strategies for settling tax disputes - mayer brown · strategies for settling tax disputes seminar...

Strategies for Settling Tax Disputes

SEMINARRecent Developments:Tax Controversy and Tax Reform

Scott M. Stewart

Partner, Chicago

+1 312 701 7821

[email protected]

John T. Hildy

Partner, Chicago

+1 312 701 7769

[email protected]

SEMINARRecent Developments:Tax Controversy and Tax ReformAgenda

• Discuss our recent experience settling large, contentiousdisputes in Tyco and Guidant

• Tactics to create opportunities to settle favorably:

› Prepare for litigation in Exam

› Signal trial strength at Appeals› Signal trial strength at Appeals

› Use offensive discovery in the Tax Court, both informal and formal

› Use summary judgment to shape the issues

› Lead the stipulation process

› Know when to initiate and reignite settlement talks

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Introduction


• Settlement is often preferable to trial:

› Risk mitigation

› Lower legal expenses

› Certainty with respect to reserves and cash flows

• Earlier is better:› Avoid entrenched positions

IntroductionSettlement Incentives

› Avoid entrenched positions

› Interest is always running

› Reputational concerns

• IRS Incentives:

› Budget and limited resources

› Settling to preserve a legal point/precedent

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IntroductionIRS Litigation Focus

• Litigation Focus:

› The IRS continues to aggressively audit multinational companies.

• IRS enforcement efforts are focused on transfer pricing, intercompany debt,repatriation strategies and other international tax issues.

› IRS Exam Teams have been conducting audits with an eye towards future litigation,including:including:

• Requesting employee interviews and site visits, and

• Retaining third-party experts to support adjustments.

› IRS Chief Counsel Wilkins recently stated that the IRS’s current pursuit of litigation“appears likely to persist for a number of years to come.”

• This presentation is meant to address strategies for settling issues that have asubstantial probability of ending up in litigation or that are particularly contentious.

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IntroductionA Tale of Two Settlements

Tyco Elec. Corp. v. Comm’r

• 1997-2000 tax years

• Debt-equity

› $2.9 billion adjustment

• Settlement

Guidant Corp. v. Comm’r

• 1999, 2001-2007 tax years

• Transfer pricing

› $3.5 billion adjustment

• Purchase price allocation

› $702 million adjustment• Settlement

› $220 million adjustment

› 8% of proposedadjustment

• Results roll forward to later audit cycleswith larger interest deductions at stake


• Settlement


› 23% of proposed adjustment

› Lower royalty rates than result inMedtronic

• Results roll forward to later audit cycle

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IntroductionA Tale of Two Settlements

• Tyco and Guidant

› Large, factually complex cases

• 15 dockets in Tyco

• 6 dockets in Guidant

› Opportunity to establish precedent, overcome prior IRS losses› Opportunity to establish precedent, overcome prior IRS losses

› Lack of serious settlement offers (starting in Appeals) followed by…

› Collapse of IRS positions

• Settlement at or below IRS hazards of litigation

› Settlements contingent on consistent application in subsequent years

• Early preparation and careful execution of zealous litigation strategies were key tofavorable outcomes.

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IntroductionSimplified Litigation Timeline (Tax Court Route)

NOPA

30-DayLetter/RAR

Notice ofDeficiency IRS Answer

Petition TrialProtest

Administrative Stages Litigation

NOPA Petition

Formal Discovery

Stipulation Negotiations

Informal Discovery

TrialProtest

30 days

~ 2-3 years for large cases

Appeals*

~ 1-2 years 90 days 60 days

Exam

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Expert Report Development (starting point varied)* Assumes traditional, pre-Notice Appeals



Exam


Exam Strategies

NOPA

30-DayLetter/RAR




Expert Report Development

NOPA Petition

Formal Discovery


Informal Discovery

TrialProtest

30 days


Appeals


Exam

• Develop an Audit Plan

• Reach out to Non-Tax Witnesses

• Engage Key Experts Early

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ExamEarly Preparation

• Treating a contentious audit as if it will go to trial will best position ataxpayer for settlement.

› Proactivity is key to gaining strategic advantages throughout the dispute.

• Pre-Exam Preparation:

› Gather and review opinion from important transactions› Gather and review opinion from important transactions

› Review FIN 48 reserves and analyses

› Review prior audit cycle issues

› Understand if you have any issues that are targeted by an IRS directive or practiceunit

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ExamEarly Preparation

• Early audit preparation is key to:

› Setting the tone of the audit;

› Controlling the case narrative; and

› Preparing for Appeals.

• Develop a plan based on the key facts and arguments that will be presented in the• Develop a plan based on the key facts and arguments that will be presented in theAppeals protest.

› Under the IRS “Appeals Judicial Approach and Culture” (AJAC) Project, the factualrecord must be developed and presented during exam.

› Key document and witness identification should begin before the audit.

› Maintain legal issue and argument outline in anticipation of Protest.

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ExamKey Exam Opportunities

• IDR Process

› LB&I guidance requires IDRs to be issue-focused and developed in consultationwith the taxpayer.

› Taxpayers should use this process to shape IDRs with an eye toward building therecord for Appeals.record for Appeals.

› Consider overall case strategy when negotiating audit response timelines.

• Taxpayers should demonstrate they are well-prepared to defend their positions.

• Front-load IDR responses that provide the most favorable facts.

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• IDR Responses DOs:

› Use IDR responses as an opportunity to ensure that helpful facts are part of theaudit record.

› Design responses with an eye towards making your case.

• You should understand who the audience is….counsel? IRS specialist? IRS• You should understand who the audience is….counsel? IRS specialist? IRScoordinated issue team?

› Engage in careful analysis of privilege issues to avoid waivers.

• § 7525

• Penalty defenses

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• IDR Responses DON’Ts:

› Don’t default to “playing hardball” with the exam team on IDRs.

› Do not miss response deadlines without communicating with the exam team.

› Do not provide best guesses or estimates without full disclosure.

› Avoid absolute statements regarding the availability (or lack thereof) of› Avoid absolute statements regarding the availability (or lack thereof) ofresponsive data.

› Avoid making legal and factual arguments in IDR responses.

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• Early Fact Witness Development

› The exam team’s audit plan will often indicate whether the IRS intends to conduct interviews andsite visits.

• Witness interviews are a key sources of facts for Appeals protest.

• Taxpayers should actively identify key witnesses to fill any gaps in the IRS audit plan.

› Socialize witnesses (outside of tax function) with key themes by involving them in responsesnarrative and document requests.

› Consider using key witnesses as presenters at site visits. IRS will often become focused on thesewitnesses (e.g., subpoenaing the same personnel at trial).

› Informal IRS interviews should not be treated informally.

• Witnesses must be prepared on topics and documents that the IRS may raise in interviews.

• Weigh the benefits and burdens of “on the record” informal interviews.

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• Early Expert Witness Development

› Experts who supported the return position are not always the best experts to defendthose positions in litigation, but Exam may be suspicious if return experts arejettisoned early.

› For factually complex issues, the IRS is now retaining third-party experts earlier in theexam process.

› Consider doing the same for key issues.› Consider doing the same for key issues.

• Early investment can lead to long-term savings.

• Typical key areas include transfer pricing, valuation, forensic accounting.

• Early mastery of key financial and accounting data is critical.

– Taxpayers must thoroughly understand their own systems includingaccounting systems, order entry, inventory management, etc.

– Identify your internal accounting experts: Who can decipher complexaccount mappings, reconciliations, consolidations?

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• Early Expert Witness Development (continued)

› Identify thought leaders in expert-driven areas early; expert quality variesdramatically and can be hard to gauge without prior experience

› Consider providing exam team with the factual bases for key expert analyses.

• Waiting until Appeals to disclose these supporting materials may lead to• Waiting until Appeals to disclose these supporting materials may lead toAppeals returning the case to exam under the AJAC initiative.

• If expert analyses cannot be provided until after the Appeals protest is filed,taxpayers should foreshadow the expert’s conclusions in the protest andconsider providing an opinion letter.

– This will give exam an opportunity to rebut the expert andpotentially avoid Appeals returning the case to them.

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Appeals


Appeals Strategies

NOPA

30-DayLetter/RAR




Expert Report Development

NOPA Petition

Formal Discovery


Informal Discovery

TrialProtest


Appeals


Exam

• Continue Developing Expert Support

• Use Protest and Conferences toDemonstrate Litigation Hazards

• Capitalize on Delay20

30 days


AppealsKey Appeals Opportunities

• Appeals is the taxpayer’s first meaningful chance to settle a dispute based on the hazards oflitigation.

› However, taxpayers should consider potential strategic advantages of skipping Appealsaltogether.

• Taxpayers must maintain credibility and reasonableness in the eyes of the Appeals officer . . .

› . . . while demonstrating they are prepared to take the case to trial.

• Expert support in the Appeals process can support both goals.

› A fresh, leading expert supporting the return position can lend credibility.

› This same expert can be presented as a testifying expert the taxpayer will use in the eventof trial.

• Showing your level of preparation at Appeals

› The ex-parte/opening conference provides the taxpayer with the opportunity to show thedepth and breadth of its trial team.

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AppealsKey Appeals Opportunities

• Elements of an effective Appeals protest

› Executive summary

› Complete set of facts

• Avoid AJAC return to exam if possible

› Tell a story

› Address weaknesses head-on to build credibility with Appeals› Address weaknesses head-on to build credibility with Appeals

› Call out RAR errors

• Computation and other facts

› Establish the hazards of litigation

› Set forth broader implications for exam’s position (where appropriate)

• Bare-bones protests may occasionally be appropriate, but they signal to Appealsthat the taxpayer isn’t serious about settlement

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AppealsCapitalizing on Administrative Delay

• Take advantage of the delay between Appeals and the Notice of Deficiency (NOD)

› Tyco: two years; Guidant: one year

• Consider making FOIA requests for the administrative file to date.

› In disputes over the timeliness of discovery responses, the FOIA request date can becited as evidence of unreasonable delay. The request effectively gives notice ofpotential litigation.potential litigation.

• Collect universe of relevant documents, building on IDR process.

• Convert audit plan and Appeals protest into an issues memo and trial plan.

› Identify key trial witnesses and documents, continue developing expert analyses.

• Consider a final “last ditch” effort to settle post-Appeals

› Formal: Post-Appeals mediation

› Informal: Reinitiate dialogue with Appeals officer

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Tax Court


Litigation Strategies

NOPA

30-DayLetter/RAR



Administrative Stages Litigation• Narrative Pleadings

• Build Credibility

• Offensive Discovery

Expert Report Development (starting point varied)

NOPA Petition

Formal Discovery


Informal Discovery

TrialProtest

30 days

~ 2 years for large cases

Appeals


Exam

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Tax CourtKey Opportunities for Petition

• Taxpayers have 90 days following the receipt of the NOD to petition the Tax Court.

› Waiting until the receipt of the NOD may limit opportunities to use the petition foroffensive gains.

• Offensive use of Tax Court petitions

› First opportunity for the taxpayer to tell its story to the judge.

› The IRS is required to admit or deny every factual allegation in the petition.› The IRS is required to admit or deny every factual allegation in the petition.

• Example: In its Answers in the Guidant dockets, the IRS was forced to clarify whatmethod its economist was actually using. The economist’s report had beenintentionally vague.

› Admitted factual allegations are facts in the record.

› Strategic pleading can be used to force the IRS to admit to facts.

• The petition can frame the first settlement discussions with IRS trial counsel(initiated after Answer filed)

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Tax CourtKey Opportunities for Petition

• Offensive use of Tax Court petitions (continued)

› Narrative petitions can simplify cases and shorten discovery.

• The IRS Answer in the second Altera case admitted that the 2009 and 2011 cost-sharing rules requiring the sharing of stock-based compensation are materially thesame as the 2003 rule that was invalidated in the first Altera case (now on appeal).

• The Answer further admitted that Treasury did not possess, or even look for, manytypes of evidence concerning unrelated parties’ treatment of stock-basedtypes of evidence concerning unrelated parties’ treatment of stock-basedcompensation in these later rulemakings.

› IRS denials and denials “for lack of knowledge” can be revealing and inform ataxpayer’s discovery and stipulation strategies.

• The IRS Answers in the Tyco dockets repeatedly denied the taxpayer’s favorable facts“for lack of knowledge.”

• These denials highlighted the IRS’s weak points.

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Tax CourtManaging Informal Discovery

• Both the IRS and the taxpayer are permitted to seek any information that appearsreasonably calculated to lead to the discovery of admissible evidence.

• Parties are required to pursue discovery informally before resorting to the formaldiscovery procedures of the Court.

› Tax Ct. Rule 70(a)(1) requires the parties to engage in “informal consultation orcommunication.”

• Taxpayers should minimize being subjected to formal discovery.• Taxpayers should minimize being subjected to formal discovery.

› Informal discovery is a negotiating process; maintain open communication withopposing counsel regarding outstanding discovery requests.

› Rolling productions can help ward off formal discovery.

› Consider voluntary “mock Rule 26” production, modeled on Federal Rules

• But…formal discovery rules provide some opportunity for strategic advantages.

› Example: limited interrogatories vs. unlimited requests for production

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• Recognize IRS privilege-claim errors and shortcuts, while avoiding committing errors ofyour own. Winning privilege skirmishes can nudge the IRS back to the settlement table.

• Documents withheld under claims of privilege must be listed on a privilege log thatdescribes the nature of the withheld documents.

• At a minimum, log must provide:

› Author(s) of the document;

› Recipient(s) of the document;› Recipient(s) of the document;

› The date(s) that the document was prepared;

› A brief description of the general subject matter of the withheld document;

› The facts establishing each element of the privilege claim.

• An inadequate privilege log can lead the Tax Court to order production.

• Taxpayers must maintain “clean hands” in discovery to position themselves tocapitalize on IRS missteps.

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• The IRS will request interviews with taxpayer employees through the informal discoveryprocess.

› Like other informal discovery processes, this is a negotiation. Depositions are an extraordinarydiscovery method in the Tax Court, but are becoming more common.

› IRS may develop tunnel-vision and focus on the witnesses they already know.

• The IRS often seeks to interview former employees without notifying the taxpayer.• The IRS often seeks to interview former employees without notifying the taxpayer.

› Make a written request to the IRS that they notify you prior to contact being made.

› Anticipate and contact likely former employee interviewees. Taxpayer’s counsel can seek torepresent the former employee to help prepare for the interview and participate in the interview.

• Consider preserving testimony from employees (often retired) who have valuablerecollections, but who may not be available later due to health or other reasons.

› This is a sensitive issue, but important to address proactively. We have used formal depositions forthis purpose successfully.

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Tax CourtOffensive Discovery

• Taxpayers should pursue offensive discovery against the IRS whenever possible.

› The Tax Court will not “look behind a deficiency notice to examine the evidence used or thepropriety of [the Commissioner’s] motives or of the administrative policy or procedureinvolved in making his determination.” Greenberg’s Express, Inc. v. Comm’r, 62 T.C. 324, 327(1974).

• The Tax Court review is de novo for most matters and the IRS often argues that factsregarding how the determination was made are not relevant and not discoverable.regarding how the determination was made are not relevant and not discoverable.

› However, where the taxpayer must prove the IRS abused its discretion, the Tax Court willallow discovery on how the IRS made its determination.

• Transfer pricing; bad-debt reserves; filing extensions; changes in accounting methods.

› Forcing IRS counsel to review the Exam team’s records will force counsel to take a fresh lookat IRS’s hazards of litigation.

› In our experience, the IRS often provides administrative file records in informal discoveryeven in de novo cases.

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