax deficiency unless the partnership losses were disallowed in TEFRA partnership proceedings.  So the IRS issued a notice of deficiency asserting self-employment tax on the $2 million plus a 20% accuracy-related penalty under IRC section 6662.

While Chai’s Tax Court case was pending, the TEFRA partnership proceedings ended with the losses being disallowed. The IRS amended its answer to assert that he owed an income tax deficiency on the $2 million.  The Tax Court ruled that it did not have jurisdiction to decide whether there was an income tax deficiency as a result of disallowance of the partnership losses.  It did, however, hold that the $2 million was compensation and that Chai owed self-employment tax.  It also held that he was liable for the 20% penalty. The Tax Court further held that Chai’s argument that the IRS failed to prove that the supervisor signed off on the penalty was not raised until post-trial briefing and, thus, was too late.  The Second Circuit reversed.

While the appeal was pending in Chai, the Tax Court issued its opinion in Graev v. Commissioner, 147 T.C. No. 16 (2016).  In Graev, the Court held that section 6751(b) only requires written approval before assessment. Since that wouldn’t occur until after the Tax Court’s decision, it was premature to raise the issue in a Tax Court deficiency case.

The IRS had argued in Tax Court that Chai raised the issue of supervisor approval too late. Before the Second Circuit it changed it tune.  It argued that Chair’s claim was premature, relying on Graev.

The Second Circuit sided with the taxpayer and rejected the Graev Court’s interpretation of section 6451(b).  Based on the historical meaning of “assessment” the Second Circuit found the phrase “initial determination of such assessment” ambiguous.  It therefore looked to the legislative history.  Congress enacted section 6571(b) out of concern that the IRS was using penalties as bargaining chips to get taxpayers to agree to larger deficiencies in exchange for not being assessed a penalty.  This would indicate that approval was to be given before a notice of deficiency was issued, since if a taxpayer went to Tax Court and lost, any approval by a supervisor would be meaningless.  The Second Circuit also noted that the IRS’s administrative practice was to require that the supervisor’s written approval be given before the notice of deficiency was issued.  The Second Circuit also emphasized the fact that approval was required before the “initial determination,” which would be no later than when a notice of deficiency is issued.

The Second Circuit next held that proving supervisory approval was part of the IRS’s burden of proof under section 7491(c). The final issue was whether the Tax Court abused its discretion in determining that Chai had raised the issue too late.  It had.  The IRS failed to produce evidence that supervisory approval was given and all Chai was doing was arguing that there was insufficient evidence to permit a finding in favor of the IRS on the penalty issue.

The moral: where the IRS has the burden of proof, hold its feet to the fire. While he won on the penalty issue, it didn’t turn out all that well for Chai.  The Second Circuit reversed the Tax Court’s decision that it did not have jurisdiction to determine whether Chai was taxable on the $2 million.  But that is a story for another day.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

On March 23, 2017, the Tax Court ruled against the IRS in its lengthy transfer pricing dispute with Amazon.com, Inc. (“Amazon U.S.”) over Amazon’s transfer pricing policies relating to intangible assets provided by Amazon U.S. to its European subsidiary in 2005 and 2006 that were required to operate Amazon’s European website business.[i]  In redetermining the IRS’s reallocation of income from Amazon’s European subsidiary to Amazon U.S., the Tax Court held that the IRS abused its discretion and acted arbitrarily and capriciously in its original determinations against Amazon.

Transfer Pricing Adjustments. Under Section 482 of the Internal Revenue Code, the IRS has broad authority to allocate gross income and deductions among commonly controlled entities if necessary “to prevent evasion of taxes or clearly to reflect the income.”[ii]  The purpose of Section 482 is to prevent artificial shifting of income between controlled entities in order to ensure that the amount of income reported by each entity for U.S. tax purposes is consistent with the economics of the transactions between the related entities, which is especially relevant where income is shifted from the U.S. to a jurisdiction with a lower tax rate.[iii]

The IRS has broad powers under Section 482. While the general rule in Tax Court cases is that the taxpayer has the burden of proving by a preponderance of the evidence that the taxpayer’s return was correct, in Section 482 cases, the IRS’s determinations will be upheld unless the taxpayer is able to show that that IRS’s determination was arbitrary, capricious, or unreasonable.[iv]  Note that while the taxpayer’s burden of proving the IRS’s determination to be arbitrary, capricious, or unreasonable is unique to Section 482 adjustments, the arbitrary, capricious, or unreasonable standard is also used for determining when the IRS loses its presumption of correctness for its adjustments in a Notice of Deficiency, allowing the taxpayer to shift the burden of proof to the IRS.[v]

Amazon’s Transfer Pricing Policies. In examining Amazon’s transfer pricing policies, the IRS determined that amounts Amazon’s European subsidiary paid for the intangible assets it received in 2005 and 2006 from Amazon U.S. for use in its business in Europe in 2005 and 2006 were not at arm’s length.[vi]  The arrangement between Amazon’s European subsidiary and Amazon U.S required Amazon’s European subsidiary to make a “buy-in” payment for the preexisting intangibles it received from Amazon U.S. in a series of transactions in 2005 and 2006, as well as a cost sharing arrangement to split the costs of Amazon’s ongoing intangible development costs.  The effect of the cost sharing arrangement was to essentially make Amazon’s European subsidiary a co-owner of the subsequently developed intangibles.  Amazon originally reported a buy-in payment from Amazon’s European subsidiary of $254.5 million, to be paid over 7 years.

The IRS Acted Arbitrarily and Capriciously. The IRS determined that the buy-in payment should have instead been $3.6 billion, which it subsequently reduced to $3.468 billion.  Rather than using a method allowed in the regulations under Section 482 for specifically valuing each of the intangible assets transferred to Amazon’s European subsidiary, the IRS valued the intangible assets using a discounted cash flow analysis, as though Amazon U.S. had transferred an entire operating business to its European subsidiary.  Finding that Amazon’s European subsidiary was already an operating company when it received the intangibles, the Tax Court held the IRS abused its discretion in using this method, because it erroneously included in its determination of the arm’s length buy-in payment the value of the European subsidiary’s existing ongoing business (e.g., its existing goodwill) and also the value of subsequently created intangibles, which were separately compensated for using the cost sharing arrangement.  The IRS’s approach in the Amazon case was the same as the method it had used in the case Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), where the Tax Court had held that method to be arbitrary and capricious.[vii]  The Tax Court further held that the IRS abused its discretion in its determination of its adjustments to Amazon’s determination of amounts its European subsidiary owed pursuant to the cost sharing arrangement for subsequently created intangibles, based on its determination that 100% of Amazon’s “Technology and Content” costs are subject to the cost sharing agreement, whereas Amazon’s position was that only 50% were allocable to the ongoing intangible development costs.[viii]

The Tax Court Finds Amazon’s Methods Reasonable. Once finding that the IRS acted arbitrarily and capriciously, the Tax Court evaluated the taxpayer’s arguments in support of the amounts charged and found that the taxpayer’s “comparable uncontrolled transaction” (CUT) method is the best method for calculating the requisite buy-in payment and the taxpayer’s system of allocating costs for the cost sharing arrangement was a reasonable basis for allocating costs, though the Tax Court made certain adjustments to the taxpayer’s application of the methods.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] Amazon.com, Inc. v. Comm’r, 148 T.C. No. 8, Docket No. 31197-12, 2017 (Mar. 23, 2017).

[ii] IRC § 482.

[iii] Treas. Reg. § 1.482-1(a)(1).

[iv] Amazon.com, Inc., 148 T.C. No. 8 at p. 174.

[v] See, e.g., Sealy Power Ltd. v. Comm’r, 46 F.3d 381, 386 (5th Cir. 1995) (“Several courts have recognized, however, that they need not give effect to the presumption of correctness and may instead shift the burden from the taxpayer to the Commissioner when the notice of deficiency is determined to be arbitrary or excessive.”).

[vi] Treas. Reg. § 1.482—7(g)(2).

[vii] Amazon.com, Inc., 148 T.C. No. 8 at pp. 73-88.

[viii] Id. at 174-177.

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