Monthly Tax Roundup (Volume 2, Issue 5)
Welcome to this month's Tax Roundup. We'll analyze two recent court cases that resulted in successful taxpayer challenges to the scope of the Internal Revenue Service's (IRS) authority, discuss the impact of the recently released IRS Strategic Operating Plan, and review a slew of recent administrative guidance.
Tax Fact: In fiscal year (FY) 2021, the IRS received 2.14 million corporate returns. FY 2022 saw a five percent increase, to 2.26 million corporate returns filed. Over the same period, individual returns decreased 4.4 percent, down from 168 million filed in 2021 to 160 million in 2022.
"It was true… as taxes is. And nothing is truer than them." – Charles Dickens
District Court Finds Regulation Denying Foreign Tax Credits for Section 965 Offset Earnings to be Invalid
The recently released partial summary judgment in the FedEx case ruled invalid a 2017 Tax Cuts and Jobs Act (TCJA) regulation that disallowed a foreign tax credit for taxes paid by specified foreign corporations (SFCs) whose earnings were offset by deficits from other SFCs for purpose of the section 965 transition tax. Taxpayers that distributed offset earnings before the effective date for amendments to section 960 (SFC tax years beginning after December 31, 2017) are most directly affected and should monitor the case, which remains at the district court level, closely.
Under the section 965 transition tax, U.S. shareholders were taxed on the deferred income of their SFCs (generally, a foreign corporation with at least one 10 percent domestic corporate owner). Former section 960(a)(1) provided for a foreign tax credit for foreign taxes paid by SFCs on such deferred income. This deferred income was then treated as previously taxed earnings and profits (PTEP) so that it would not be subject to further U.S. tax when repatriated. Deferred earnings in one SFC could be reduced by a deficit in another SFC; in this case, the earnings offset by deficits (referred to as Offset Earnings) were likewise treated as PTEP. At issue in the case was Treas. Reg. § 1.965-5(c)(1)(ii), which was issued in 2019 and provides that no foreign tax credit is allowed under section 960 for foreign taxes that were paid on Offset Earnings, even though, by its terms, former section 960(a)(3) provides for a foreign tax credit for foreign taxes that were paid with respect to distributed PTEP and were not previously credited.
In deciding this case, the court applied the familiar Chevron two-step analysis under which a court first determines if Congress has directly spoken to the issue in dispute. Noting that under step one there is no deference to the agency's views, the court engaged in a thorough examination of the statutory framework to find that foreign tax credits on the distribution of Offset Earnings were unambiguously permitted under section 960(a)(3) in effect at the time. The court reasoned that the conditions for application of former section 960(a)(3) were met because it was undisputed that (1) its distributed Offset Earnings were excluded from income under section 959, (2) the Offset Earnings are treated as dividends for which indirect foreign tax credits are otherwise permitted under section 902, and (3) foreign taxes associated with those earnings were not previously deemed paid by former section 960(a)(1).
The court rejected the government's claims that FedEx's interpretation was contradicted by the statutory text. Citing to section 965(b)(4)(A), the government argued that even though Offset Earnings are never actually included in income under section 951, they must be treated as though they were and therefore any foreign taxes paid with respect to Offset Earnings should be treated as having been already deemed paid and thus ineligible for foreign tax credits under former section 960(a)(3). All this "deeming" proved too much for the court to accept. First, the court noted that section 965(b)(4)(A) treats offset earnings as included in income only for purposes of applying section 959 and refused to extend this fiction to section 960. The court further declined to accept the government's argument that by its terms, former section 960(a)(3) denied the claimed foreign tax credits because they had already been deemed paid under former section 960(a)(1). As the court explained, "[t]he government thus needs subsection (a)(1) to perform a dual and self-contradictory role – not deeming taxes paid for purposes of subsection (a)(1) itself, but treating taxes as previously paid for purposes of subsection (a)(3)."
The court expressly rejected the government's arguments that this holding contradicted relevant legislative history and the policy justification for the foreign tax credit. Given that the Offset Earnings were excluded from income under section 965, the government argued that there was no double taxation of the kind the foreign tax credit was intended to address. But the court said that it could not consider such "extra-textual indicators of congressional intent" under Chevron step one, and even if it did, they would not alter the court's interpretation of an unambiguous text.
Finding the regulations impermissible under Chevron step 1, the court did not need to determine if the regulation was permissible under Chevron step 2. But the court nevertheless asserted that for the reasons it had given under Chevron step 1, the government's interpretation was not reasonable. And because the court decided the issue under Chevron, it did not address FedEx's alternative argument that the regulation was invalid under the Administrative Procedures Act (APA).
The FedEx ruling is notable for the court's willingness to wrestle with the complex and evolving U.S. international tax regime, and the taxpayer's victory is particularly significant given that the regulation's validity was decided on its merits, rather than on APA procedural grounds. Taxpayers should welcome rulings like this that seek to faithfully discern the meaning of the statutory text and in so doing, check the government's occasional inclination to re-write the law via regulation. An appeal seems likely, and it may be some time before we see final judgment, as the government may offer alternative grounds for challenging the $223 million in foreign tax credits at issue. Taxpayers potentially impacted by this ruling should evaluate and monitor their limitations period for foreign tax credit refund claims but may be able to wait for further judicial development in this case, and perhaps other cases.
IRS Lacks Authority to Assess Certain International Reporting Penalties
The Tax Court recently held that the IRS has no authority to assess penalties under Section 6038(b) when a taxpayer fails to timely file a Form 5471. See Farhy v. Comm'r, 160 T.C. No. 6 (2023). The case is a significant loss for the IRS and has meaningful consequences for taxpayers who have recently paid a section 6038(b) penalty or are currently disputing one. The Tax Court's opinion also seems to implicate similar penalties — such as those under section 6038A(d) regarding late-filed Forms 5472 — and doom them to the same fate as section 6038(b) penalties. The Commissioner is almost certain to appeal his loss, likely to the U.S. Court of Appeals for the DC Circuit. Until then, taxpayers disputing penalties located outside of sections 6651 through 6751 should consider their legal rights and obligations, and taxpayers that have recently paid such penalties should consider the possibility of filing a protective refund claim before the applicable refund statute of limitations expires.
The taxpayer in Farhy willfully failed to file Forms 5471 with respect to two wholly owned Belizean corporations. The IRS imposed penalties under section 6038(b) and assessed these penalties under section 6201. Assessment under section 6201 gives the IRS access to its collection toolbox, including liens and levies. The IRS used the latter of these to pursue collection from Farhy. He responded by requesting a collection due process hearing and asserting that the IRS lacked authority to assess section 6038(b) penalties. The IRS Independent Office of Appeals issued a Notice of Determination sustaining the penalties and Farhy then petitioned the Tax Court.
The Tax Court agreed with the taxpayer that section 6038 — unlike many other penalty provisions in the Internal Revenue Code— contains no provision authorizing the IRS to assess the penalty provided in section 6038(b). Nor does any other Code provision provide such authority. In contrast, section 6665(a)(1) explicitly states that penalties in section 6651 through 6751 (Title 26, Subtitle F, Chapter 68) "shall be assessed . . . in the same manner as taxes," which the IRS has authority to assess under section 6201. When Code sections outside of Chapter 68 impose a penalty for a violation, they commonly (1) contain their own express provision specifying the treatment of penalties or other amounts as a tax or an assessable penalty for assessment purposes, (2) contain a cross-reference to a provision within Chapter 68 providing a penalty, or (3) are expressly covered by a penalty provision within Chapter 68. Section 6038 does none of this. Without the authority to assess section 6038(b) penalties, the IRS cannot use liens and levies to collect them.
The Tax Court further observed that 28 U.S.C. § 2461 expressly provides that "[w]henever a civil fine, penalty, or pecuniary forfeiture is prescribed for the violation of an Act of Congress without specifying the mode of recovery or enforcement thereof, it may be recovered in a civil action." Without explicitly holding as much, the clear implication is that such a civil action is the IRS's only avenue to pursue section 6038(b) penalties. This would require the IRS to refer the matter to the U.S. Department of Justice (DOJ) and the DOJ to initiate a civil action against the taxpayer. To give the reader a sense of the administrative difficulty this approach presents, the National Taxpayer Advocate recently observed that the IRS assessed an average of 9,800 section 6038(b) penalties per year from 2014 to 2022.
We expect the IRS to appeal Farhy in the near term and seek a legislative fix in the longer term. In the meantime, taxpayers currently disputing section 6038(b) penalties should consider raising Farhy with the IRS at the next available opportunity. Taxpayers that have recently paid a section 6038(b) penalty should also consider filing a protective claim for refund if the refund statute of limitations remains open. That said, we anticipate the IRS will decline to act on such refund claims, thereby requiring taxpayers to file a refund suit to force a resolution. The prospect of success in such litigation is unclear given longstanding U.S. Supreme Court precedent holding that when the IRS evaluates a refund claim, "the ultimate question . . . is whether the taxpayer has overpaid." Lewis v. Reynolds, 284 U.S. 281, 283 (1932). In answering this question, the IRS may determine that even without a proper assessment, a taxpayer that has paid a section 6038(b) penalty has merely paid what the taxpayer owes and so is entitled to no refund.
Taxpayers should also consider the extent to which Farhy implicates other penalties outside of Title 26, Subtitle F, Chapter 68. The clearest example appears to be section 6038A(d), which imposes a penalty for failing to file a Form 5472 timely. Like section 6038, section 6038A contains no provision authorizing assessment. Under the Tax Court's reasoning in Farhy, section 6038A(d) penalties therefore appear subject to the same fate as section 6038(b) penalties.
Preparing for Heightened Tax Enforcement Under the IRS Strategic Operating Plan
On April 5, 2023, the IRS issued its long-awaited Strategic Operating Plan for implementing the $80 billion in additional funding provided by the Inflation Reduction Act (IRA). The 150-page report contains several proposals for improving customer service and technology as well as recruitment of new IRS employees. The centerpiece of the Plan, however, is the unveiling of a new enforcement strategy, backed by $45.6 billion in earmarked funding. The Plan makes no secret of its intended targets: large corporations, large partnerships, and high net worth families. Increasing audit rates for those groups is an explicit goal.
There are two clear themes in the Strategic Operating Plan's enforcement strategy: centralization and data analytics. Specifically, the Plan provides that the IRS "will develop a centralized, integrated approach to assess risk to inform the selection of cases and appropriate treatments." This "centralized planning function will use risk analytics to prioritize and assign cases." If all goes to plan, taxpayers will be selected for audit "by centralized compliance planning function using new analytics systems and refined risk-based case selection and routing" by FY 2026.
Centralization will make resolving tax issues harder for many taxpayers. A top-down approach to enforcement means field agents will have less discretion about how to conduct an audit. Information Document Requests (IDRs) will be dictated centrally and agents will have less flexibility in tailoring those requests to the situation of individual taxpayers. Decisions on whether to disallow a position will be made globally based on policy decisions made in Washington, forcing taxpayers increasingly to challenge adjustments in IRS Appeals or in court.
The effects of the funding will not be apparent over the next two years. Indeed, the IRS has hinted that audit activity may actually decline in the short run as agents are trained and new systems are placed into service. This may tempt taxpayers in high-scrutiny categories to postpone any preparations for IRS audit activity. This would be short-sighted. The best time for large businesses and high net worth families to prepare for increased IRS scrutiny is now.
As for the data analytics part of the new IRS enforcement strategy, there is little public information about the precise nature of the technology the IRS will deploy. Because data analytics is statistics-based, it is fair to assume that statistical outliers will be subject to more scrutiny. For example, if a corporation claims research credits significantly higher than the norm for similarly situated corporations, the algorithm will likely flag that as an anomaly. Therefore, a taxpayer who has recently increased research and development (R&D) activity to gain a competitive advantage over its competitors, resulting in a concomitant increase in research credits, could reasonably expect additional scrutiny based on that fact alone.
At the same time, taxpayers should expect the unexpected. IRS has access to a treasure trove of data beyond income tax returns. Financial statements, information returns, and information obtained from international tax authorities are all fair game. Inadvertent discrepancies between reporting positions taken in the U.S. versus other countries will be less likely to escape detection, making consistency increasingly important for multinational corporations.
Finally, the Plan indicates a strategy for increasing scrutiny of excise taxes. Excise tax disputes tend to involve large sums and can be intensely fact specific. They also frequently involve industry-wide issues, so the IRS uses a coordinated approach to such cases. Taxpayers subject to significant excise taxes, particularly in the energy and transportation sectors, should likewise develop an industry-wide approach to anticipating and responding to IRS activity, to the extent feasible.
Not all the new proposed enforcement strategies may come to pass, but it is an undeniable fact that the IRS has $45.6 billion in earmarked funds to spend. Equally undeniable is the IRS's explicit intent to using that money to target large businesses, large partnerships, and high net worth families. Those taxpayers must appreciate that increased IRS scrutiny is certain and that early preparation is the best defense.
Proposed Regulations Issued to Replace Notice 2016-66 and Designate Certain Micro-captive Insurance Programs as Listed Transactions and Transactions of Interest
On April 11, 2023, the U.S. Department of the Treasury (Treasury) and the IRS issued proposed regulations under Code section 6011 to designate certain micro-captive insurance arrangements as listed transactions and transactions of interest. Notice 2016-66 had previously designated certain micro-captive insurance arrangements as transactions of interest and set forth reporting requirements for those arrangements. But Notice 2016-66 was struck down in CIC Servs., LLC v. I.R.S., 592 F. Supp. 3d 677 (E.D. Tenn. 2022), which held that the government failed to satisfy the notice-and-comment requirements of the APA in the issuance of Notice 2016-66. The proposed regulations are a direct response to CIC Services. And while the preamble to the proposed regulations states that Treasury and the IRS disagree with CIC Services and other court decisions holding that APA requirements must be met for the designation of listed transactions and transactions of interest, it also states that Notice 2016-66 is obsolete and the IRS will no longer enforce the reporting obligations that were imposed by the notice.
The proposed regulations set forth requirements and criteria that are similar to Notice 2016-66, with a few modifications and some new rules to categorize certain micro-captive insurance arrangements as either listed transactions or transactions of interest. The proposed regulations provide two tests for determining if an arrangement is a listed transaction and one test to determine if it is a transaction of interest. The proposed regulations also expand the types of captives that are subject to reporting to include those where the related owner has an interest in the captive that is not a stock or equity interest but provides similar rights and benefits.
A captive arrangement will be treated as a listed transaction if it either (1) provides certain types of financing, or (2) fails the loss ratio test as measured over a 10-year period. Under the financing factor test, if the captive made financing available at any time over the prior five years (or less, if it has been in existence for less than five years), the arrangement will be a listed transaction. See Prop. Treas. Reg. § 1.6011-10(c)(1). For this purpose, prohibited financing includes loans, guarantees, or other arrangements provided to certain related persons, if the amount that is made available is in excess of the amount of the captive's investment income (which has been subject to tax). Prop. Treas. Reg. § 1.6011-10(b)(2)(i).
The second category of listed transaction covers captives that fail the 65 percent loss ratio test set forth in the proposed regulations. This test measures the ratio of losses incurred and claims administration expenses over the earned premiums minus any policyholder dividends paid. Prop. Treas. Reg. § 1.6011-10(c)(2). This 65 percent test is slightly more favorable than the 70 percent loss ratio test that was used in Notice 2016-66, but this change is unlikely to make much of a difference. A captive's loss ratio is measured over its most recent 10 taxable years. Thus, a captive that has been in existence for less than 10 years will not be a listed transaction based on the loss ratio test. Prop. Treas. Reg. § 1.6011-10(b)(2)(ii). Note, however, that a captive that provides prohibited financing will be a listed transaction regardless of how long it has been in existence. Each of these tests stands alone, and the failure of one of them will result in a listed transaction.
Finally, the proposed regulations provide that a captive arrangement that does not meet the 65 percent loss ratio test over either its nine most recent taxable years or, if in existence for fewer than nine years, its period of existence, will be a transaction of interest. Prop. Treas. Reg. § 1.6011-11(b)(2), (c).
The proposed regulations also make some changes to the information reporting requirements and who is required to report the transactions, but the reporting requirements still require a significant amount of detail. Prop. Treas. Reg. § 1.6011-11(b)(2).
The preamble to the proposed regulations describes the comments that were received by Treasury and the IRS in response to Notice 2016-66 and asserts that the APA does not require a response to those comments, but the comments are being provided to assist taxpayers in understanding the proposed regulations. In one of the few taxpayer-favorable provisions, in reaction to the comments, the proposed regulations provide a limited exception to the disclosure requirements for some consumer coverage arrangements (e.g., circumstances where customers are unrelated to the insurer, and are provided with coverage for products or services, such as repair or replacement coverage if a product breaks or is damaged), as long as certain requirements regarding the amount of paid commissions are satisfied. Arrangements that satisfy the requirements for the exception are not treated as listed transactions or transactions of interest. See Prop. Treas. Reg. § 1.6011-10(d)(2); Prop. Treas. Reg. § 1.6011-11(d)(2).
Comments on the proposed regulations are due by June 12, 2023, and a hearing is scheduled for July 19, 2023.
We believe these proposed regulations are part of an initial phase of guidance projects under which Treasury and the IRS will endeavor to replace previously issued notices regarding the designation of listed transactions and transactions of interest with regulations that satisfy APA requirements. The CIC Services decision was just one in a series of recent decisions addressing the application of the APA to IRS rulemaking. See also Mann Construction, Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022), Green Valley Investors, LLC v. Commissioner, 159 T.C. No. 9 (2022), and Green Rock LLC v. I.R.S., Docket No. 2:21-cv-01320 (N.D. Ala. Feb. 02, 2023). These cases similarly held that IRS notices to identify listed transactions were improperly issued because they did not comply with the APA's notice and comment procedures. Treasury and the IRS issued proposed regulations in December 2022 to replace Notice 2017-10 and designate syndicated conservation easements as listed transactions. These proposed micro-captive regulations are the second set of proposed regulations for these purposes, and we expect more to come. The decisions in CIC Services, Mann Construction, and Green Valley were covered in prior alerts.
IRS Publishes Safe-Harbor Guidance for Conservation Easement Deed Defects
On April 10, 2023, the IRS issued Notice 2023-30, which provides safe harbor language to correct certain defects in the language of deeds granting conservation easements. Congress made several changes to the charitable contribution deduction for conservation easements in section 170(h) in the Consolidated Appropriations Act, 2023, P.L. 117-328, § 605 (Dec. 29, 2022) (the Act). Most significantly, the Act attempted to curb perceived abuses by adding new Code section 170(h)(7), which disallows a charitable contribution deduction where the reported value of a conservation easement contributed by a partnership exceeds 2.5 times the partners' aggregate basis in the partnership. In addition, however, the Act included a taxpayer-favorable provision to deal with common technical issues in existing conservation easements. The Act directed the IRS to publish model easement language to address two common technical deficiencies in easement deeds — extinguishment clauses and boundary adjustment provisions. Congress further directed the IRS to allow taxpayers a 90-day period to amend their deeds to conform to the safe harbor language. See here for more information on the Act's changes to the conservation easement provisions.
The IRS issued safe harbor deed language in the notice, which also includes procedures for making the amendments. The notice provides that an amendment will be effective for purposes of section 170 only if the amended deed is signed by the donor and the donee and recorded before July 24, 2023. Certain deeds are not eligible for amendment, including deeds that are part of a reportable transaction or described in Notice 2017-10, deeds in connection with a contribution subject to disallowance under section 170(h)(7), deeds at issue in a docketed case in federal court, and deeds relating to a claimed deduction for which a penalty has been finally determined by either the IRS or a court. If a taxpayer makes an effective amendment under the procedures in the notice, the amended deed will be treated as effective for purposes of section 170 from the date on which the original deed was recorded, regardless of whether the amendment is respected under state law.
Treasury and IRS Aim to Clarify Supervisory Approval Requirement with Proposed Regulations
On April 11, 2023, Treasury and the IRS issued proposed regulations on the requirement in section 6751(b) that approval be obtained before certain penalties are assessed by the IRS. Section 6751(b) provides that "[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher-level official as the Secretary may designate." The approval requirement does not apply to certain penalties or additions to tax, including those automatically calculated by electronic means.
There has been significant litigation with respect to the application of section 6751(b), particularly in the Tax Court, that has, for the most part, focused on identifying the "initial determination," or the time by which the IRS employee who proposed penalties should have obtained supervisory approval. In general, the Tax Court has defined the initial determination was the first time at which the IRS formally proposed penalties in a communication that allowed taxpayers a chance to appeal the proposal, whether that be to Appeals or to court. Thus, the Tax Court has held that the IRS employee must have obtained written approval for the penalty from their supervisor before that formal communication. However, several Circuit Courts of Appeal have set a cleaner and less taxpayer-favorable rule, holding that the initial determination means the notice of deficiency or assessment. This litigation has resulted in considerable uncertainty regarding taxpayers' liability for penalties and the application of section 6751(b).
To eliminate this uncertainty, Treasury and the IRS issued proposed regulations that put forward bright line rules. For purposes of determining when an IRS employee must obtain supervisory approval, the proposed regulations split cases into three buckets. First, penalties not subject to pre-assessment Tax Court review, such as assessable penalties, for which the IRS must obtain approval on or before the date of assessment of the penalty. Second, penalties subject to pre-assessment Tax Court review, for which the IRS must obtain written approval on or before the date the notice of deficiency (or other notice giving the Tax Court jurisdiction) is issued. And third, penalties subject to pre-assessment Tax Court review that are raised in the government's answer in a docketed case, for which the Chief Counsel attorney serving as attorney of record must have gotten written approval from a supervisor on or before the date they assert the penalty in court.
The proposed regulations also provide certain key definitions for applying the supervisory approval requirement and its exceptions. Those definitions elaborate on which IRS employee must obtain approval, which IRS employee's approval will satisfy the requirement, and which penalties are automatically calculated by electronic means and exempt from the requirement.
While the bright line rules proposed by Treasury and the IRS may not be as taxpayer favorable as the Tax Court's interpretation, it gives much needed clarity to an uncertain area of the law that was a source of constant litigation.
Treasury Issues Proposed Guidance on CHIPS Act Investment Tax Credit
On March 23, 2023, Treasury and the Department of Commerce (Commerce) issued proposed guidance on incentives for domestic semiconductor manufacturing enacted in the Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act. Treasury and the IRS issued proposed regulations to implement the section 48D advanced manufacturing investment credit established by the CHIPS Act of 2022 to incentivize semiconductor manufacturing in the U.S. The Proposed Treasury Regulations provide guidance on critical definitions in the statute, provide for the treatment of investments that stretch past the termination of the credit, and elaborate on provisions meant to discourage investments in semiconductor manufacturing capacity in China. Read our full alert here.
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