ABIG Makes It Unanimous

“Everything that needs to be said has been said, but everybody hasn’t said it.” This quote from Mo Udall introduces the court’s decision in Honeywell Int’l, Inc. v. U.S., 64 Fed. Cl. 188 (2005). In this decision and in America Online v. U.S., 64 Fed. Cl. 571 (2005), the Court of Federal Claims joins four other federal courts in determining that long distance telephone services are not subject to the federal communications excise tax under Code section 4252(b)(2) where the charge for such service does not vary by both the distance and the elapsed transmission time of each individual communication. See National R.R. Passenger Corp.(“Amtrak”) v. U.S., 338 F. Supp.2d 22 (D.DC 2004), appeal pending DC Cir.; OfficeMax, Inc. v. U.S., 309 F. Supp.2d 984 (N.D. Oh. 2004), appeal pending 6th Cir.; Fortis, Inc. v. U.S., No. 03 Civ. 5137, 2004 U.S. Dist. LEXIS 18686 (S.D.N.Y. 2004); Reese Bros. Inc. v. U.S., No. 03-745, 2004 U.S. Dist. LEXIS 27507 (W.D. Pa. 2004), appeal pending 3d Cir.

Only the district court in American Bankers Ins. Group, Inc. v. U.S., 308 F. Supp.2d 1360 (S.D. Fla. 2004), had agreed with the Government’s various arguments and determined that the word ‘and’ as used in section 4252(b)(1) should be read as ‘or.’

The Eleventh Circuit reversed the lower court in ABIG. American Bankers Ins. Group, Inc. v. U.S., No. 04-10720, 2005 U.S. App. LEXIS 8132 (11th Cir. May 10, 2005). The court concluded that there was nothing in the statute or other provisions of the federal communications excise tax that warranted the conclusion that Congress used ‘and’ in any sense other than its ordinary conjunctive sense. Since the statutory language was consistent with its “plain meaning, ” the inquiry ends and it is not necessary to consider the provision’s legislative history.

The Eleventh Circuit nevertheless examined that legislative history, concluding that there was nothing in the legislative history inconsistent with the statute’s plain meaning. In fact, Congress was seeking to modify and narrow the definition and to phase this excise tax out entirely by 1969. Quoting AOL and Amtrak, the court concluded:

Consequently, now, forty years later, “if the statutory language no longer fits the infrastructure of the industry, the IRS needs to ask for congressional action to bring the statute in line with today’s reality. It cannot create an ambiguity that does not exist or misinterpret the plain meaning of statutory language to bend an old law toward a new direction.”

Having determined that congressional intent is clear, the court gave no deference to the long-standing Revenue Ruling 79-404, 1979-2 C.B. 382. The court also found no evidence that Congress had “reenacted” the Revenue Ruling.

In Notice 2004-57, the IRS confirmed that because of the then-conflicting results in the litigation, it would continue to assess and collect the federal communications excise tax on all taxable communications services, including those communications services similar to those at issue in the cases. It remains to be seen how the battle will play out.

IRS Summons Enforceable

In Xelan, Inc. v. U.S., 361 F. Supp.2d 459 (D.Md. 2005), the court denied a petition by Xelan to quash an IRS summons. The court granted the government’s corresponding motion for summary enforcement.

Xelan provides its members -- doctors and dentists -- with financial and tax planning. The IRS was investigating Xelan for promoting abusive tax shelters and issued a summons to Xelan’s accountants for information about Xelan, individuals related to Xelan, and the products that Xelan offered. Xelan argued that the IRS could not make a prima facie showing that: (1) the investigation had a legitimate purpose; (2) the IRS did not already have the summonsed information; and (3) the IRS had taken the required administrative steps. Xelan also argued that enforcement of the summons would be an abuse of the court’s process.

Xelan argued that the IRS’s actual -- and illegitimate -- purpose in issuing the summons was to learn the members’ names and audit their returns. The court -- emphasizing the IRS’s broad subpoena power -- held that using the doctor-members’ names to figure out how Xelan structured its tax-saving program would be “patently legitimate.”

Xelan said it had already produced “thousands of pages of documents” in related cases and requested a list of the documents the IRS already had. The court held that the IRS could rely on an IRS agent’s affidavit to show it did not already have the information since this was the IRS’s first summons to Xelan’s accountants.

Xelan argued that the Code required the IRS to provide notice to all persons identified in the summons, including Xelan’s employees and members. The court observed that to require the IRS to send notice to all Xelan participants would thwart the IRS’s “expansive information-gathering authority.”

Finally, Xelan argued that enforcing the summons would be an abuse of the court’s process because a grand jury subpoena had already been issued in the Southern District of California to the Vanguard Group, seeking information relating to Xelan. The court determined that this was not the same as a “Justice Department referral” since it was “just as plausible” that the subpoena related to criminal antitrust or insurance fraud investigations. As of publication of this issue, Xelan has not appealed. In Cohen v. U.S., 306 F. Supp.2d 495 (E.D.Pa. February 10, 2004), another court denied a similar motion to quash a summons issued to one of Xelan’s doctor-members. The doctor and Xelan appealed that decision to the Third Circuit.

Evasion of Foreign Taxes Can Be Actionable in U.S.

A recent Supreme Court decision could significantly increase U.S.-court involvement in foreign tax disputes and heighten the scrutiny given to the activities of U.S. companies abroad, particularly their level of foreign tax compliance. Pasquantino v. U.S., 125 S.Ct. 1766 (2005). The question before the Court was the scope of the common law “revenue rule,” which limits the authority of U.S. courts to enforce the tax laws of foreign nations. The defendants were convicted of violating the federal wire fraud statute, 18 U.S.C. § 1343, because of their scheme to smuggle liquor into Canada without paying Canadian excise tax. They ordered large quantities of liquor by phone from discount stores in the U.S. and then drove the liquor across the border into Canada without declaring the goods to Canadian customs officials.

The defendants argued that the prosecution contravened the “revenue rule” because the fraud’s only effect was Canadian tax evasion, and the common law rule allegedly prevented the U.S. courts from considering those laws and from taking actions to help enforce them. A panel of the Fourth Circuit agreed with the defendants and reversed the convictions, but the en banc court reinstated them. A unanimous Supreme Court agreed, holding that the revenue rule allowed courts to refuse to enforce the tax judgments of foreign nations, but did not prevent them from recognizing foreign tax law in the context of a fraud prosecution.

The Court focused its attention on what Congress would have understood as the contours of the revenue rule when it enacted the wire fraud statute in 1952. The Court explained that the revenue rule was merely a corollary of the criminal law rule that the “[c]ourts of no country execute the penal laws of another.” The core of the revenue rule thus focuses on “the collection of tax obligations of foreign nations.” The wire fraud prosecution, however, did not seek to recover a foreign tax liability; it was “a criminal prosecution brought by the United States in its sovereign capacity to punish domestic criminal conduct.” The Court reached this conclusion notwithstanding that the conviction would lead to restitution of the lost tax revenue to Canada. Finally, the Court rejected the proposition that it was giving the wire fraud statute “extraterritorial effect,” emphasizing that the conviction was punishing the “domestic element of [the defendants’] conduct” in committing wire fraud. The Court acknowledged that it is “an odd use of the Federal Government’s resources to prosecute a U.S. citizen for smuggling - 3 - cheap liquor into Canada,” but it found no basis in either the statute, the common law, or policy for preventing application of the wire fraud statute.

The impact of Pasquantino likely will extend beyond the wire fraud setting. For example, the courts of appeals have previously invoked the revenue rule to reject civil RICO actions brought by foreign governments against U.S. cigarette manufacturers. These suits alleged that the manufacturers engaged in cigarette smuggling and money laundering schemes to facilitate evasion of foreign tax liability in connection with exports of their cigarettes. Attorney General of Canada v. R.J. Reynolds Tobacco Holdings, Inc., 268 F.3d 103 (2d Cir. 2001); Republic of Honduras v. Philip Morris Companies, Inc., 341 F.3d 1253, 1255 (11th Cir. 2003). The Supreme Court, however, has now vacated a decision in a similar case brought by the European Community and remanded it for reconsideration by the Second Circuit in light of Pasquantino. European Community v. RJR Nabisco, Inc., 355 F.3d 123 (2d Cir. 2004), vacated and remanded, 73 U.S.L.W. 3647 (U.S. May 2, 2005). Indeed, foreign governments (like the U.S. in the days of Al Capone) sometimes use tax law enforcement to further other policies. For example, the Russian government’s actions against the Yukos Oil oligopoly began with tax evasion charges. If a U.S. nexus can be drawn to the activities in question, the U.S. courts could find themselves embroiled in some knotty foreign disputes.

Of particular interest to tax planners is the possibility that U.S. law could be implicated by tax planning schemes of multinationals that focus on reducing foreign taxes, rather than U.S. taxes. If such a scheme is hatched in the United States and could be regarded as designed to defraud a foreign government of its tax collections, Pasquantino opens the door to a fraud prosecution in the U.S. courts. Moreover, even if U.S. law enforcement authorities take no action, the foreign government might be able to invoke the U.S. courts through a civil RICO action (with the attendant threat of treble damages).

Guardian Entitled to Foreign Tax Credits

The Court of Federal Claims held that a domestic corporation was entitled to direct foreign tax credits for Luxembourg tax paid by its wholly owned and disregarded subsidiary on the combined income of the disregarded sub’s Luxembourg subsidiaries. Guardian Industries Corp. v. U.S., No. 02-1936 T, 2005 U.S. Claims LEXIS 87 (2005).

Guardian is the parent of a U.S. consolidated group. IHC was a wholly owned Guardian member, and it wholly owned GIE, which in turn held controlling interests in nine Luxembourg companies (the “Subs”). For Luxembourg tax purposes, GIE and the Subs formed a fiscal unitary group (or “FUG”) under Luxembourg law and paid tax on a consolidated basis. Guardian elected to treat GIE, the parent of the FUG, as a disregarded entity for U.S. tax purposes.

Regardless of who remits the tax, the person who is legally liable for the tax under foreign law is entitled to direct foreign tax credits. On its 2001 amended return, Guardian claimed direct credits because GIE was solely liable for the FUG’s tax under Luxembourg law and GIE and IHC were the same entity for U.S. tax purposes. But if foreign law imposes joint and several liability on two or more related parties for a tax on their combined income, then each party is liable for the amount of tax attributable to its base of the tax. The IRS argued that Luxembourg imposed joint and several liability on the Subs.

The court held that the Subs were not jointly and severally liable. Two things tipped the scales in Guardian’s favor. First, Guardian proffered an expert from Luxembourg’s tax administration, and he testified that the FUG parent is “the sole debtor” for the group’s taxes and Luxembourg law does not assess “a separate tax liability that is only attributable to the parent company.” Second, the way Luxembourg administers FUG tax is consistent only with Guardian’s “sole debtor” theory: individual FUG members file returns, but their income and losses are attributed to the parent. Luxembourg assesses the tax only against the parent; it sends the members assessment notices that show zero taxable income.

District Court Upholds IRC § 7525 Privilege

An Illinois federal district court held that the statutory tax-practitioner privilege protected all but one of 267 documents that BDO Seidman (“BDO”) and its clients withheld from production. U.S. v. BDO Seidman, No. 02-C4822, 2005 U.S. Dist. LEXIS 5555 (N.D.Ill. Mar. 30, 2005).

The tax-practitioner privilege -- codified at section 7525 -- extends the protections of the attorney-client privilege to communications between a client and a federally authorized tax practitioner “[w]ith respect to tax advice.” The tax practitioner privilege does not apply to communications in criminal matters or to written communications “in connection with the promotion of the direct or indirect participation . . . in any tax shelter. . . .” The tax-practitioner privilege also is subject to the common-law crime-fraud exception.

The IRS alleged that BDO and its clients engaged in criminal or fraudulent activity and that BDO promoted tax shelters. Prior to this case, most taxpayers assumed that if the IRS characterized their transaction as a tax shelter, the tax-practitioner privilege would not protect any of their communications with their non-attorney tax advisors regarding the transaction. But in language taxpayers will seize on, the BDO court held: “The fact that the IRS characterizes a business or individual’s transactions as abusive or unlawful cookie cutter tax shelters does not mean that this characterization is proper as a matter of law.” The court explained that whether the clients and BDO “engaged in lawful activity, or alternatively, properly complied with the tax code, is one of the ultimate questions for this litigation.” Instead of presenting a prima facie case that BDO and its clients engaged in criminal or fraudulent activity, the IRS relied on “speculation.” Accordingly, the court concluded that to reach a crime-fraud determination at this stage of the litigation would be to place the proverbial “cart before the horse.” Likewise, the court concluded it was premature to conclude that the transactions were tax shelters. The court refused to accept the Government’s allegations at face value in determining whether the privilege applied.

This BDO decision is the latest in the prolonged summons enforcement proceeding the IRS brought in July 2002 while investigating whether BDO is liable for penalties for promoting abusive tax shelters from 1995 to 2002. BDO’s clients intervened to assert privilege claims at various stages of the proceedings. Earlier, the court held -- and the Seventh Circuit affirmed -- that the tax-practitioner privilege did not protect the clients’ identity because the clients could not reasonably expect that their identity would remain confidential given the Code’s tax-shelter-registration requirements and because the clients could not establish that the disclosure of their identify would reveal the substance of the advice received. U.S. v. BDO Seidman, No. 02-C4822, 2003 U.S. Dist. LEXIS 1634 (N.D. Ill. Feb. 4, 2003), aff’d, 337 F.3d 802 (7th Cir. 2003).

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