June 1999
After a long lapse, T&J is back with its newsletter items of interest. We shall use this format to provide selected summary informational items useful to those who practice in the tax controversy area. Occasionally, we will provide more detailed discussions. We hope that this service is useful.
We include two recent items related to income from illegal activities. Fortunately, our clients do not have these problems and it is unlikely that we would accept clients that do. However, IRS and the Courts' approach to these issues are informative.
The first item is a "Field Service Advice" whereby IRS Chief Counsel's office advises examination on legal issues. In FSA 1999-1132 (reproduced at 1999 TNT 105-44 6/2/99), the IRS concluded that a drug dealer must include the value of drugs he owned at his date of death and that the value to include was the "street price." In the facts, a drug smuggler died in a plane crash while ferrying marijuana and cash. The federal authorities seized these items.
The first question was whether the items (drugs and cash) could be treated as the decedent's property. The decedent's estate claimed that he was merely a pilot in the operation and not the owner of these items. The IRS suspected but had no real proof that he was the owner. The FSA concludes that the approach to ownership for estate tax purposes should be similar to the approach for determining whether a taxpayer has illegal income. In the income tax arena, the presumption of correctness will not alone suffice and the IRS must offer affirmative substantive evidence that the taxpayer received income from the illegal activity. Applying a similar approach to the estate tax issue of ownership, the FSA concludes that although the IRS can show a relationship between the items and the decedent (i.e., he was in possession of them), the IRS might be unable to show in any other manner that the taxpayer was the owner. Because of the latter, the FSA concludes that this is not an appropriate litigation vehicle and recommends against issuance of a notice of deficiency.
The FSA then goes on to address the related issue of value if the IRS is able to develop better facts to support the decedent's ownership. The FSA concludes that the fair market value under the willing buyer-willing seller concept is the "street price" for the drugs. And, the street price is based on unit sales rather than a bulk sales transaction.
The second item is the Tax Court decision in Ames v. Commissioner, 112 T.C. No. 20 (5/28/99). You will remember that the infamous Aldrich Ames pleaded guilty to turning over state secrets to the Soviet Union and received a life sentence, served concurrently with a 27-year sentence for conspiring to defraud the IRS. He also forfeited all espionage-related assets. During the period 1989-92, Ames deposited over $1,000,000 in proceeds from his espionage activity and did not report them as income. The IRS asserted tax liability and penalties accordingly. The taxpayer petitioned the Tax Court for redetermination of the deficiency.
The Tax Court first addressed the taxpayer's argument that he was entitled to obtain the criminal reference letter (commonly referred to as the "CRL") in discovery. The CRL is the letter the IRS sends to the DOJ in the criminal process of referring cases to DOJ for criminal prosecution which had, of course, been done earlier prior to Ames' plea of guilty to the tax charge. The CRL is prepared by the District Counsel. The Court determined that the CRL is attorney work product and is therefore not discoverable absent the type of showing traditionally required to discover attorney work product. The Tax Court rejected the taxpayer's argument that the work-product doctrine did not apply after the conclusion of the litigation (the criminal case) for which the materials were prepared or gathered. The Court noted that it could be expected in the preparation of the materials that a civil case involving the same issues would follow and therefore the doctrine applied.
The Tax Court next rejected the taxpayer's argument that he had shown the requisite need to overcome the assertion of the work-product doctrine. The taxpayer said that the materials could show that the IRS was using the civil penalties in issue in the case as a type of criminal punishment in addition to the criminal conviction and thus was relevant to the issue of whether the civil penalties were a type of double jeopardy. The Tax Court held that the IRS's purposes behind pursuing the civil case was not relevant to the issue of double jeopardy and therefore the taxpayer had not shown the requisite need.
The Tax Court then rejected the taxpayer's argument that he had constructively received the income in earlier years because, he argued but perhaps did not prove, the Soviets had set aside the funds for him in earlier years although he had not actually received them. The Tax Court held that the funds would not be taxable to the taxpayer until he received them.
The Tax Court then addressed the applicability of the negligence penalty. The taxpayer argued amazingly that his conduct was subject only to the fraud penalty and not the negligence penalty, arguing that the two are mutually exclusive. The Tax Court rejected that argument because, it reasoned, fraud necessarily includes negligence, so that the negligence penalty could apply even if the facts could also support fraud. (This is somewhat like, but not the same, as the lesser included offense doctrine applicable in criminal cases.)
The Tax Court finally rejected the taxpayer's argument that imposing the tax and/or negligence penalty violates the Double Jeopardy Clause of the Fifth Amendment. The Court handily held that the negligence penalty is not a criminal penalty and therefore its imposition cannot violate the Double Jeopardy clause.
Attorney-Client Privilege and New Section 7525 in the News
Perhaps the most hotly debated recent development in the tax controversy arena is the recent decision and amended decision in United States v. Frederick. The official federal second citations of the two decisions are not available, but the original decision is unofficially reported at 1999 TNT 74-21 (original decision) and 1999 TNT 102-9 (amended decision).
In Frederick, the IRS issued summonses to Frederick who was both a lawyer and an accountant. Frederick provided legal representation and tax return preparation services to a corporation and its shareholders who the IRS was investigating. Frederick also performed services in the IRS investigation/audit of the taxpayers. The summonses sought documents in Frederick's possession incident to providing these services. On behalf of the taxpayers, Frederick asserted the attorney-client privilege. The district court examined the documents in camera and ruled that some were privileged and some were not. Frederick appealed.
Judge Posner for the majority on the Court of Appeals panel started the decision off by noting that the applicability of privilege assertions are mixed questions of fact and law as to which a uniform appellate rule cannot be applied. Rather, Judge Posner asserted "a light appellate touch" is best. This touch, he explained, is the clear error standard to the application of law to specific facts.
Judge Posner then moved the assertion of privilege with respect to Frederick's return preparation services. Most of the documents in question were created by Frederick in connection with preparing the shareholders' tax returns. The documents included drafts of returns, schedules, worksheets, etc. Judge Posner concluded that "These are the kinds of document that accountants and other preparers generate as an incident to preparing their clients' returns, or that the taxpayers themselves generate if they prepare their own returns * * * *." Judge Posner then reasoned that, since there is no privilege for this type of work if performed by the taxpayer or by the taxpayer's accountant, it cannot be that there is an attorney-client privilege for the work simply because performed by an attorney. Judge Posner reasoned:
To rule otherwise would be to impede tax investigations, reward lawyers for doing nonlawyers' work, and create a privileged position for lawyers in competition with other tax preparers -- and to do all this without promoting the legitimate aims of the attorney-client and work-product privileges. The attorney-client privilege is intended to encourage people who find themselves involved in actual or potential legal disputes to be candid with any lawyer they retain to advise them. Upjohn Co. v. United States, 449 U.S. 383, 389 (1981). The hope is that this will assist the lawyer in giving the client good advice (which may head off litigation, bring the client's conduct into conformity with law, or dispel legal concerns that are causing the client unnecessary anxiety or inhibiting him from engaging in lawful, socially productive activity) and will also avoid the disruption of the lawyer-client relationship that is brought about when a lawyer is made a witness against his client. The work-product privilege is intended to prevent a litigant from taking a free ride on the research and thinking of his opponent's lawyer and thus avoid deterring a lawyer's committing his thoughts to paper. United States v. Nobles, 422 U.S. 225, 236-39 (1975); Hickman v. Taylor, 329 U.S. 495, 510-11 (1947); id. at 516 (Jackson, J., concurring).
Communications from a client that neither reflect the lawyer's thinking nor are made for the purpose of eliciting the lawyer's professional advice or other legal assistance are not privileged. The information that a person furnishes the preparer of his tax return is furnished for the purpose of enabling the preparation of the return, not the preparation of a brief or an opinion letter, and therefore is not privileged. But we do not accept the government's argument that there is no issue of privilege here because the information was transmitted to a tax preparer with the expectation of its being relayed to a third party, namely the IRS. It is true that "if the client transmitted the information so that it might be used on the tax return, such a transmission destroys any expectation of confidentiality." United States v. Lawless, supra, 709 F.2d at 487; see also United States v. Windfelder, 790 F.2d 576, 579 (7th Cir. 1986); In re Grand Jury Proceedings, 727 F.2d 1352, 1356 (4th Cir. 1984). That is, the transmittal operates as a waiver of the privilege. But here the tax preparer was also the taxpayers' lawyer, and it cannot be assumed that everything the taxpayer gave him was intended to assist him in his tax-preparation function and so might be conveyed to the IRS, rather than in his legal-representation function. Cf. United States v. (Under Seal), 748 F.2d 871, 875-76 (4th Cir. 1984).
Judge Posner then noted the sensitive relationship between the preparation of the current year returns and the IRS's investigation of earlier years:
A complicating factor is that when Frederick was doing these worksheets and filling out the Lenzes' tax returns, he knew that the IRS was investigating the Lenzes and their company, albeit in connection with different tax years, and he was representing them in that investigation. But people who are under investigation and represented by a lawyer have the same duty as anyone else to file tax returns. They should not be permitted, by using a lawyer in lieu of another type of tax preparer, to obtain greater confidentiality than other taxpayers. By using Frederick as their tax preparer, the Lenzes ran the risk that his legal cogitations born out of his legal representation of them would creep into his worksheets and so become discoverable by the government. The Lenzes undoubtedly benefited from having their lawyer do their returns, but they must take the bad with the good; if his legal thinking infects his worksheets, that does not cast the cloak of privilege over the worksheets; they are still accountants' worksheets, unprotected no matter who prepares them.
Put differently, a dual-purpose document -- a document prepared for use in preparing tax returns AND for use in litigation -- is not privileged; otherwise, people in or contemplating litigation would be able to invoke, in effect, an accountant's privilege, provided that they used their lawyer to fill out their tax returns. Likewise, if a taxpayer involved in or contemplating litigation sat down with his lawyer (who was also his tax preparer) to discuss both legal strategy and the preparation of his tax returns, and in the course of the discussion bandied about numbers related to both consultations, the taxpayer could not shield these numbers from the Internal Revenue Service. This would be not because they were numbers, but because, being intended (though that was not the only intention) for use in connection with the preparation of tax returns, they were an unprivileged category of numbers.
Judge Posner then moved to the documents prepared in connection with the IRS's investigation/audit, reasoning as follows:
The most difficult question presented by this appeal, and one on which we cannot find any precedent, relates to documents, numerical and otherwise, prepared in connection with audits of the taxpayers' returns. An example is a memo from Frederick to a paralegal asking her for the amount that Mr. Lenz and his corporation had paid Frederick for legal services rendered personally to Lenz in 1992. The memo was prepared to help Frederick respond to questions raised in an audit of the Lenzes' and the corporation's tax returns. An audit is both a stage in the determination of tax liability, often leading to the submission of revised tax returns, and a possible antechamber to litigation. Normally, however, taxpayers in audit proceedings are represented by accountants, or not represented at all, rather than by lawyers; and so the principal effect of equating audits to litigation and thus throwing the cloak of privilege over the audit-related work of the taxpayer's representative would be to create an accountant's privilege usable only by lawyers.
Judge Posner then discussed the new tax practitioner privilege in recently enacted Section 7525, although it was not involved in the matter at hand (hence being what lawyer's call dicta):
But we should consider the bearing of a new statute, 26 U.S.C. section 7525, which extends the attorney-client privilege to "a federally authorized tax practitioner," that is, a nonlawyer who is nevertheless authorized to practice before the Internal Revenue Service. Section 7525(a)(3)(A). The new privilege protects communications between a taxpayer and a federally authorized tax practitioner "to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney." Section 7525(a)(1). It does not protect work product.
The IRS has long allowed nonlawyers (including tax preparers) to practice before it. 31 C.F.R. sections 10.3, 10.7(c)(viii). Nothing in the new statute, however, suggests that these nonlawyer practitioners are entitled to privilege when they are doing other than lawyers' work; and so the statute would not change our analysis even if it were applicable to this case, which it is not, because it is not applicable to lawyers, or to communications made before July 22, 1998, the date on which the statute was enacted. See Note following 26 U.S.C. section 7525. And so we may set the new statute to one side.
Judge Posner thus finds that the privilege applies only when tax practitioners other than lawyers are doing lawyer's work which, of course, they are not authorized to do (except as Section 7525 may override the state regulatory regimes for the practice of law.
The dissent (Judge Wood) objected only to Judge Posner's statements as to the standard of appellate review (his "light appellate touch" analysis), which need not detain us here. Judge Wood therefore agreed on the other aspects of the opinion.
Judge Posner's opinion ignited a fire storm of concern. See e.g., Appellate Court in Dictum, Narrows Tax Adviser Privilege, 1999 TNT 79-1 (4/26/91); Raby, Illusions, Delusions and the Tax Practice Privilege, 1999 TNT 82-82 (4/29/99). Some typical expressed concerns were: the indicated limits of Section 7525, the new tax practitioner privilege; the problems with wearing two hats -- the attorney and accountant hat, that may or may not be a concern with the accountant's new push into legal and litigation services; Judge Posner's apparent insensitivity to audits as precursors to litigation (do courts really want to invite the quagmire of determining what portion of audit or even tax return preparation is the practice of law and what portion is not?); etc. (See particularly Mr. Raby's thoughtful discussion.)
The controversy apparently was heard by Judge Posner. Even without a formal petition for rehearing, Judge Posner revised the opinion. The amended opinion omits the following sentence:
Normally, however, taxpayers in audit proceedings are represented by accountants, or not represented at all, rather than by lawyers; and so the principal effect of equating audits to litigation and thus throwing the cloak of privilege over the audit-related work of the taxpayer's representative would be to create an accountant's privilege usable only by lawyers.
and provides instead the following:
When a revenue agent is merely verifying the accuracy of a return, often with the assistance of the taxpayer's accountant, this is accountants' work and it remains such even if the person rendering the assistance is a lawyer rather than an accountant.
Judge Posner then continues with the original language that "Throwing a cloak of privilege over this type of audit-related work of the taxpayer's representative would create an accountant's privilege usable only by lawyers." Judge Posner then adds the following:
If, however, the taxpayer is accompanied to the audit by a lawyer who is there to deal with issues of statutory interpretation or case law that the revenue agent may have raised in connection with his examination of the taxpayer's return, the lawyer is doing lawyer's work and the attorney-client privilege may attach. But the documents in issue do not, so far as we are able to determine, relate to such representation.
The general practitioner and scholarly reaction is that the changes are for the better in the audit context, although concern in other areas is still expressed. E.g., Amendment to Opinion Narrowing Privilege Addresses Lawyers in Audits, 1999 TNT 98-4 (5/21/99). That article also notes that the taxpayers are preparing and will file a petition for rehearing. It is reported elsewhere that at least one state bar may file an amicus brief. Privilege Ruling Worries Tax Lawyer/Accountants, Chicago Daily Law Bulletin (5/27/99).
There will undoubtedly be more to come in this case and in other cases as Section 7525 ripens.
The IRS has released the transfer pricing report that Congress required. It is Publication 3218 titled "Report on the Application and Administration of Section 482." The Publication may be downloaded in PDF format (Adobe Acrobat) by clicking here. There are no surprising revelation, but the report does have interesting statistics and is a good introduction to the current state of transfer pricing law and issues from the IRS's perspective.
Tax Court Says Consolidated Intercompany Transaction Rule Is Not Method of Accounting
The Tax Court decision in General Motors Corp. v. Commissioner, 112 T.C. No. 19 (5/25/99), dealing with GM's change of timing for its deduction for interest subsidies paid to its related affiliated financing affiliate (GMAC) to promote sale of slow selling units. GM had previously deducted the interest subsidies as intercompany transactions and thus reported the deductions as the related outside interest income was earned by the affiliate -- i.e., as the ultimate consumer paid interest to GMAC. In 1985, GM changed the calculations so as to report the deductions immediately as paid to GMAC and filed refund claims for prior years on the same basis. GM's theory was that the net effect of the subsidy was not a transaction between GM and GMAC subject to the deferred intercompany transaction rules but rather was between GM and the ultimate consumer and hence not subject to those rules even though GMAC was the intermediary for the transaction. The battle ground was not whether GM's new position was correct but rather whether the change was an accounting method change requiring the IRS to consent. Judge Vasquez gave the victory to GM. Presumably, the IRS was not happy and, for what it is worth, neither was Lee Sheppard (see Sheppard, The Hazards of Defining "Method of Accounting, 1999 TNT 108-4 (6/7/99)).
Fifth Circuit Gives Penalty Relief for Large and Small Taxpayers
The Fifth Circuit continues to be a favorable forum for penalties, this time helping large taxpayers. In Pan American Life Insurance Co. v. United States, unofficially reported at 1999 TNT 97-12 (5/20/99), the taxpayer did not affirmatively disclose the return reporting position found by the district court and the court of appeals to be wrong, but there were certain inconsistencies on the return that should have and apparently did alert the IRS to the issue. The court perfunctorily gave the taxpayer relief from the substantial understatement penalty, noting the taxpayer was "audited every year and * * * closely monitored by the IRS and stating:
We note, that in prior instances this Court has implemented the use of section 6661(a) to punish taxpayers who have tried to defraud the IRS. Sandvall v. Commissioner, 898 F.2d 455 (5th Cir. 1990). This Court has waived the punishment, however, when the taxpayer has been able to show that the understatement was for good cause and in good faith. Heasley, 902 F.2d at 385; Stanford v. Commissioner, 152 F.3d 450 (5th Cir. 1998). The latter case is similar to the one at hand, therefore, we find that the tax penalty was improperly imposed against [the taxpayer].
Heasley relief for the big guys is now available to those of us lucky enough to live in the Fifth Circuit. The Fifth Circuit had already moved in that direction in Stanford, but we now have it full bore. I think this case is worthy of some attention. And, of course, this largesse should filter down to the Tax Court and may filter over to other Circuits as Heasley has.
Client Suffers as Another Lawyer and Accountant Learn Kovel's Simple Lesson
Law Students in a basic tax procedure class learn that there is no accountant-client privilege but that an accountant can be swept under the attorney-client privilege if engaged by the attorney to assist the attorney in rendering legal services to the client. The leading case establishing this elementary proposition is United States v. Kovel, 296 F.2d 918 (2nd Cir. 1961) did just that for accountants, but the concept sweeps broader than just accountants, for lawyers may need assistance from many disciplines in rendering legal advice. The law student and the practitioner also learn quickly that it is critical to establish the relationship between the lawyer and the accountant in writing, so that it is clear that the accountant (or other expert) is functioning as the lawyer's assistant and not independently. For an object lesson on this point, see our previous discussions of the Adlman case. (Taking the name of the leading case, the relationship is often referred to as a Kovel relationship, with the expert being called a Kovel expert (e.g., Kovel accountant) and the written agreement documenting the relationship being called the Kovel agreement.)
In United States v. Randall, ___ F. Supp. ___ (D. Mass. 5/21/99), unofficially reported at 1999 TNT 116-14 (5/17/99), although the facts are not fully fleshed out, the following seems to be what occurred: the attorney prepared tax returns acting solely as a return preparer; thereafter, incident to an IRS civil audit, the attorney simply referred the taxpayers to an accountant more experienced in audits; the taxpayers met with the accountant and disclosed information and gave him documents, shortly thereafter the taxpayer's new (more experienced) attorneys engaged the accountant under a Kovel agreement; at some point the civil audit turned criminal. The IRS summonsed the accountant to testify regarding client communications prior to the engagement by the attorneys and to produce the documents the accountant received prior to that date. At the request of one of the taxpayers involved, the accountant asserted the attorney-client privilege. The IRS then brought a summons enforcement proceeding.
The Court held that the taxpayer must establish that the accountant "was acting as an agent for her attorney, and that the confidential conversations at issue actually assisted the lawyer with his "legal advice," as opposed tax preparation or accounting assistance advice." The Court found that the taxpayer failed to establish either element. The attorney who prepared the returns testified that he acted as the taxpayers' tax return preparer and nothing more. Tax return preparation is not legal advice (see e.g., the discussion above regarding the Frederick case). Accordingly, the accountant could not have been engaged to render legal services. In addition, the attorney testified that he did not retain the accountant as an agent, but simply referred them to the accountant as someone more experienced in audit matters than was the lawyer.
The taxpayer also asserted the standard fall back position that the accountant's information and the documents he received during the critical time frame were protected by the work-product doctrine. See Adlman. Without in depth analysis, the Court rejected the argument.
The Court's decision is a bit superficial which does not necessarily mean that it is wrong at the bottom-line. Nevertheless, right or wrong, it contains valuable lessons regarding Kovel, lessons that should have been evident from Adlman. First, think about what you are doing. (Not a bad lesson in all areas of life.) It would have been very easy for the taxpayer's attorney-return preparer to enter a Kovel relationship with the accountant. Second, document the Kovel relationship. In these facts, the taxpayers' new, more experienced lawyers did document the relationship, thus preventing the IRS from getting to communications and documents received by the accountant after the relationship was entered. This is a good lesson and I hope all readers will remember it.
There is still another pressure-point not readily evident from the case. Practitioners in this area are concerned when persons engaged as Kovel experts have knowledge gained prior to the engagement. The classic situation is whether to engage as the Kovel accountant in a civil or criminal investigation the accountant who prepared the returns being examined. Obviously, there could be significant economies if that accountant is engaged. But, as in Randall, everything he received and learned prior to engagement is subject to discovery by the IRS. Of course, the taxpayer is no worse off than if the accountant is not engaged as a Kovel expert, for that same information and the same documents are discoverable by the IRS. The concern is that, if that accountant is engaged as the Kovel expert, he may not be able to distinguish to the satisfaction of the IRS or a court what he learned before and after the engagement. Most careful practitioners therefore discourage the engagement of the return-preparing accountant as a Kovel expert. The client is, however, the boss on the issue. If, after proper advice, the client decides (for cost reasons or whatever) to have the return preparer as the Kovel accountant, the attorney should attempt to establish for the file clearly what was known and received prior to the engagement.
Supreme Court Applies Harmless Error Analysis to Materiality Issue
Many criminal sections explicitly or, by interpretation, have a materiality requirement. The tax perjury statute (Section 7206(1)) is one such section. Since Gaudin (United States v. Gaudin, 515 U.S. 506 (1995)), the courts of appeals and district courts have struggled with the cases wherein materiality was not submitted to the jury in those circuits where the law, as interpreted prior to Gaudin, made materiality an issue to be decided by the judge. The Supreme Court turned to one facet of this problem in Neder v. US, ___ U.S. ___ (6/10/99), unofficially reported at 1999 TNT 112-15 (6/11/99). The requirement that the jury make the determination as to whether the Government has established the elements of a crime beyond a reasonable doubt is constitutional. Accordingly, the sea-change required by Gaudin means that materiality is an element that must be submitted to a jury. The Court held that a pre-Gaudin failure to submit the issue to a jury does not necessarily require reversal because it is not a fundamental constitutional error. Rather, the failure to submit the issue to the jury is subject to harmless-error review. The Court cited its earlier opinion in Johnson (Johnson v. United States, 520 U.S. 461 (1997)), a perjury prosecution, where the Court affirmed the conviction where there was overwhelming and uncontradicted evidence of materiality. The Court held that such was the case here and thus the error was harmless under the facts of the case. Speaking directly to the issue of whether the holding denigrates the constitutional right to a jury determination of each element of the offense, the Court said that the court of appeals applies the test as follows:
Rather a court, in typical appellate-court fashion, asks whether the record contains evidence that could rationally lead to a contrary finding with respect to the omitted element. If the answer to that question is "no," holding the error harmless does not "reflec[t] a denigration of the constitutional rights involved." * * * On the contrary, it "serve[s] a very useful purpose insofar as [it] block[s] setting aside convictions for small errors or defects that have little, if any, likelihood of having changed the result of the trial." .
The Supreme Court also held that the mail fraud statute, a frequent companion to tax charges, must be interpreted to include a materiality requirement even though the statute does not expressly contain that requirement. The Court reasoned that the statute was based on common-law fraud which does have that element of the offense. Hence, the Court said, barring legislative history to the contrary, the statute should be presumed to include that element since the statute was closely enacted under circumstances indicating that common law fraud was its background.
In the dissent, Justice Scalia attacks the majority's notion that, upon appellate review, the judges can constitutionally determine what the jury would have done had it been properly instructed. Justice Scalia believes that that cannot be the subject of harmless error analysis because the jury has the right to base that determination on its own "logic (or illogic)."
An interesting dialogue occurred between Justice Stevens in a concurring opinion and Justice Scalia (joined by Justices Souter and Ginsburg) in a dissenting opinion. Justice Stevens wrote to state his belief that misreporting total income is, in effect, per se material so that the jury verdict which included a finding that the taxpayer has misreported income necessarily included a finding of materiality, even though it was not submitted to the jury. This would, of course, read materiality out of the statute and permit conviction merely upon the false information in the return. Justice Scalia correctly attacks that nonsense, consistent with his overall thesis that the jury can and constitutionally must be entrusted with this decision. Justice Scalia says (fn. 2):
JUSTICE STEVENS thinks that the jury findings as to the amounts that petitioner failed to report on his tax returns "necessarily included" a finding on materiality, since "'total income'" is OBVIOUSLY 'information necessary to a determination of a taxpayer's income tax liability.'" Ante, at 2 (emphasis added). If that analysis were valid, we could simply dispense with submitting the materiality issue to the jury in ALL future tax cases involving understatement of income; a finding of intentional understatement would be a finding of guilt -- no matter how insignificant the understatement might be, and no matter whether it was offset by understatement of deductions as well. But the right to a jury trial on all elements of the offense does not mean the right to a jury trial on only so many elements as are necessary in order logically to deduce the remainder. The jury has the right to apply its own logic (or illogic) to its decision to convict or acquit.
IRS Denies Competent Authority Relief for Game Playing
A recently released 1993 Field Service Advice, known acronymically as "FSA," deals with some of the more arcane notions of the competent authority process. See FSA 1999-1155, reported at 1999 TNT 122-98 (6/25/99). The competent authority process is the process whereby one treaty partner negotiates with another treaty partner, usually at the behest of a taxpayer in the first treaty partner country, to achieve a benefit under the treaty. In transfer pricing contexts, the benefit of the treaty is avoidance of double taxation by setting the transfer prices consistently in each treaty country so that neither treaty country taxes the same quantum of income.
The facts in the FSA are somewhat complex, so we shall simplify them to set up the issues. The treaty countries were the U.S. and Australia. A foreign multinational (U.K. parent company, referred herein a "FP," an acronym for foreign parent) owned a U.S. subsidiary ("US Sub") and an Australian subsidiary ("Aus Sub"). In the tax year involved (let's say year 1), the US Sub purchased certain equipment from Aus Sub. Aus Sub took the position in reporting its taxes for year 1 that the gain was not taxable under Australian tax law. US Sub used the purchase price in computing its U.S. tax. US Sub reduced its reported U.S. tax depreciation and depletion resulting from the purchase price paid. Obviously, if the sale were not taxed in Australian and the purchase price did give rise to U.S. tax benefits, the related parties would have an incentive to overstate the purchase price. The IRS determined that they did overstate the purchase price and proposed a deficiency against US Sub accordingly. As is typical in such brother-sister corporation adjustments, the IRS proposed another adjustment to treat the excess purchase price as a constructive dividend to the common parent from the corporation paying too much in the transaction (i.e., from the U.S. Sub), thus subjecting the US Sub to withholding tax on the dividend. And, to further exacerbate the problem, the taxpayer indicated a desire to make the cash pot right if there is an adjustment by having Aus Sub return the excess purchase price to US Sub, thus potentially attracting some type of Australian tax on that return (e.g., dividend withholding).
The taxpayer sought competent authority relief. As noted, however, the Australian affiliate's Australian tax reporting position was that its gain was not subject to Australian tax. Hence, the IRS concluded, if that position were correct, Australian tax would not be affected by the U.S. initiated adjustment and the key predicate for competent authority relief -- double inconsistent taxation -- was absent. US Sub sought to avoid this threshold problem by arguing that Australian was then auditing Aus Sub and might take the position that the gain on the sale was taxable in Australia. In addition, by invoking competent authority relief, the taxpayer sought to obtain relief under Rev. Proc. 65-17 which permits parties subject to a U.S. transfer pricing adjustment to avoid the collateral consequences (here the dividend to the common parent (FP) resulting from the transfer pricing adjustment) by setting up an account receivable in US Sub for the excess purchase price and having Aus Sub pay the account receivable. The FSA refers to the latter payment as a "repatriation" to make the cash positions consistent with the transfer pricing adjustment.
Chief Counsel concluded that competent authority assistance was not available. First, Chief Counsel concluded that the taxpayer had not shown proof of the likelihood of double taxation. The FSA says:
The fact that Australia may take a position on the * * * sale transaction during the audit of the * * * tax year, and that this position may somehow result in double taxation, does not constitute proof that the action of Australia is likely to result in double taxation. Thus, there is no basis for filing a request for competent authority assistance under Rev. Proc. 91-23, 1991-1 C.B. 534, section 5.01.
The FSA does not that the IRS could delay its proposed action to see whether Australia would take that inconsistent position. The FSA recommends to the Field that it not give that delay relief for the following reasons:
It appears that the Taxpayer has initiated a request for competent authority assistance on a flimsy basis in order to delay the issuance of the statutory notice of deficiency. Further, the Australian examination could take several more years and would prejudice the timely administration of this case by the United States. Of course, the Taxpayer could make a second request to competent authority if Australia takes an action that triggers Article XVII of the Treaty. This would be true even if the case is designated for trial or pending in a U.S. court. See Rev. Proc. 91-23, 1991-1 C.B. 534, section 6.01.
The FSA also concludes also that the taxpayer failed to show double taxation relief with respect to the dividend and repatriation, and thus denied Rev. Proc. 65-17 relief. Rev. Proc. 65-17 is designed to take the sting out of transfer pricing adjustments by mitigating the collateral consequences noted above (i.e., dividend from the related party paying too much and possible additional dividend if the cash is repatriated to make the pot right after the adjustment). One of the conditions for such relief is that the transfer pricing error has as one of its principal purposes the avoidance of federal income tax. The FSA concludes that the affiliated group had, through improper transfer pricing, attempted to understate US Sub's U.S. tax at no Australian tax cost to AUS Sub. Furthermore, as a threshold question, the FSA concludes that the taxpayer failed to show that Australia might tax the repatriation, instead just adverting generally to that risk. Furthermore, the FSA concludes that competent authority relief would not be available with respect to Australia's taxation of the repatriation because the treaty permits relief only if Australia's imposition of tax arises from the U.S. adjustment. Here, the repatriation is not a "direct result" of the U.S. proposed transfer pricing adjustment but rather an independent decision by the related parties. The FSA concludes:
The repatriation is not required by the United States. In addition, the repatriation would be accounted for in a different taxable year than the year of the adjustment.
The treatment of the repatriation can be contrasted to the deemed dividend. It is required by the United States as part of the section 482 adjustment. Because the deemed dividend accounts for the amount in excess of the arm's length purchase price that is transferred to * * * it is treated as occurring simultaneously with the purchase of the gas field property and is accounted for in the year of the adjustment.
In addition, we do not believe that taxation of the deemed dividend and repatriation would be double taxation of the same income. The tax consequences of the deemed dividend would be treated as a distribution by * * * of its earnings determined as of * * *. The repatriation would be a distribution by * * * of its earnings determined as of * * * or thereafter. The same earnings, therefore, would not support both distributions.
In fact, double taxation would occur with respect to the deemed dividend only to the extent that The * * * a U.K. corporation, was taxed by both the United States and the United Kingdom. Thus, it would be more appropriate for The * * * to seek relief from the U.K. competent Authority to ensure that the U.S. withholding tax is a creditable foreign tax in Great Britain. Similarly, if Australia treated the repatriation as a dividend to The * * * it would be more appropriate to seek relief from the U.K. Competent Authority to ensure that the Australian withholding tax is creditable in Great Britain.
T&J Comments:
This FSA shows one of the risks of an IRS perception that a taxpayer has played games with its transfer pricing. The IRS simply will not be inclined to make discretionary calls in the taxpayer's favor. The IRS did find, in effect, that the taxpayer had not shown a real likelihood of double taxation from the direct U.S. initiated adjustment (which, if correct, would mean that Aus Sub should have had less gain) because Australia had not yet taken the position that the gain in any amount was taxable. Australia might or might not take that position, but the IRS was not even willing to put the U.S. adjustment "on hold" to take a wait and see approach (presumably through a consent to extend the statute of limitations) because the taxpayer had played games Of course, the taxpayer can, when it gets a notice of deficiency, put the case in the Tax Court and achieve some delays there to see if Australia will take an inconsistent position. In addition, if and when Australia takes the position that is entitled to tax the "gain," the Aus Sub might take a run at Australia's competent authority to open negotiations with the U.S. competent authority for a consistent result but even there may have laid the foundation for a cold reception because of the apparent games the taxpayer played there. In all events, however, a taxpayer in this situation will want to watch carefully its statutes of limitations and, even with respect to those treaties waiving statutes of limitation, will want to avoid doing something that would be preclusive of relief (such as a closing agreement or a final court decision).
The FSA points, ever so subtly, to another truism. Treaties do not confer rights upon taxpayers. Rather, they confer rights upon countries. A treaty country will invoke the process with a treaty partner only if the treaty country feels that it is in the treaty country's interest to do so and, likewise, a treaty partner is not required to reach agreement with a treaty country invoking the process unless the treaty partner believes that it is in its best interest to do so. The respective countries' interests underlying the treaty provision is that encouraging cross-border trade is in both countries' interests and thus eliminating, if possible, double taxation will promote cross-border trade, to each countries' benefit. So normally the two countries will find it in their interests to permit the process to work to eliminate double taxation. But, in a given case, each country may for reasons good and sufficient to itself cause the process not to work. In the FSA, the IRS holds out the possibility that it will not cooperate with a taxpayer who is playing games.
The denial Rev. Proc. 65-17 relief also illustrates a related problem. For a taxpayer qualifying for Rev. Proc. 65-17 relief, we understand that the U.S. competent authority will seek to obtain consistent treaty partner relief even though the treaty does not require such consistent treatment. Here, the IRS simply said it would not even try because of the taxpayer's game-playing, although it justified that in part by some stab at a conceptual notion that such relief is not even available in the competent authority process.
Readers should note that, in Announcement 99-1,1999-2 I.R.B. 41, the IRS updates the requirements for Rev. Proc. 65-17 relief. The updates are discussed in Mr. Townsend's article titled Competent Authority: Selected Issues which may be downloaded on Townsend & Jones' download page.
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