Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
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The Week of November 14 – November 20, 2020
Bruno v. Comm’r, T.C. Memo. 2020-156 | November 16, 2020 | Lauber, J. | Dkt. No. 15525-18
Short Summary: The Internal Revenue Service determined deficiencies of $15,438, $20,409, and $12,527 with respect to petitioner’s Federal income tax for 2013, 2014, and 2016, respectively.
Petitioner divorced from ex-spouse. The divorce decree directed an equitable distribution of the their marital property, which required that petitioner’s ex-spouse transfer certain properties to her. Petitioner did not receive this property because the ex-spouse persistently disregarded the orders of the divorce court, which repeatedly held him in contempt and ordered him to pay interest on his unpaid obligations.
On her returns for 2013 and 2014 petitioner claimed and the IRS disallowed NOL carryforward deductions of $12,622,635 and $12,543,221, respectively. These carryforwards included an alleged 2012 loss attributable to an asserted “illegal transfer, conveyance and fraudulent concealment of * * * [the ex-spouse’s] LLC business interests.”
Key Issue: The sole issue or decision is petitioner’s claim that she sustained in 2015 a deductible theft loss of approximately $2.5 million. Petitioner contends that this loss resulted from her ex-husband’s refusal to transfer marital property awarded to her in 2008 by order of a Connecticut divorce court. Petitioner contends that this theft loss generated a net operating loss (NOL) in 2015, which she seeks to carry forward to 2016 and back to 2013 and 2014.
Key Points of Law:
Insight: The Bruno case demonstrates yet again that the theft-loss provisions of the Code require careful analysis and present significant hurdles for taxpayers. Particularly with respect to complex embezzlement and similar theft losses, taxpayers should generally seek legal advice from a qualified attorney to ensure that all technicalities are satisfied.
Aghadjanian v. Comm’r, T.C. Memo. 2020-155| November 16, 2020 | Greaves T. | Dkt. No. 9339-18W
Short Summary: Petitioner filed a petition with the Tax Court appealing the denial of his whistleblower claim. The IRS filed a Rule 121 motion for summary judgment, arguing that Petitioner failed to timely file his petition or alternatively that the IRS Whistleblower Office (“WBO” did not abuse its discretion in denying Petitioner’s claim for an award. The Tax Court granted the IRS’ motion finding that the Petitioner did not timely file his petition.
Key Issue: Did the Petitioner timely file his petition with the Tax Court in accordance with IRC § 7623(b)(4)?
Insight: This case highlights the importance of meeting filing deadlines. It shows that taxpayers who do not timely file have little or no recourse to appeal a denial of a claim.
Kane v. Comm’r, T.C. Memo. 2020-154 | November 16, 2020 | Morrison, J. | Dkt. No. 17338-16
Short Summary: Padda, who filed joint returns with spouse, Kane, practices medicine through his wholly owned C corporation, Interventional Center, a pain-management clinic. Between 2008 and 2012, Padda and CFO, Grimes, opened five restaurants.
During the relevant years, Padda owned a 50% interest in each of the five restaurant partnerships; Grimes owned the other 50%. Grimes did not contribute cash or other property to acquire her interests in the partnerships. Although Padda owned only 50% of each of the five restaurant partnerships, he was allocated 100% of the losses. Grimes was not allocated any losses. The IRS does not challenge this loss allocation.
Padda also invested in a brewery operated by Ninkasi, LLC. During the years at issue, Padda owned a 90% interest in Ninkasi; Grimes owned 5% and Padda’s brother (who was also his attorney) owned the remaining 5%. Ninkasi opened for business in 2008 and operated under the name Cathedral Square Brewery. Although Padda owned 90% of Ninkasi, he was allocated 100% of the losses. Grimes and Padda’s brother were not allocated any of the losses. The IRS does not challenge this loss allocation.
On their 2010 return, Padda and Kane filed an “Election to Group Activities”. They elected to group the following activities: (1) Ninkasi with 3914 Lindell, LLC; and (2) Cafe Ventana with 3919 West Pine, LLC.
On May 2, 2016, the IRS issued a notice of deficiency to Padda and Kane for the 2010, 2011, and 2012 taxable years. The notice determined deficiencies for all three years based on the following determinations: (1) the restaurants and the brewery were passive activities for all three years and (2) Padda and Kane failed to report constructive-dividend income for 2010. As indicated at the beginning of the opinion, the notice of deficiency determined section 6662(a) penalties for all three years.
Insight: The Bruno case demonstrates the IRS’s continued focus on passive activity losses and constructive dividends. Passive Activity Losses (PALs) have long been a focus for the IRS and a basis for denying deductions attributable to passive activities. The Bruno case, however, demonstrates an important planning consideration: activity “grouping.” In addition, the IRS has often asserted that distributions or payments from closely-held corporations are constructive dividends under certain circumstances. Courts often look to the Fifth Circuit’s decision in United States v. Smith, 418 F.2d 589, 593 (5th Cir. 1969) to analyze constructive dividend claims.
U.S. Tax Court Summaries
The Coca-Cola Company & Subsidiaries v. Comm’r, 155 T.C. No. 10 | November 18, 2020 | Lauber, J. | Dkt. No. 31183-15
Short Summary: The case involved the validity of the transfer pricing methodology used by the IRS to reallocate income to Coca-Cola from its subsidiaries, under section 482 for the 2007-2009 period.
Coca-Cola (the taxpayer) licensed its intellectual property (IP) to foreign manufacturing affiliates (called supply points and referred here as foreign affiliates). The foreign affiliates used this IP to manufacture concentrate, which was then sold to bottlers, who produced the beverages using the concentrate. In return for using the IP, the foreign affiliates compensated Coca-Cola using a “10-50-50” method, which allowed them to retain profit equal to 10% of the gross sales, and the remainder to be split 50-50 with Coca-Cola. It must be mentioned that this formulary apportionment method had been agreed by the taxpayer and the IRS in 1996 as part of a settlement (the 1996 agreement) entered by the taxpayer and the IRS for tax liabilities concerning the 1987-1995 period. The 1996 agreement also allowed the foreign affiliates to cover their royalty payments – for the use of the IP-, by actually paying royalties or remit dividends to the taxpayer. During the 2007-2009, the foreign affiliates remitted “dividends” to the taxpayer in the amount of $1.8 billion as royalties’ payment.
The IRS examined the 2007-2009 taxpayer’s return and determined that the methodology used by the taxpayer did not reflected arm’s-length rules, by undercompensating the taxpayer (and reducing taxable income in the U.S.) and overcompensating the foreign affiliates. To reallocate income to the taxpayer under section 482, the IRS applied the Comparable Profits Method (CPM) and used unrelated bottlers, as comparable parties. Using this methodology, the IRS assessed a $9M deficiency in taxable income.
The taxpayer challenged such deficiency in Tax Court alleging that the IRS had abused its discretion to reallocate income to the taxpayer under the CPM. The taxpayer also argued that the 1996 agreement prevented the IRS from changing its allocation method. Finally, it argued that the remitted dividends from the foreign affiliates in satisfaction to the royalty obligations should reduce the reallocations of the IRS.
The Court ruled in a 244 pages judgment that the IRS did not abused its discretion when applying the CPM and using the independent bottlers as comparable parties. Moreover, it ruled that the 1996 agreement did not prevented the IRS from reallocating income during the period of examination; it also ruled that the IRS did not erred by recomputing section 987 losses of the taxpayer after the CPM change the allocable income to the taxpayer’s Mexican affiliate; and finally the Court sided with the taxpayer by allowing the remitted dividends to reduce the reallocations considering the timely election to employ dividend offset.
Key Issues: (i) Whether the IRS abused its discretion by applying the CPM method to the taxpayer’s transactions using the independent bottlers as comparable parties; (ii) Is the IRS allowed to recompute section 987 losses of the taxpayer after making a section 482 allocation? and (iii) Is the taxpayer allowed to apply dividend offset even if it did not meet the formal requirements established on the Regulations?
Primary Holdings: (i) The IRS did not abuse its discretion under section 482 by using the CPM to reallocate income to the taxpayer from its subsidiaries; (ii) the IRS did not erred by recomputing the taxpayer’s section 987 losses after the CPM changed the income allocable to the taxpayer’s Mexican affiliate and (iii) the taxpayer made a timely election to employ dividend offset treatment regarding the dividends paid by the foreign affiliates, and consequently such dividends should be allowed to reduce the IRS’ reallocation amount.
Section 482 allows the IRS to apportion or allocate gross income, deductions, credits between related parties. The discretionary action of the IRS under this section can be invalid if the IRS abuses its discretion when the determination is arbitrary, capricious, and unreasonable. See Guidant LLC v. Comm’r, 146 T.C. 60, 73(2016). To determine whether the IRS abuses its discretion is a question of fact. See Amazon.com, Inc. 148 T.C. at 150. Additionally, the abuse of discretion is determined upon the reasonableness of the IRS’ result and not the methodology involved. To evidence such, the taxpayer requires evidence of comparable uncontrolled transactions, but in certain cases, considering that there are not comparable transactions because of the uniqueness of the property, the taxpayer must establish the unreasonableness of the methodology.
Considering the standard described, the Court considered some important factors to determine whether the IRS’ reallocation result was unreasonable because of the method employed:
Based on these assumptions, the Court determined that the CPM used by the IRS was proper considering the nature of assets and the activities performed by the controlled taxpayers (foreign affiliates) and that the IRS selection of the independent bottlers as comparable parties (to determine this point, the Court analyzed factors such as functions performed, contractual terms, risks, economic conditions and property employed or transferred).
Moreover, it determined that the CPM methodology was reasonable in this case, considering that the foreign affiliates act as wholly owned contract manufacturers. This is because the CPM evaluates the profitability only of the tested party (foreign affiliates) and determines the arm’s length profit range of such affiliates without attempting to value the hard-to-value intangible assets, which is reasonable in this case (considering the uniqueness of the intangibles of the taxpayer). Finally, the Court determined that the data employed by the IRS was reliable and represented the universe of independent bottlers. Based on these factors, the Court concluded that the IRS’ methodology to reallocate income from the foreign affiliates to the taxpayer was reasonable and not arbitrary.
As for the second question, concerning collateral adjustments including the IRS’ recomputation of the taxpayer’s section 987 loss as consequence of reallocating income from the Mexican affiliate to the taxpayer, the Court determined that as consequence of the allocation of income, the losses reported in the Mexican branch were no longer correct and consequently, the IRS was correct in recomputing them.
Finally, the Court determined that dividends remitted from the foreign affiliates to the taxpayer to meet their royalty obligations with the taxpayer, should be offset against the reallocation made by the IRS. This is because Rev. Proc. 99-32 afforded a qualifying taxpayer two forms of relief, which were available to the taxpayer here. And despite the procedural requirement added by this revenue procedure was not met by the taxpayer (which basically required the taxpayer to include a statement jointly with the tax return for each year of the section 482 allocation period), the Court held that IRS regulations and guidance can be satisfied by substantial rather than strict compliance. In this case, the taxpayer substantially complied by claiming dividend offsets as agreed in its 1996 Agreement which provided for such treatment.
Insight: This case is relevant because it introduces an opinion that is favorable to the IRS when electing a new transfer pricing methodology to allocate income among related parties. Past cases, such as Amazon, had been favorable to the taxpayer in the methodology election and rejection of the choice elected by the IRS. This case will set a foundation for future tax litigation in the transfer pricing area. Special analysis must be given to the CPM method in cases where hard-to-value-intangibles are main part of the business structure.