Taxpayer integrity in US law enforcement practice.

Muratov Ruslan Adamovich Postgraduate student, the department of Financial Law, O. E. Kutafin Moscow State Law University 123001, Russia, g. Moscow, ul. Sadovaya-Kudrinskaya, 9 muratovrus@inbox.ru Other publications by this author

According to the US Internal Revenue Service, the most significant factor in determining whether a taxpayer had a reasonable reason and acted in good faith is the taxpayer's attempt to fulfill a tax obligation in an appropriate form.

As an example, the US Internal Revenue Service (hereinafter referred to as the Service) cites a situation when a taxpayer submits an incorrect tax return, but does not know that the amounts are incorrect, a reasonable reason may apply. In addition, a separate error of the taxpayer in calculations or data transfer may indicate a reasonable cause and good faith of actions.

The extent of the taxpayer's efforts to properly fulfill the tax obligation is the most important factor in determining a reasonable cause^[1]. The rules do not offer vivid tests to measure taxpayers' efforts. When assessing the taxpayer's efforts, inspectors should take into account all relevant facts.

In addition, the US Internal Revenue Code provides examples that allow us to understand the main criteria for assessing the integrity of taxpayers, which can reveal circumstances that will be important when considering a particular case by the Internal Revenue Service or a court.

According to the case "Neonatology Assocs., P.A. v. Commissioner"^[2] medical companies reduced the income tax base and these contributions so exceeded the cost of annual life insurance that they could not be plausibly qualified as ordinary and necessary business expenses in accordance with section 162 of the US Internal Revenue Code. In fact, Neonatology applied a specially created form of doing business in order to circumvent the provisions of the US Tax Code by paying inflated life insurance premiums by the company to account for deductions on insurance policies in an excessive amount for the purpose of reducing income tax. As the Tax Court correctly recognized, these contributions represented hidden dividends subject to taxation, and not deductible expenses. Moreover, individual taxpayers who were paid insurance premiums could not use the insurance policy in good faith. The tax Court duly held them liable for negligence related to the accuracy of the data specified in the tax return. The reasons for making this decision, indicated in the case file, we will consider in more detail.^[2]

The US Internal Revenue Service conducted an audit of Neonatology's tax returns for calendar years 1992 and 1993 and the tax returns of doctors who received insurance policies that were the subject of a court case. As a result of the inspections , the tax authority made the following conclusions:

(1) The excess contributions were not normal and necessary business expenses under section 162 (a) of the U.S. Internal Revenue Code. Even if the amounts represented ordinary and necessary business expenses, they were nevertheless not deductible in accordance with articles §§ 404 (a) and 419 (a) of the Internal Revenue Code, which limit the deduction of contributions paid to deferred compensation plans and social benefit plans.

(2) The amounts of insurance premiums were deposited for the purposes of obtaining economic benefits by individual taxpayers and as such represented hidden dividends in accordance with §§ 61 (a)(7) and 301 of the US Tax Code. Assuming that the life insurance Plans of Neonatology and the individual doctors for whom these insurance policies were issued constitute deferred compensation plans, the excess contributions, in any case, should have been included in accordance with section 402 (b).

Finally, the tax authority determined that due to underpayment of taxes, individual taxpayers are subject to fines in accordance with Article 6662 (a) of the US Internal Revenue Code.

According to the Tax Court, the Neonatology life insurance plan is primarily a method that was developed and intended for the hidden distribution of surplus funds (in the form of excess contributions) from corporations for the end use and benefit of employees and (or) owners.

In the case of "MacMurray vs. Commissioner"^[3] The Tax Court ruled that the taxpayer's exclusion of income received as a result of the transaction represents a significant understatement of income for the purposes of calculating income tax. Thus, the taxpayer is obliged to pay a fine related to the accuracy of the data provided in the tax return, in accordance with Section 6662 of the US Internal Revenue Code.

The US Tax Court found that the taxpayer failed to fulfill the conditions specified in accordance with article 6664(c)(1), which we mentioned in the previous paragraph, in order to obtain an exemption from compliance with section 6662(a). In particular, the court concluded that the taxpayer could not avoid the fine because he did not provide reasonable grounds for deduction in the amount that he indicated in the tax return, and, moreover, he acted in bad faith.

In this case, it is alleged that the Tax Court, determining whether a taxpayer was entitled to exemption from a fine related to the reliability of data in the tax return, established the incorrect application of the provisions provided for by law and judicial practice.

The taxpayer tried to exercise the right to exemption from the fine after the regulatory authorities detected a tax offense when deducting amounts that the taxpayer did not have the right to apply to reduce the tax base.

Thus, in accordance with the US tax legislation, taxpayers have the right to deduct amounts transferred as charity when filling out a tax return^[4]. Also, if a taxpayer makes a charitable contribution in non-monetary form, then he can deduct the fair market value. Fair market value refers to "the price at which a property could be bought by a willing buyer or sold by a willing seller, neither of whom is forced to buy or sell, and both have an understanding of the actual state of the property."

However, during the inspection, the supervisory authority found out that the valuation of the property was overstated. It was also established that all experts assessed McMurray's property below the one that was in the act to which he referred when proving his innocence.

In this regard, the Tax Court considered McMurray's evidence inadequate, since the expert who provided the conclusion to McMurray did not take into account restrictions on peat extraction in the territory transferred to them for charitable purposes or the costs associated with such an operation. Also, the expert did not adequately assess other characteristics of the property transferred to charity, which led to an overestimation of the price of the property compared to a reasonable price, which further led to an unjustified underestimation of the tax base for calculating income tax. Thus, the court concluded that McMurray did not provide sufficient evidence to indicate a large amount as a deduction reducing the tax base.^[5]

According to Elena Vasilyevna Kilinkarova, the basis for the formation of judicial doctrines in the United States on the limits of tax optimization was the case "Gregory v. Helvering»^[6]. In accordance with this case, Evelyn Gregory was the owner of all shares of the United Mortgage Company (hereinafter referred to as "United"), which, in turn, owned 1,000 shares of Monitor Securities Corporation (hereinafter referred to as "Monitor"). Ms. Gregory wanted to become the rightholder of Monitor shares for subsequent sale in order to make a profit, but using the most obvious method of transferring rights to shares — transferring them from United as dividends — Ms. Gregory would have to pay a significant amount of tax.

In order to reduce the tax burden on the acquisition of shares by the taxpayer , the following method was used:

1. On September 18, 1928, Mrs. Gregory created a new company, Averill Corporation (hereinafter referred to as "Averill"), and three days later, United, on the instructions of Mrs. Gregory, transferred all the shares of Monitor to the newly created Averill Company. Averill did not make any other transactions and had no intention to do so.

2.                 After that, Ms. Gregory took over all the shares of United, which no longer owned shares of Monitor, and all the shares of Averill, which owned only 1,000 shares of Monitor.

3. On September 24, 1928, Mrs. Gregory liquidated the Averill company and, as its founder, received all the property - 1000 shares of the Monitor company.

4.                 On the same day, Ms. Gregory sold the shares received to a third party and, in connection with the sale of the shares, paid less tax than if she had sold the shares received as dividends from United.

The actions as a result of which Ms. Gregory acquired shares of Monitor were qualified by her as a distribution of shares in corporate reorganization, which, according to the legislation in force at that time, was exempt from tax^[7].

Assessing the above actions of Ms. Gregory on tax optimization, the US Supreme Court indicated that the taxpayer has the right to reduce the amount of tax payable to the extent that the law allows. However, as the court pointed out, if the transaction does not have a business or corporate purpose implied by law (and the reorganization under consideration was not really aimed at restructuring the business or part of it, but was made solely for the transfer of shares to Ms. Gregory), this set of transactions cannot be recognized as reorganization for tax exemption purposes. In the considered case, the taxpayer was held accountable and obliged to pay taxes, as if the reorganization had not been carried out, but there had been a payment of dividends from United to the taxpayer.

As the court pointed out, the reorganization had no economic content, which the legislator assumed when defining the term "reorganization" (the doctrine of economic substance), and the reorganization was not taken into account for tax purposes, since it did not pursue a real business goal of business restructuring (the doctrine of business purpose). In addition, the court pointed out the need to analyze the essence of the mechanism used to identify the true purpose of its use (the doctrine of the priority of substance over form).^[8]

Due to the fact that the principle of good faith lays down the main vector of behavior of both tax authorities and taxpayers in relation to all tax relations, it is proposed to consider the law enforcement practice under the rules of transfer pricing.

In the case of "US vs Whirlpool"^[9], the US Internal Revenue Service increased the tax base of "Whirlpool US", since the income attributed to the company "Whirlpool Luxembourg" for the sale of household appliances was considered taxable income from sales of a foreign parent company or income from a controlled foreign company of the parent company in the United States in accordance with the "rule of the production department" according to Section 951(a) of the US Tax Code. The income from the sale of household appliances was transferred to Whirlpool Luxembourg through a production and distribution agreement, according to which it was the nominal manufacturer of household appliances manufactured in Mexico, which were then sold to Whirlpool US and Whirlpool Mexico. According to the aforementioned agreement, income attributed to Luxembourg was not taxed in either Mexico or Luxembourg. Whirlpool challenged the assessment of the Internal Revenue Service and filed a lawsuit in the US Tax Court. In May 2020, the Tax Court ruled in favor of the tax service. According to the court, "if Whirlpool Luxembourg had conducted its manufacturing operations in Mexico through a separate entity, its sales revenue could have been attributed to the sales income of the foreign parent company (FCBSI) in accordance with section 954 (d)(1)." Thus, the income should be treated as "FBCSI" according to the US Tax Code. In such a case, Section 954 (d)(2) of the US Internal Revenue Code applies, which states that "for the purposes of determining income from sales of a foreign parent company in situations where the conduct of activities of a controlled foreign corporation through a branch or similar institution outside the country of registration of a controlled foreign corporation has virtually the same effect, as if such a branch or similar institution were a wholly owned subsidiary corporation receiving such income, in accordance with the provisions established by the Secretary, income related to the performance of such activities of such a branch or similar institution should be treated as income received by a wholly owned subsidiary of a controlled foreign corporation, and amounts to income from sales of a foreign base company to a controlled foreign corporation."

The Court of Appeal upheld the decision of the first instance and found that only according to the text of the law, sales income is income from sales of a foreign parent company, which should be included in the taxpayer's income under subsection F of the US Tax Code.

The question presented is whether the income of "Whirlpool Luxembourg" from the sale of household appliances "Whirlpool-US" and "Whirlpool-Mexico" in 2009 is income from sales of a foreign parent company in accordance with §954(d)(2).

As the Tax Court correctly noted, § 954(d)(2) consists of two conditions and two consequences that follow if these conditions are met.

The first condition is that the controlled foreign company "carried out" activities "through a branch or similar institution" outside the country of its registration.

The second condition is that the branch agreement had "almost the same effect as if such a branch were a wholly owned subsidiary corporation [CFC] receiving such income."

If these conditions are met, then the following two consequences apply to income related to the activities of the branch:

1) income should be treated as income received by a wholly owned subsidiary of a controlled foreign corporation;

2) income related to the activities of the branch should be income from sales of a foreign parent company to a controlled foreign corporation^[10].^[11]

Despite the absence of the principle of taxpayer integrity in the USA, we see that when considering various cases, the US tax courts consider the issue of the integrity of both taxpayers and tax authorities.

There are several circumstances that influenced the decision of the tax courts in favor of the taxpayer or tax authority, for example:

1)                 The correctness of the application of the provisions of tax legislation in the implementation of tax control measures by the tax authority;

2)                 Application of the provisions of tax legislation in accordance with the purpose of their introduction;

3) Reasonableness in requesting documents for the implementation of tax control procedures (for example, the availability of the opportunity to study the entire volume of required documents or the need to request all documents to verify the taxpayer's activities);

4) The presence of a reasonable reason for the taxpayer when choosing a method of carrying out his activities other than tax evasion.

In fact, when considering law enforcement practice in the United States, it can be seen that when considering each specific US Tax Court considered the question of the reason for the taxpayer's behavior in each case and, very importantly, the justification for such behavior. In cases where the taxpayer provided sufficient evidence of his position and with the correct application of the relevant provisions of tax legislation, the tax courts made decisions in favor of the taxpayer.