Monthly Tax Roundup (Volume 2, Issue 10)
October saw continued briefing at the Supreme Court in the Moore case and other judicial developments addressing the economic substance doctrine and attorney-client privilege. The U.S. Department of the Treasury (Treasury) has requested comments on the Organisation for Economic Cooperation and Development's (OECD) draft multilateral convention on Pillar One Amount A, and together with the Internal Revenue Service (IRS), issued published guidance relating to so-called "Killer B" transactions and regarding clean vehicle credits.
Tax Fact: According to the IRS Taxpayer Advocate, when a case is transferred to the Independent Office of Appeals, it takes an average of 48 days before it is assigned to an Appeals Officer. Cycle times for these cases have lengthened 103 percent from FY 2017 to FY 2022, from 180 days to 365 days, on average.
"Instead of taking the pants off the taxpayer, it might be better to take the vest off the vested interests." — Mark Twain
Briefing Concludes and Oral Argument Set in Moore
On October 16, 2023, the U.S. filed its brief on the merits in Moore v. United States, the high-profile case pending in the Supreme Court challenging the constitutionality of the section 965 transition tax (see our prior coverage here). The government's brief was followed shortly thereafter by briefs amici curiae submitted by more than a dozen individuals and organizations in support of the government, including the American College of Tax Counsel, the Tax Law Center at New York University School of Law, attorneys general from 16 states and the District of Columbia, small business trade organizations, law professors, and economists. The Supreme Court has scheduled oral argument for December 5, 2023. Taxpayers should continue to review the briefing, monitor oral arguments, and consider the potential implications of a decision.
Economic Substance Doctrine Applies to Fuel Credits and Variance Doctrine Prohibits Challenge to Penalty Assessment
In Chemoil Corp. v. United States, the court applied the economic substance doctrine to conclude that the taxpayer was not entitled to the alcohol fuel mixture credit under section 6426(b). 2023 WL 6257928 (S.D.N.Y. 2023). The court also held that the taxpayer could not challenge whether the IRS complied with the procedural requirements of IRC section 6751(b) for the imposition of a penalty, because the argument was raised for the first time in the taxpayer's complaint and was therefore barred under the variance doctrine. Id.
The Chemoil case involved seven transactions for which the company was seeking the excise tax credit. In some of the first transactions, the taxpayer purchased ethanol from a third party, then, after adding a small amount of gasoline to the ethanol, sold the mixture back to the same counterparty for $0.40 per gallon less than the original purchase price. Id. at 2. The sales price for the mixture, when combined with the $0.45 per gallon excise tax credit, would net the taxpayer $0.05 per gallon on the transactions. Id. In the remaining transactions, the taxpayer agreed to sell the fuel at a below-market price. Id. at 3. In all the transactions, the sales would have resulted in a net loss for the taxpayer without the excise tax credit. Id. at 5. The IRS disallowed the excise tax credits for the seven transactions. The IRS also imposed an excessive claims penalty on one of the transactions, in which the taxpayer had attempted to change the terms of the contract so that title to the fuel would be transferred on December 31, 2011, the last day to claim the credit, rather than upon delivery in accordance with the original terms of the agreement. Id. at 6.
The court relied on the economic substance doctrine to disallow the claimed credits. The court explained that the economic substance doctrine requires a two-part test: (1) whether the transaction had an objective pre-tax profit motive and an overall economic effect; and (2) whether the taxpayer's sole motivation for entering the transaction was to realize a tax benefit. Id. at 5. On the first part, the court acknowledged that it was possible for a legitimate transaction to "conceivably lack economic profit," but in this case found that the pre-tax loss failed the test because the addition of a very small amount of gasoline to the ethanol had no legitimate purpose other than qualifying for the tax credit. Id. (citations omitted). On the second part of the test, the court found that the taxpayer's sole motivation for the transactions was the tax benefit of the credits. The court also rejected the taxpayer's argument that the economic substance doctrine should not apply to transactions that Congress intended to encourage, noting that there are no categorical exceptions to the doctrine. Id. In addition, the court noted that while the codified economic substance doctrine in IRC section 7701(o) applies only to income taxes, the common law economic substance doctrine continues to apply to all forms of taxes. Id., n. 5.
Finally, the court relied on the variance doctrine to reject the taxpayer's challenge to the IRS's imposition of penalties. Id. at 7. The variance doctrine arises from section 7422(a), which requires the filing of an administrative refund claim prior to filing a refund suit. Here, the taxpayer asserted that the IRS did not satisfy the procedural requirements of section 6751(b), which requires supervisory approval before the imposition of penalties. Id. But the taxpayer did not raise that issue in its administrative refund claim, and the court therefore concluded that under the variance doctrine, the taxpayer was barred from raising the issue in its complaint. Id. This holding is consistent with prior cases that have come to the same conclusion. See, e.g., Ginsburg v. United States, 17 F.4th 78, 85 (11th Cir. 2021) ("because the supervisory approval argument wasn't exhausted before the Service [in the claim for refund], the district court rightly didn't consider it in Ginsburg's refund lawsuit."); Rische v. United States, 2021 WL 2856598, 7 (W.D. Wash. 2021) (where a taxpayer asserted non-compliance with section 6751(b) for the first time at trial, the court dismissed the claim under the variance doctrine because the issue had not been raised in the taxpayer's administrative refund claim); Colliot v. United States, 2021 WL 2709676, 5-6 (W.D. Tex. 2021) (finding the taxpayer 's attempt to preserve its section 6751(b) claim ineffective because the taxpayer did not specify which of the eight entities at issue were the subject of the section 6751(b) claim). Chemoil provides a useful reminder that taxpayers should include a claim regarding section 6751(b) compliance in any refund claim with penalties at issue, since it is likely that any facts regarding possible mistakes in the IRS's procedures may not be discovered until the case is in litigation, at which point it would be too late to raise the issue for the first time.
Attempts to Block Accountant Testimony Through Privilege and Work Product Doctrine Denied by Trial Court in Tax Evasion Case
In United States v. Barrett, the court declined to block an accountant's testimony concerning tax return preparation, holding that the attorney-client privilege and work product doctrine do not apply. 2023 WL 6784364 (M.D. La. 2023). The court determined that the attorney-client privilege does not extend to communications with accountants, even considering a Kovel agreement, when disclosure to the IRS is contemplated.
Barrett is a physician who owns a holding company (LLC), which includes in its holdings urgent care clinics. At issue in this criminal case was the omission of ownership in the LLC on IRS Form 433-A. The IRS alleges that Barrett committed "affirmative acts of evasion" by not properly claiming ownership and paying the required tax. Barrett had been represented by a law firm that employed an accountant as part of their tax team. The accountant "assisted Dr. Barrett in filing disclosures and advised Dr. Barrett on various administrative actions."
Form 433-A requires that taxpayers disclose their "investments," including LLCs in which the taxpayer has ownership. The form submitted to the IRS was certified and signed by the accountant and included the ownership of the LLC on the cover page, but not in the form itself. The IRS alleged that "a competent tax attorney" would have properly included the ownership on the form, and to that end, issued a subpoena to compel the accountant's testimony. Barrett and the law firm filed motions to quash the subpoena, basing their motions on the attorney-client privilege and work product doctrine.
The court outlined that attorney-client privilege extends only to: "(1) a confidential communication; (2) to a lawyer or subordinate; (3) for the primary purpose of securing a legal opinion, legal services, or assistance in the legal proceeding." For an accountant (or other expert) to fall under this rule, lawyers often utilize Kovel agreements, where the accountant is helping the attorney provide legal advice. See United States v. Kovel, 296 F.2d 918, 922 (2d. Cir. 1961).
However, the court explained that in the Fifth Circuit, even in light of a Kovel agreement, "unless the accountant is translating complex tax terms into a form intelligible to a lawyer or at the lawyer's behest," the communications are not privileged. The court, finding that the moving parties did not provide any details as to the accountant's work, rejected the privilege altogether. Had the parties properly outlined the activities and responsibilities of the accountant, it is possible that the outcome may have been different.
Similarly, the court described that the work product doctrine applies when "the primary motivating purpose behind the creation of the document was to aid in possible future litigation." The court found that no information was provided to support a claim that the work the accountant completed was done in anticipation of litigation and denied the motion on those grounds.
Further, even if privilege did exist, the defendant waived the protection by injecting into the trial a question of good faith and reliance on the accountant to have completed the forms correctly. As such, the court held that "the Government must be allowed to question" the accountant to investigate the circumstances surrounding the Form 433-A to determine if a mistake or negligence occurred.
This case serves as a useful reminder of several recurring privilege issues, (1) the challenges of maintaining privilege for tax return preparation, (2) that when engaging experts, Kovel arrangements must be evaluated with care for the best chance at maintaining privilege, and (3) the risk that privilege can be waived by putting protected communications "at issue" as part of a defense.
Federal Circuit Holds that Court of Federal Claims Conflated the Step Transaction Doctrine and Economic Substance Doctrine
On September 21, 2023, the U.S. Court of Appeals for the Federal Circuit clarified the boundary between the step transaction doctrine and the economic substance doctrine in a precedential opinion in GSS Holdings (Liberty) Inc. v. United States, 81 F.4th 1378 (Fed. Cir. 2023). The courts have long acknowledged that the soft doctrines – including the step transaction, business purpose, and substance over form doctrines – tend to "overlap and it is not always clear in a particular case which one is most appropriate[.]" King Enterprises, Inc. v. United States, 418 F.2d 511, 516 n.6 (Ct. Cl. 1969). In GSS Holdings, the Federal Circuit issued a rare decision placing limits on mixing and matching between the doctrines, specifically finding that the Court of Federal Claims had inappropriately "applied a hybrid legal standard conflating the step transaction doctrine and the economic substance doctrine." The Federal Circuit vacated judgment entered for the government at the Court of Federal Claims and remanded for further proceedings under the proper legal standard for the step transaction doctrine specifically.
In GSS Holdings, the IRS asserted that the step transaction doctrine applied to integrate (1) a partnership's 2011 sale of an investment asset to a bank through exercise of a put option with (2) amounts the partnership was required to pay to that bank under a separate loss sharing agreement. If the transactions were collapsed under the step transaction doctrine, then the partnership's payment to the bank would be an adjustment to the sales price received from the bank for the sale of the investment asset. For tax purposes, the bank was a majority partner in the partnership. Under section 707(b)(1), no deduction would be allowed for any loss incurred by the partnership from the related party sale of the investment asset. However, if the court respected the transactions as separate, then a deduction arising from the partnership's standalone payment to the bank may have been permissible under section 165.
The taxpayer and the government agreed that the "end result test" should be deployed to determine whether the step transaction doctrine applied to collapse the transactions. Under the end result test, the court analyzes whether multiple transactions "were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result." Falconwood Corp. v. United States, 422 F.3d 1339, 1349 (Fed. Cir. 2005) (internal quotation marks omitted). The partnership had entered into the put option in 2006 and had established the loss sharing agreement in 2007, with that loss sharing agreement originally involving an unrelated third party. Rather than assessing the taxpayer's intention at the start of the series of transactions, the Court of Federal Claims examined the taxpayer's intentions at the time of the 2011 option exercise that triggered the claimed loss. Specifically, the court invoked case law under the economic substance doctrine to conclude that it should evaluate the taxpayer's intent at the time of the "transaction giving rise to the alleged tax benefit." The Federal Circuit ruled that this "hybrid legal standard" constituted "legal error" and remanded for a decision under the proper standard of assessing the taxpayer's intention at the outset of the series of transactions.
Notably, the Federal Circuit declined to address when the relevant transactions began in this case. The parties dispute whether the series of transactions started in 2006 or a later date connected with subsequent amendments of the put option or the transfer of the loss sharing agreement from the original third party to the bank. With the Federal Circuit directing the trial court on remand to "determine the outset of the series of transactions," it remains possible that the government prevails in disallowing the loss.
Text of Multilateral Convention on Amount A of Pillar One Released; U.S. Treasury Requests Comments
The OECD/Group of 20 (G20) Inclusive Framework on Base Erosion and Profit Shifting (Inclusive Framework) released a multilateral convention (MLC) to implement Pillar One's Amount A, as well as a voluminous Explanatory Statement and other accompanying documents, on October 11, 2023. The goal of Pillar One's Amount A is to reallocate taxing rights to market jurisdictions over a portion of the excess profits of the largest and most profitable multinational enterprises (MNEs).
The MLC is not yet open for signature and cannot take effect until at least 30 jurisdictions, including the headquarters jurisdictions of at least 60 percent of MNEs currently expected to be in scope, have ratified the agreement. As a practical matter, the MLC cannot take effect without ratification by the U.S., which is home to more than 40 percent of in-scope MNEs. Treasury has requested public input on the MLC and accompanying documents by December 11, 2023.
The framework of the MLC consists of a five-step process. First, a group revenue and profitability test must be applied to determine whether the MNE is in scope. Amount A applies only to MNEs with annual revenues exceeding €20 billion and pre-tax profitability exceeding 10 percent of revenues. Second, the eligible market jurisdictions must be identified by using a sourced revenue-based nexus test. Third, 25 percent of profit in excess of 10 percent of revenue (Amount A) is calculated and apportioned to eligible market jurisdictions using a revenue-based allocation key. To prevent double counting, the allocated profit is adjusted downwards to account for excess profits already taxed in market jurisdictions on a net basis or through withholding taxes. Fourth, relief from double taxation of allocated profits is required to be provided by jurisdictions under a tiered approach, drawing profits first from jurisdictions with relatively high returns on depreciation and payroll. The fifth and final step is to file and pay the Amount A tax. Mechanisms are proposed with the objective of providing multilateral certainty to MNEs.
The MLC contains multiple footnotes denoting reservations lodged by Brazil, Colombia, and India. The vast majority of their contentions relate to the allocation of Amount A to market jurisdictions and the rules that limit double counting of income.
The MLC is intended to enhance the stability of the international tax system by providing market jurisdictions an alternative to digital services taxes (DSTs) and other gross-basis taxes. Inclusive Framework members generally have agreed to extend a moratorium on DSTs through the end of 2024 if at least 30 jurisdictions accounting for at least 60 percent of the headquarters jurisdictions of in-scope MNEs sign the MLC before the end of 2023. Treasury Secretary Janet Yellen has commented that the process is likely to run into 2024. Pillar One has been the subject of considerable criticism by members of Congress, which will have to approve any changes to U.S. law necessary to implement the MLC. Meanwhile, not all countries are holding to the current moratorium on DSTs (e.g., Canada). Finally, Treasury and the IRS have confirmed that DSTs are not creditable taxes under the U.S. foreign tax credit rules, meaning that U.S. MNEs paying DSTs will be subject to unrelieved double taxation. See Notice 2023-55; 2023-32 IRB 427 (July 21, 2023).
In-scope MNEs should review the MLC and accompanying documents and continue to monitor and engage in the policy discussions regarding Pillar One at the OECD as well as on a jurisdictional level. It is unusual for Treasury to request public comments on the work of the OECD. MNEs with concerns regarding the MLC should consider registering those concerns through the comment process to ensure appropriate consideration.
Treasury Proposes Regulations Addressing "Killer B" Transactions, with Potential Impact on Other Inbound Transactions
On October 5, 2023, Treasury and the IRS issued proposed regulations under section 367(b) addressing so-called "Killer B" triangular reorganizations and inbound reorganizations. The proposed regulations largely follow Notice 2014-32 and Notice 2016-73, in which the IRS targeted certain "transactions designed to repatriate earnings and basis of foreign corporations without incurring U.S. tax." However, the proposed regulations reflect notable differences from the prior Notices, including a narrowed scope of the excess asset basis rule and rules addressing the application of the section 1411 net investment income tax to inbound transactions.
Notice 2016-73 provided that in the case of an inbound reorganization or liquidation, the "all earnings and profits amount" may be increased by certain earnings and profits of lower-tier foreign corporations if the foreign corporation's inside asset basis exceeded the sum of its earnings and profits, outside stock basis, and liabilities assumed. This rule would have applied to any inbound nonrecognition transaction. In response to comments that highlighted the significant compliance burden that would be imposed on legitimate business transactions, the proposed regulations provide that this excess asset basis rule applies only to inbound nonrecognition transactions that follow a triangular reorganization or a transaction undertaken with a principal purpose to create excess asset basis.
In addition, the proposed regulations also provide rules addressing the application of the net investment income tax under section 1411 to section 367(b) inbound transactions. In particular, the proposed regulations provide that earnings and profits that are characterized as previously taxed earnings and profits (PTEP) and otherwise excluded from inclusion as a deemed dividend under section 367(b) are nonetheless included in the all earnings and profits amount and the section 1248 amount for purposes of section 1411.
To the extent the proposed regulations implement the rules announced in Notice 2014-32 and Notice 2016-73, they are proposed to be applicable to transactions completed as of the dates of those Notices, i.e., they will apply to transactions completed on or after April 25, 2014, for rules described in Notice 2014-32 and December 2, 2016, for rules described in Notice 2016-73. To the extent the proposed regulations contain rules not previously announced in the Notices, they would be applicable to transactions completed on or after October 6, 2023. While barriers to the repatriation of earnings into the U.S. have decreased since 2017, the issuance of the proposed regulations now and their retroactive applicability dates are likely in response to transactions that the IRS is currently challenging. If finalized, the proposed regulations will likely be challenged on various grounds, including the extent to which they would be retroactive. At a minimum, basing retroactive regulations on IRS notices issued more than seven years earlier seems to conflict with a 2019 Treasury Policy Statement on the Tax Regulatory Process. That statement signaled that Treasury and the IRS would not take a position adverse to taxpayers based on a notice issued more than 18 months before proposed regulations are issued.
Comments are due by December 5, 2023.
Treasury and IRS Guidance Explains Transfer of Clean Vehicle Credits Under Sections 25E and 30D
This month, Treasury and the IRS released proposed regulations and Revenue Procedure 2023-33 to provide guidance for taxpayers electing to transfer credits under sections 25E (previously owned clean vehicle credit) and 30D (new clean vehicle credit) to dealers and for dealers to become eligible entities to receive advance payments of these credits.
Transfers of clean vehicle credits from taxpayers to certain dealers referred as "eligible entities" under section 30(D)(g)(2) are allowed starting on January 1, 2024. Section 30D, as modified by the 2022 Inflation Reduction Act (IRA), provides a maximum credit of $7,500 for each qualifying new clean vehicle: $3,750 for meeting critical mineral requirements and an additional $3,750 for meeting battery component requirements. Vehicles must have their final assembly occur in North America and must not exceed certain manufacturer's recommended retail price thresholds. Further, the purchaser's modified adjusted gross income must not exceed $300,000 for taxpayers married filing jointly, $225,000 for taxpayers filing head of household, and $150,000 for others. The battery component and critical mineral sourcing requirements are detailed in the proposed regulations published in April 2023 and our previous alert.
Section 30D(g) applies to vehicles placed in service after December 31, 2023, and provides a mechanism by which vehicle purchasers can make an election to have the credit be available to an "eligible entity," which is the dealer who sells the vehicle to the taxpayer and meets certain requirements. The provision sets forth several rules relating to the requirements of being an eligible entity, the timing of the transfer, the tax treatment of payments, advance payments to dealers, and recapture. Thus, section 30D(g) allows a qualifying dealer to claim the credit rather the purchaser-taxpayer. Under section 30D(g)(7), the IRS is to establish a program to make "advanced payments to any eligible entity [i.e., a qualifying dealer] in an amount equal to the cumulative amount of credits" for which a transfer election is made.
Section 25E allows a credit for a qualifying buyer who places in service a previously owned clean vehicle equal to the lesser of $4,000 or 30 percent of the vehicle sales price. Section 25E(f) states that rules similar to the rules of section 30D(g) apply with respect to the transfer of the credit.
Taxpayer Election and Advanced Payment Program
Under the Proposed Regulations, "electing taxpayer" means an individual that purchases and places in service a clean vehicle and elects to transfer a credit associated with that vehicle. The taxpayer must make certain attestations regarding meeting the modified adjusted gross income limitation for the section 30D or 25E credit or using the vehicle predominantly for personal use for the section 30D credit. Additionally, the taxpayer must not have been allowed a section 25E credit in the prior three years. The transfer election must be made by the taxpayer no later than at the time of sale (i.e., the date the taxpayer takes possession of the vehicle) and is irrevocable. The taxpayer must transfer the entire amount of the credit. The eligible entity is allowed the credit and in exchange must pay the taxpayer an amount equal to the transferred credit either in cash or in the form of a partial or down payment. The taxpayer is limited to two transfer elections per taxable year either for two section 30D credits or for one section 30D credit and one section 25E credit.
Tax Returns and Consequences
The section 25E and 30D credits are non-refundable credits, but this limitation effectively does not apply in cases where the taxpayer makes an election to transfer the credit to the dealer. In such cases, the credit amount for transfer may exceed the taxpayer's regular tax liability for the taxable year the sale occurs, and the excess is not subject to recapture except where the vehicle ceases to be the property eligible for the credit under section 30D(f)(5) or the taxpayer exceeds the modified adjusted gross income limitation under 30D(f)(10).
The payment made by the eligible entity to the taxpayer is not includible in the taxpayer's gross income and is treated as repaid by the taxpayer to the eligible entity as part of the vehicle purchase price with respect to the basis reduction rule in section 30D(f)(1). In the case of a credit not allowable because the purchaser of the vehicle exceeds the modified adjusted gross income threshold set out in section 30D(g)(10), the tax imposed on the taxpayer is increased by the amount of the payment received by the taxpayer pursuant to the transfer election.
For an eligible entity, an advance payment is not includible in the eligible entity's gross income for the taxable year the payment is received, consistent with section 30D(g)(5). The payment may exceed the eligible entity's regular tax liability.
The eligible entity may not deduct the payment made to the taxpayer. The taxpayer is treated as paying the eligible entity the amount of the transferred credit as part of the vehicle purchase price and this payment amount is treated as part of the amount realized by the eligible entity under section 1001 from the sale of the vehicle.
In the case of any advance payment that the IRS determines "excessive," the tax imposed on the eligible entity for the taxable year the determination is made will be increased by the amount of the excessive payment, plus an amount equal to 20 percent of such excessive payment. For this purpose, "excessive payment" means an advance payment made to a registered dealer that fails to meet the requirements to be an eligible entity or made to an eligible entity with respect to a vehicle to the extent the payment exceeds the amount of the credit allowable. This additional payment will not apply if the eligible entity demonstrates to the IRS that the excessive payment was due to reasonable cause and has a vehicle returned within thirty days of placing it in service.
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