Monthly Tax Roundup (Volume 1, Issue 8)
Although the tax legislative agenda is on hold given the pre-election Congressional recess, the Internal Revenue Service (IRS) and the courts have been quite active over the last month. We anticipate an active lame duck session after the mid-term elections but, in the interim, this issue provides a summary of significant administrative and judicial developments of interest.
Tax Fact: As explained by the Joint Committee on Taxation, federal excise taxes on alcohol translate into about 33 cents on a six-pack of beer, 21 cents on a 750ml bottle of wine, and $2.14 on a 750ml bottle of 80-proof spirits.
"We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle." – Winston S. Churchill
Recent R&E Credit Refund Claim Developments
In the last few weeks, there were three taxpayer-friendly developments relating to research and experimentation (R&E) credit refund claims.
Two of those developments are related to the IRS's position on the requirements for a valid R&E credit refund claim. On October 15, 2021, the IRS announced its view that a valid R&E credit refund claim must include certain documentation setting out detailed information underlying a taxpayer's additional R&E credits. On September 30, 2022, the IRS extended by one year a transition period during which the IRS will notify taxpayers of its determination that an R&E credit refund claim was deficient and allow the taxpayer 45 days to cure it. The transition period now goes through January 10, 2024.
In addition, on October 4, 2022, the IRS updated the Frequently Asked Questions it issued in connection with its R&E credit refund claim position to clarify that a taxpayer need only satisfy the documentation requirements if its refund claim "relates to the Research Credit." An amended return that does not include a refund claim or one that does not request an adjustment to the R&E credit does not need to meet the documentation requirements.
The third development was a September 26, 2022 order in Cromwell Architects Engineers, Inc. v. United States, No. 4:21-cv-00829-KGB (E.D. Ark. Sept. 26, 2022). The federal district court rejected the government's argument that the taxpayer's complaint was deficient because it did not contain any specific qualified research expenses (QREs), how those QREs satisfy the four-part test in section 41, or how the taxpayer calculated the additional R&E credit it claimed. The court reaffirmed that a complaint in an R&E credit refund suit is subject to the same standard as all other complaints in federal district court — a complaint need only contain factual allegations sufficient to state a claim that not speculative but "is plausible on its face."
Each of these developments is discussed in greater detail in our alert.
IRS Releases Draft Schedule UTP with Additional Reporting Requirements
The IRS recently announced draft changes to the 2022 schedule used by large corporations to report uncertain tax positions (Schedule UTP and the UTP Instructions for Tax Year 2022). Comments on the draft form are due by November 18, 2022 and may be submitted through the draft form process or by emailing the Large Business & International Division (LB&I) here.
Generally, if a corporation is required by ASC 740-10 to record a financial reserve for an uncertain tax position, that position must be disclosed to the IRS on Schedule UTP. Historically, for each position reported, the taxpayer was required to disclose: the related Internal Revenue Code (IRC) section; whether the position was permanent, temporary, or both; the employer identification number of any pass-through entity involved; whether the position was a major tax position; and, finally, the rankings of the position by size without disclosing the amount of the reserve associated with each position.
The proposed changes to Schedule UTP would give the IRS additional insights into the basis for the taxpayer's position. As announced in the IRS's statement regarding the draft changes, additional reporting items have been added in an effort to improve the form's usefulness for the IRS. While potentially more helpful for the IRS's audit agenda, the proposed changes raise questions regarding whether the newly requested information is a deviation from the IRS's policy of restraint with respect to privileged and attorney work product necessary to produce Schedule UTP reporting.
Specifically, under the draft changes to Schedule UTP, taxpayers would be required to report any IRS guidance, court decision, or Treasury Regulation that is contrary to the tax position, the location of the position on the tax return by form/schedule and line number, as well as the incremental amount included on the line relating to the position. Additionally, the Schedule UTP instructions include more detailed guidance on the adequacy of concise descriptions required on the Schedule UTP, including more detailed examples.
The changes follow criticisms from a Treasury Inspector General for Tax Administration (TIGTA) 2018 report frankly titled The Uncertain Tax Position Statement Does Not Contain Sufficient Information to Be Useful in Compliance Efforts. TIGTA recommended more robust descriptions and dollar amounts for disclosed positions to allow examiners to identify specific issues beyond the mere confirmation of their existence. Even before the TIGTA report, the IRS sent letters to many taxpayers asking for more detailed descriptions. Taxpayers have thus had to provide concise descriptions that enabled the IRS to identify the item and begin to ask questions in the context of an audit, while also being careful not to include anything in those concise descriptions that might reveal a taxpayer’s hazards analysis.
Two aspects in particular of the proposed changes potentially implicate the policy of restraint, which, as set forth in 2010 in Announcement 2010-76, specifically provides that the IRS will not assert waiver of privilege during an audit for documents shared with financial auditors to produce the Schedule UTP. In line with that guidance, the Schedule UTP has traditionally focused on the description of the item, rather than why the position was uncertain. The example descriptions in the proposed new instructions seem to be pushing the taxpayer to reveal why it is uncertain about a particular item.
In addition, the requirement to identify the line item and the amount of the uncertain position, when coupled with the requirement to list the items by size of the reserve, may also implicate confidential taxpayer information to the extent the taxpayer ranks positions with lower dollar amounts higher than positions with higher dollar amounts.
In light of these changes, taxpayers should carefully assess their potential UTPs as both the dollar amount and the requirement to report contrary IRS guidance may impact their future reporting.
Treasury Withdraws 2006 Proposed PTEP Regulations
On October 20, the IRS and the Treasury Department (Treasury) announced the formal withdrawal of 2006 proposed regulations (REG-121509-00) concerning the treatment of previously taxed earnings and profits (PTEP) and related basis adjustments under section 959 and section 961. In Notice 2019-01, the IRS and Treasury had previously announced their intent to withdraw the 2006 proposed regulations and issue new proposed regulations that accounted for the new categories of PTEP created by the 2017 Tax Cuts and Jobs Act (TCJA). Notwithstanding the withdrawal of the 2006 proposed regulations, further PTEP guidance is not expected until the first half of 2023.
Final regulations under section 959 were last amended in 1983. The 2006 proposed regulations were intended to address numerous statutory changes to the international tax rules and section 304 since 1983 and included guidance on the maintenance of shareholder-specific and CFC-level PTEP accounts, ordering rules for applying distributions to different PTEP accounts, cross-affiliate PTEP sharing rules for section 304 transactions, deficit earnings and profit (E&P) situations, and basis adjustments for lower-tiered CFCs under section 961. However, the 2006 proposed regulations were never finalized and did not include language permitting taxpayers to rely on them.
In withdrawing the 2006 proposed regulations, the IRS and Treasury stated that withdrawing the regulations would "prevent possible abuse or other misuse," including "inappropriate basis adjustments" in certain brother-sister stock acquisitions under section 304. The withdrawal means that taxpayers can no longer rely on the (former) proposed regulations as "substantial authority" for penalty protection purposes under Treas. Reg. § 1.6662-4(d)(3)(iii). In addition, the IRS Office of Chief Counsel is now permitted (under IRS policy) to render advice that yields results harsher than the former proposed rules. See Internal Revenue Manual, 188.8.131.52.2(3) ("The Office of Chief Counsel ordinarily should not take any position in litigation or advice that would yield a result that would be harsher to the taxpayer than what the taxpayer would be allowed under the proposed regulations").
Government Asserts Economic Substance Doctrine Against Liberty Global
Liberty Global Inc.'s tax dispute continues, with the government filing a complaint on October 7, 2022 asserting that Liberty Global owes an additional $284 million in taxes and penalties (prior coverage: Monthly Tax Roundup (September 2022); Monthly Tax Roundup (May 2022); client alert (April 2022); tax break podcast (June 2021)). The amount sought reflects $236 million in unpaid taxes and $47 million in penalties under section 6662(b)(6) for an underpayment of tax by reason of a transaction lacking economic substance.
Liberty Global originally sought a refund of $109 million in connection with a December 2018 transaction in which they claimed the dividends received deduction under section 245A. The government asserted that the section 245A deduction was prohibited under Temporary Regulations issued in June 2019. In April 2022, the U.S. District Court for the District of Colorado granted partial summary judgment to Liberty Global, concluding that the section 245A Temporary Regulations were invalid for failure to comply with notice-and-comment requirements in the Administrative Procedure Act (APA). To date, the government has refrained from seeking interlocutory appeal.
In its October 7 complaint, the U.S. Department of Justice (DOJ) asserts that Liberty Global undertook preparatory transactions solely for the purpose of generating earnings and profits in a second-tier controlled foreign corporation (CFC), before that target CFC was sold upstream to Liberty Global's ultimate foreign parent. Because the preparatory transactions purportedly lacked substantial purpose and did not meaningfully change Liberty Global's economic position, the government asserts that the steps should be disregarded under the codified economic substance doctrine or one of the related judicial doctrines (business purpose, step transaction, or substance-over-form). If those steps are disregarded, the government estimates that an additional $2.3 billion would have been taxable as capital gain, rather than as a dividend. The government's complaint contemplates that this new action would be consolidated with Liberty Global's pending refund suit. In general, the tax consequences of the recharacterized transaction would not depend on the validity of the section 245A Temporary Regulations.
The government's assertion of the economic substance doctrine may signal a broader willingness by the IRS and the DOJ Tax Division to deploy the "soft doctrines" in response to taxpayer challenges to regulatory validity. At the American Bar Association (ABA) Section of Taxation meeting on October 14, the IRS Associate Chief Counsel (International) stated that the IRS may "look to bring up the economic substance doctrine to a greater extent than in the past." See Tax Notes (subscription required). Interested taxpayers should continue to track developments in Liberty Global as they arise.
Supreme Court to Hear Case on Privilege of Dual-Purpose Communications
On October 3, 2022, the U.S. Supreme Court granted a petition for a writ of certiorari asking the Court to review a Ninth Circuit decision involving the application of the attorney-client privilege to dual-purpose communications. In re Grand Jury, 23 F.4th 1088 (9th Cir. 2022), cert. granted, No. 21-1397 (S. Ct.). The case will provide the Court an opportunity to address a split in the circuits on the issue. The dispute in In re Grand Jury arose after an unnamed law firm specializing in international tax issues withheld communications with its client from its response to grand jury subpoenas seeking documents related to a criminal investigation of the client. The law firm had provided advice regarding the tax consequences of the client's planned expatriation and prepared some of the client's tax returns and expatriation-related tax forms. The law firm withheld from production to the grand jury some communications made both to allow the law firm to provide the client with legal advice and to facilitate the law firm's preparation of the client's tax returns, claiming that they were protected by the attorney-client privilege. The Ninth Circuit Court of Appeals upheld the district court's decision that the "primary purpose test" applied to determine if the dual-purpose communications are privileged. The district court determined that under that test, some of the communications were not privileged because "the predominate purpose of the disputed communications was not to obtain legal advice" but rather was about the procedural aspects of preparing tax returns. 23 F.4th at 1095. The district court did not decide whether the solicitation of legal advice was also a significant purpose of the communications.
There is a circuit split on the question of the standard to apply to determine if dual-purpose communications are protected by the attorney-client privilege. While the Ninth Circuit held that the primary purpose test is the applicable test, the DC Circuit Court of Appeals has applied a more generous standard that considers whether obtaining or providing legal advice was one of the material purposes of the communication. See In re Kellogg Brown & Root, Inc., 756 F.3d 754, 759-60 (D.C. Cir. 2014). In Kellogg, the court recognized that a communication can have more than one primary purpose and found that a dual-purpose communication is protected by the attorney-client privilege so long as one of the significant purposes is getting or providing legal advice, even if there is also a significant non-legal purpose for the communication. Interestingly, that opinion was authored by Justice Brett Kavanaugh when he was a judge on the DC Circuit Court of Appeals.
In In re Grand Jury, the Ninth Circuit Court of Appeals interpreted Kellogg narrowly to apply only to "truly close cases" where the legal and non-legal purposes of the communication are equally significant. 23 F.4th at 1095. Because the district court in In re Grand Jury determined that "the predominant purpose" of the communications at issue was non-legal, the Ninth Circuit found it unnecessary to address whether it should adopt the Kellogg standard. In its petition to the Supreme Court, the petitioner argued that the Ninth Circuit misconstrued the Kellogg test and that its primary purpose test is irreconcilable with the DC Circuit's standard.
At the other extreme, the Seventh Circuit Court of Appeals concluded that dual-purpose documents used for tax return preparation purposes and in litigation are not privileged. United States v. Frederick, 182 F.2d 496 (7th Cir. 1999). The Frederick court was particularly concerned with taxpayers using lawyers to perform tax preparation work to shield communications about the tax return on the basis of the attorney-client privilege.
The holdings in these cases raise another issue that the Court may decide to address – whether there should be a uniform standard for all dual-purpose communications, or whether dual-purpose communications in the tax context should be subject to a different standard. Kellogg was not a tax case – it involved communications relating to an internal investigation. The Ninth Circuit found this meaningful, concluding that "Kellogg dealt with the very specific context of corporate internal investigations, and its reasoning does not apply with equal force in the tax context." 23 F.4th at 1094-95. In the petition for writ of certiorari, the petitioning law firm argued that the Ninth Circuit was incorrect in asserting that the standard may be different for tax law and that the Court has never considered different approaches to the attorney-client privilege in different areas of substantive law and should not do so here.
Treasury Requests Preliminary Comments on Inflation Reduction Act Energy Credit Guidance
On October 5, 2022, Treasury and the IRS released six Notices, requesting comment on certain energy credits and deductions added or amended by the Inflation Reduction Act (IRA). The deadline for public comments is November 4, 2022, though in the Fact Sheet released simultaneously with the Notices, Treasury noted that later comments would be "accepted and considered as practicable."
Four of the six Notices request comments on technical matters related to the specific credit or deduction such as how a particular term should be defined, whether guidance is needed, and how various standards should be determined:
- Notice 2022-46 requests comments on issues related to the credits for clean vehicles under amended section 30D (clean vehicle credit) and new section 25E (previously owned clean vehicles credit).
- Notice 2022-47 requests comments on issues related to new sections 45X (advanced manufacturing production credit) and 48C (qualifying advanced energy project credit).
- Notice 2022-48 requests comments on issues related to deductions and credits for energy efficient residential and commercial buildings, specifically sections 25C (energy efficient home improvement), 25D (residential clean energy credit), 45L (new energy efficient homes), and 179D (energy efficient commercial buildings deduction).
- Notice 2022-49 requests comments on issues related to the energy generation credits, specifically sections 45 (production credit for renewable energy), 45U (nuclear power production credit), 45Y (clean electricity production credit), 48 (investment energy credit), and 48E (clean electricity investment credit).
Helpfully, each Notices contains the first summary by Treasury of these new or amended credits and deductions.
The other two Notices address and request comments on certain procedural and administrative issues:
- Notice 2022-50 addresses the elections under new sections 6417 and 6418 to treat certain credits as direct payments of tax and to transfer certain credits to unrelated taxpayers, respectively. Treasury and the IRS also requested comments on whether the direct pay election is available for taxpayers claiming the Advanced Manufacturing Investment Tax Credit under section 48D should operate differently from the direct pay election available under section 6417.
- Notice 2022-51 requests taxpayer input on the new prevailing wage/apprenticeship requirements, which can increase many of the credits substantially.
Closely Watched Crypto Case Dismissed as Moot, Leaving Questions Unanswered
Closely watched Jarrett v. Commissioner, which asked when cryptocurrency received from staking is taxed, has been dismissed because there is, according to a September 30 court order, no live controversy. As previously reported, the Jarretts filed a claim for refund for $3,793, arguing that the new crypto ("Tezos tokens") that they created by staking (lending their virtual coins and computing power) during 2019 were not taxable until they sold or exchanged their newly created property. The IRS argued that the Tezos tokens were taxable upon receipt because the Jarretts received them from a third party in exchange for investing their capital and services.
As it happens, however, this refund suit would not resolve this substantive issue. Following the complaint, the IRS issued a refund for the full amount requested plus interest. In response, the Jarretts did not cash the check and instead sought to "vindicat[e] their rights in court." They amended their complaint to seek injunctive and declaratory relief. Shortly thereafter, the government moved to dismiss the complaint for lack of subject matter jurisdiction on grounds that the issue was moot. The court granted that motion, stating that there is no live "controversy" or "case" as is required by Article III of the Constitution. The court explained that tender of full payment meets the refund claim and the Jarretts cannot reject the IRS's payment to maintain subject matter jurisdiction.
The court also dismissed several other arguments put forth by the Jarretts and found that their claims did not fall within any of the exceptions to mootness. Given this case's dismissal and the general lack of IRS guidance on the issue, taxpayers are currently left without clear direction as to whether staking rewards are taxable upon receipt or sale.
Are False Claims Act Cases the Next Wave of Tax Enforcement?
State attorneys general have increasingly pursued tax enforcement through False Claims Act (FCA) cases. Most white collar defense attorneys have done at least some work in the FCA area, though most tax controversy attorneys, thus far, have not. This could be changing. Several states — and, most recently, the District of Columbia — are leading the charge to bring FCA claims based on evasion of tax. These efforts have introduced a new creature into the tax enforcement ecosystem: the state attorney general's office. Tax practitioners are trying to get their arms around how exactly the arrival of state attorneys general will change the enforcement environment they know.
In this Tax Notes article, Joseph Rillotta and Ian Herbert examine this trend.
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