The U.S.-Malta Treaty Retirement Account: The IRS’ Latest Listed Transaction

Abstract: IRS targets Malta Retirement Scheme

The IRS’s duty to ensure the public’s compliance with tax law largely involves defining what taxpayers must report on their tax returns. Since its formation in 1862, when Congress formed the Office of the Commissioner of Internal Revenue under the Treasury Department, citizens of the United States have developed unique schemes to pay less taxes. To create fairness, Congress granted the IRS the power to label certain taxpayer schemes as “listed transactions.” The IRS uses this power to list a certain transaction, triggering both a taxpayer participant and material advisor obligation to report any participation in said listed transaction including details about the transaction. Participants and material advisors who fail to comply with the listed transaction reporting results in financial penalties enforced by the IRS. There are currently 36 listed transactions available for viewing on the IRS’s website, yet the newest listing has yet to officially make the list. The Malta Personal Retirement transaction was conceived after the United States signed the U.S.-Malta Tax Treaty in 2008. This Treaty addressed the highly favorable tax law in Malta that allows individuals to place money in an account without being taxed upon contribution or dispersion, so long as the account is considered a pension or retirement account. Once the IRS became aware of the situation, the IRS began taking measures to place the Malta retirement scheme on their list of reportable transactions. However, in the past year, the IRS began changing the way it lists transactions due to courts rejecting some of their reportable and listed transaction notices (including those dealing with syndicated conservation easements and micro-captives). In 2022, the Tax Court ruled that the IRS must comply with guidelines enforced by the Administrative Procedure Act (APA). The most recent listed transaction (regarding syndicated conservation easements) was ruled void after the Tax Court found the IRS did not comply with the necessary notice-and-comment requirements. After the transactions were deemed void, participants and material advisors no longer have the obligation to report their conservation easement transactions. The IRS is taking measures to fix the problem, but the process is lengthy. The first major attempt at meeting the court-required APA compliance is the new Proposed Regulations on micro-captives. To ensure the same error is not repeated with the Malta Personal Retirement Scheme proposal, the IRS is attempting to go through all the necessary steps to ensure proper notice-and-comment requirements are fulfilled so their listed transaction is upheld upon future challenge. Assuming everything goes smoothly in the September public hearing, the Malta Personal Retirement Scheme should successfully be added as the 37th listed transaction, and taxpayer participants and material advisors must abide by this regulation or suffer the penalties.

Introduction

Pension plans and retirement accounts have been in the United States since 1875 when a company named the American Express Company put in force the first private pension plan. [1] Before then, most companies were so small that they did not need to provide this option for their employees. However, as times have changed, especially at the turn of the 20th Century, larger corporations began providing retirement accounts for their employees. [2] Upon the passing of the Internal Revenue Act of 1921, contributions towards employee pension funds became exempt from federal corporate income, accelerating growth. [3] With time, these pension funds became more and more regulated by the IRS, creating guidelines and rules to enforce fair contributions from all taxpayers across the United States. [4] However, American taxpayers slowly realized that these rules allow the government to limit the amount of capital possible in these accounts. [5] Taxpayers began looking for new methods to avoid these rules. [6] Before 2011, the U.S.-Malta Tax Treaty attracted very little attention in the United States. [7] Malta is a very small country, forming the Southeastern point of an equilateral triangle between Sicily and Northern Africa that was under British rule until 1964. [8] During World War II, Malta was destroyed by the Germans and Italians who wanted to gain control of the country, forcing the citizens of Malta to live underground while their country was decorated with bomb craters. [9] After successfully surviving the War, the Maltese continued their way of life primarily as a trading port between Southern Europe and North Africa. [10] In the 1990s, Malta changed course, developing large global financial centers and becoming the most prominent offshore jurisdiction for large international corporations and wealthy third country citizens who took advantage of Malta’s tax-favoring laws to store their off-shore wealth. [11] Americans were still using offshore accounts mainly in the Caribbean and Switzerland for easy access, and only realized the appeal of Malta after the 2011 Treaty. [12] This Treaty created a loophole, where third party citizens could still take advantage of Malta’s tax-favoring laws by creating a pension or retirement account through Malta’s banking system. American taxpayers took advantage of this rule and tried to lay low, successfully hiding the fact that they were storing their money and reaping the rewards in offshore accounts, away from the prying-eyes of the IRS. Eventually, however, taxpayers and their material advisors started to share this scheme, publishing articles online to get more business, and eventually drew the attention of the IRS. [13] In 2021, a decade after the treaty, the U.S. and Mata entered a Competent Authority Arrangement (CAA) to clarify their mistake in the original treaty where they failed to specifically define a pension fund. [14] A CAA is a “bilateral agreement between the United States and th[eir] treaty partner to clarify or interpret treaty provisions.” [15] However, there seems to be a difference of opinion regarding whether a CAA is binding and if it may change a law without being passed by the U.S. Senate. [16] To address this difference of opinion, the IRS published Proposed Regulations to designate the Malta Personal Retirement transaction as a listed transaction. [17] This provides a high disincentive for potential participants and material advisors to be involved with this method of tax-avoidance, given they would be running the risk of steep penalties being enforced. [18]

I. What is a Listed Transaction?

The Internal Revenue Service’s (IRS) mission is to “[p]rovide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all.” [19] This role ensures that the majority of compliant taxpayers comply with tax law, while ensuring the minority of taxpayers who attempt to avoid taxes pay their fair share. [20] A large portion of this mission involves efforts to curb abusive tax transactions. [21] When it comes to tax planning and avoiding, taxpayers become very creative, promoting the IRS to create regulations to help discover and quash abusive tax transactions. [22] These proposed regulations require taxpayers, participants and material advisors to disclose certain information for listed transactions they have been involved in by filing disclosure statement Form 8886 (Form 8918 for material advisors) and submitting it with their tax return. [23] A “‘listed transaction’ is a transaction that is the same as, or substantially similar to, one that the IRS has determined to be a tax avoidance transaction and identified by IRS notice or other form of published guidance.” [24] Parties who file a listed transaction under Form 8886 may need to do one or all of the following: (1) disclose the transaction as required by the regulations; (2) register the transaction with the IRS; or (3) maintain lists of investors in the transactions and provide the list to the IRS upon request. [25] These types of transactions may artificially reduce a Taxpayer’s tax liability (the combined amount of taxes a person owes the IRS from income tax, capital gains tax, self-employment tax, and any penalties and interest). [26] Where the IRS disagrees with such a transaction to the point of listing it, it warrants filing a Form 8886. [27]

A. What is Required of Material Advisors?

The IRS defines a material advisor as:[a]nyone who provides material aid, assistance, or advice with respect to organizing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and [d]irectly or indirectly derives gross income in excess of the threshold amount (or such other amount as may be prescribed by the secretary) for such aid, assistance, or advice. [28] This definition solely applies to advisors involved in transactions that has been deemed a “reportable transaction” by the IRS, that is, a transaction that may have the potential to be classified as tax avoidance or tax evasion. [29] However, an advisor is not regarded as a material advisor if they make tax statements solely in their capacity as an employee, shareholder, partner, or agent of another person. [30] If an individual fits any of these categories, then all tax statements made are considered to be made by their employer, corporation, partnership or principal. [31] An individual provides material assistance if they makes or assists in producing a “‘tax statement’ to or for the benefit of a taxpayer,” at which point they are considered a material advisor. [32] A material advisor must first properly disclose the reportable transaction to the IRS, as well as maintain all relevant information about the transaction to produce it to the IRS upon request. [33] This may include all relevant taxpayers who were associated in the reportable transaction. If the IRS requests such a list, the material advisor must produce it within 20 business days from the date of the IRS’s request. [34] To assist material advisors in keeping track of all of this information, the IRS provides Form 13976, the Itemized Statement Component of Advisee List, on their website. This is an optional form to help the material advisor identify: (1) all persons who benefit from the material advisor’s tax statement; and (2) information about the transaction, including “investors, the amounts invested, the structure of the transaction, the tax benefits expected from the transaction, and the names of any other material advisors.” [35] Material advisors also complete their tasks by filing Form 8918, a disclosure statement submitted to the Office of Tax Shelter Analysis (OTSA). [36] If an advisor is unsure whether they are a material advisor or if the transaction is reportable, the IRS advises the reporting party to err on the side of safety by filing a Form 8918, while placing a banner across the top of the form stating that it is a “protective disclosure.” [37] Form 8918 must be filed by the last day of the month at the end of the calendar quarter in which the material advisor is responsible for all and any of the reportable transactions in which they were associated. [38] The IRS then returns a reportable transaction number to the material advisor, who in turn must report that number to all taxpayers and other material advisors involved in the transaction so those parties can use the number in correlating reporting obligations. [39] If a material advisor fails to provide any of the necessary forms or lists to the IRS upon their request, harsh penalties may ensue. If the material advisor does not file one of the forms (or files a false or incomplete form) the material advisor may be penalized $50,000 for each failure. [40] This penalty may be increased to $200,000 or fifty percent of the gross income of the material advisor derived from the listed transaction. [41] The gross income is derived from each type of listed transaction and considered separately and is not aggregated. [42] Whichever number is greater will be the imposed penalty. If it is found that the failure to report was intentional, then the penalty increases to seventy-five percent of the gross income of the material advisor. [43] Intentional failure is determined on a case-by-case basis based on all relevant facts and circumstances. [44] Reasonable cause defenses are not applicable to Form 8918 violations. [45] However, a material advisor may request a recission from the Commissioner if the transaction was not a listed transaction, or if “[r]escinding the penalty would promote compliance with the requirements of the Code and effective tax administration.” [46] Therefore, complying with the initial regulations is vitally important and will prevent an unfortunate series of events and dealing with harsh consequences.

B. What is Required of Taxpayer Participants

Once a taxpayer becomes aware that they have been part of a listed transaction, it is their duty to report such transaction in the form of a disclosure statement. [47] A taxpayer should be aware of their listed transaction if “the taxpayer’s return reflects, or the taxpayer knows or has reason to know, that the taxpayer’s tax benefits are derived directly or indirectly from tax consequences or a tax strategy described in IRS guidance as a listed transaction.” [48] To fulfill the disclosure statement requirement, a taxpayer attaches Form 8886 (Reportable Transaction Disclosure Statement) to the tax return. Form 8886 must include the following information to be considered complete: (1) describe the expected tax treatment and all potential tax benefits expected to result from the transaction; (2) describe any tax result protection (as defined in § 301.6111-3(c)(12)) for the transaction; and (3) identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the reportable transaction and the identity of all parties involved in it. [49] A copy of this disclosure statement must also be sent to OTSA “at the same time that any disclosure statement is first filed by the taxpayer pertaining to a particular reportable transaction.” [50] Taxpayers may also submit a ruling request like a material advisor, and the potential obligation to disclose is not suspended during the period that the request is pending. [51] Taxpayers may also request a ruling on the merits of the transaction. [52] The request must fully disclose all relevant facts relating to the reportable transaction and must be done on or before the date that the disclosure or reporting would otherwise have been required. [53] If the taxpayer fails to disclose any of the above information, they are also subject to penalties similar to those which apply to material advisors but calculated slightly differently. The penalty to taxpayers equals “75% of the decrease in tax shown on the return as a result of the transaction or that would have resulted if the transaction were respected for federal tax purposes.” [54] The minimum penalties are $5,000 for natural persons and $10,000 for all other taxpayers, while the maximum amounts for listed transactions are $10,000 for natural persons or $200,000 for all other taxpayers. [55] So, although a taxpayer may trust a material advisor to handle their affairs, it is still important to understand the applicable rules and guidelines to follow to avoid pitfalls and erroneous mistakes that could be detrimental to taxpayers.

II. The Malta Listed Transaction

A. Overview of the Transaction

In 2011, the country of Malta, an archipelago in the central of the Mediterranean Sea between Sicily and North Africa, enacted personal retirement schemes as a part of the Retirement Pensions Act. [56] These are “tax-favored savings arrangements in Malta that allow individuals or their employers to contribute assets to a trust or other investment vehicle for such individuals’ benefit.” [57] Unlike American individual savings arrangements, in Malta, “there is no requirement that contributions be limited by reference to income earned from employment or self-employment activities, no limitation on contribution amounts, and no restriction on the types of assets (such as securities) that may be contributed.” [58] All distributions placed in these Malta retirement accounts, from the time an individual is fifty, but no later than age seventy-five, may be exempt from Maltese income tax “if the individual elects to receive initial and additional cash lump sum distributions.” [59] United States taxpayers began interpreting these regulations to their benefit, placing contributions with built-in gains in Malta pension plans, where the contributions continue to appreciate in value tax free. [60] Upon reaching the minimum age of fifty, the taxpayer may then sell the contributions, pocket large lump sum payments labeled “excess funds” and avoid both U.S. and Maltese tax. [61] The appreciated contributions are higher than what would be allowed as contributions to American Individual Retirement Arrangement (IRA) accounts, and individuals are able to add assets from sources such as annuities, securities, partnership interests, and cryptocurrencies. [62] The Proposed Regulations provides an example of how this scheme works. In Year 1, Taxpayer A who can either be a U.S. citizen or a U.S. resident alien, contributes cash or appreciated property into one of the Malta personal retirement accounts. [63] Year 2, Taxpayer A may sell their contributed assets (cash or property) at a non-taxed gain. [64] In contrast, in the U.S., Taxpayer A does not include the gain on their income tax returns, because with broad interpretation, that gain can be seen as exempt from U.S. taxation due to language found in Articles 18 and 1(5)(a) of the Treaty. [65] This language states that income earned by a pension fund that is a resident of the other State (U.S. or Malta), may not be taxed by either State (U.S. or Malta). [66] American retirement options are subject to far more limitations, making the Malta retirement transaction a more favorable option for taxpayers. Most of the participants of this transaction are U.S. taxpayers who have no association with Malta other than participating in these transactions. [67] These U.S. taxpayers claim that under their interpretation of the Malta-U.S. income tax treaty, they are justified utilizing the Malta pension plans. [68] However, the government asserts that this interpretation is incorrect, leading to the proposed rule to label the Malta personal retirement scheme as a listed transaction.

B. The U.S. Malta Treaty

As a result of the differences between the two countries’ tax laws, the Convention Between the Government of the United States and the Government of Malta for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income was signed at Valetta in August of 2008 (the Treaty). [69] The Treaty was created to prevent “treaty shopping”, which is the inappropriate use of a tax treaty by third-country residents. [70] Due to the unique features of Malta’s tax system, the Treaty contains more restrictive protections than any other U.S. tax treaty signed with another country. These features include Maltese law not requiring withholding taxes on cross-border payments, as well as providing for a low effective tax rate on income owned by foreign-owned corporations. [71] The Treaty also provides for the exchange of banking information between the tax authorities of each country so that each country can still effectively carry out their domestic tax laws. [72] To prevent third-country residents from taking advantage of Maltese tax laws, the Treaty “provides for a withholding rate of 15 percent on cross-border portfolio dividend payments, and five percent on dividends when the beneficial owner of the dividend is a company that directly owns at least 10 percent of the stock of the company paying the dividend.” [73] However, there is an exception to this requirement that provides that when a company resident contributes to a pension fund in Malta, they are exempt from withholding on dividends for the purpose of U.S. taxes. [74] The exemption from U.S. income tax also applies to “(1) ‘pensions and other similar remuneration’ arising in Malta to the extent such pensions or remuneration would be exempt from tax under Maltese law if the beneficial owner were a resident of Malta... (2) income earned by a ‘pension fund’ established in Malta until such income is distributed.” [75] A “pension fund” is defined under Paragraph (1)(k) of Article 3 of the Treaty as, “a licensed fund or scheme subject to tax only on income derived from immovable property situated in Malta; and operated principally either: A) to administer or provide pension or retirement benefits; or B) to earn income for the benefit of one or more persons meeting the requirements of [above] subparagraph[s].” [76] Once the IRS became aware of what U.S. taxpayers were doing with Malta pension funds, they released a CAA published in the Internal Revenue Bulletin in December of 2021. [77] In the CAA, the American and the Maltese governments concurred that “individual retirement arrangements established under Malta’s Retirement Pensions Act of 2011 are not considered ‘pension funds’ for purpose of relevant provisions of the Treaty.” [78] Also in 2021, the IRS placed the Maltese pension plans on its “Dirty Dozen” list of abusive tax shelters. The Dirty Dozen represents the worst of the worst tax scams, and the IRS compiles a list annually and reports it on their website, naming common scams that taxpayers may encounter and should look out for while preparing their tax statements. [79] However, after little to no change occurred in the reporting of taxpayers regarding Maltese pension plans, the IRS has now proposed a new regulation in order to classify Malta personal retirement transactions as a listed transaction. [80] This new Proposed Regulation is scheduled for a public hearing on September 21, 2023, with all requests to speak and outlines of topics to be discussed to be submitted no later than August 7, 2023. [81]

C. The U.S. Retirement Account

In the United States, individual saving arrangements such as pension or retirement plans are not entitled the same tax-favoring treatment unless they meet the requirements of an IRA, or a Roth IRA as declared in § 408 in Title 26 of the Internal Revenue Code. [82] Although the IRS considers IRAs to be tax-favored personal savings accounts for retirement, there are still rules that limit the amount of tax a person can save by investing in one of these accounts, which differs from Malta retirement accounts. [83] IRAs and Roth IRAs both require that “an individual’s contributions, other than certain rollovers, are restricted to cash and limited by reference to an individual’s earned income.” [84] However, there are some differences between the two retirement account options. For IRAs, the amount of money contributed to the account is not taxed when entering the account but is taxed when withdrawn and distributed to the individual for retirement. [85] To contribute to the traditional IRA, only taxable compensation is admitted, excluding compensation such as “earnings and profits from property, such as rental income, interest and dividend income, or any amount received as pension or annuity income, or as deferred compensation.” [86] Upon distribution, the money is fully or partially taxed in the year of distribution. [87] However, distributions made prior to retirement age (59½) are subject to an additional ten percent tax, and lack of withdrawing distributions after the age of seventy-two that do not meet the minimum requirements also incur an excise tax. [88] Roth IRA contributions are not deductible and taxpayers do not report the contributions on their tax return. Additionally, distributions that are a return of contributions put into the account are not subject to tax. [89] Roth IRAs must be designated as such when set up to ensure appropriate taxation occurs before contributing assets to the account. [90] Both options limit the amount of contributions available, as well as enforce a tax either upon contribution or distribution, making these far less favorable an option in comparison to the Malta pension retirement plans.

D. The IRS Case Against the Malta Transaction

In the new Proposed Regulations, the IRS designates the Malta retirement transaction as a listed transaction, thereby mandating all U.S. account holders and their material advisors to report a significant information associated with the Malta accounts. [91] U.S. Malta account holders claim they have done nothing non-compliant with U.S. law given they claim they compliance with the Treaty. [92] The IRS disagrees for several reasons. [93] First, the IRS argues Treaty benefits regarding Malta personal retirement accounts are not available to U.S. account holders because although the Treaty never specifically defines the terms “pension” and “retirement”, the IRS claims these terms should have been interpreted in accordance with United States tax law. [94] Since it is U.S. citizens who are benefiting from these Malta individual retirement account and not citizens of Malta, it is only logical that U.S. tax law applies. Second, the IRS states that Malta retirement accounts do not provide “retirement benefits” for purposes of the Treaty. [95] This is because “Maltese law does not condition the tax benefits it provides for these arrangements upon reasonably analogous requirements of U.S. law.” [96] The IRS argues that U.S. retirement account requirements, which include that an individual’s contributions must be made in cash that is based on income earned from employment activities, should also apply to those retirement accounts U.S. taxpayers open in Malta. [97] The Treaty merely exempts “qualified rollovers from a pension or retirement arrangement that is tax-favored under the same country’s laws.” [98] Third, the Treaty was created to avoid double taxation, not to create instances of non-taxation “especially in cases in which the person establishing the retirement arrangement has no other connection to the treaty jurisdiction.” [99] Thus, the IRS argues, the benefits were solely for U.S. taxpayers working in Malta. Lastly, the IRS believes that in certain circumstances, one or more judicial doctrines may apply to disqualify the transaction benefits. The Treasury Department will also make an exception for U.S. individuals who transferred their otherwise U.S. compliant foreign pension or retirement accounts to Malta in accordance with the competent foreign law before the Proposed Regulations were published in the Federal Register, and these individuals shall not be treated as participants in this new listed transaction. [100] That being said, U.S. citizens without this fact pattern who participate in Malta personal retirement schemes after June 6, 2023, and do not report such transaction on a U.S. Federal income tax return shall be subject to penalties. [101]

III. Analysis

In the attempt to combat abusive tax schemes, the IRS developed the comprehensive strategy of placing designated listed transactions on their website to be transparent with taxpayers about the potential harms associated with engaging in one of these schemes. However, by merely listing a particular transaction on their website does not always ensure the IRS has properly complied with all administrative law requirements for making taxpayers subject to the penalties for failing to disclose the listed transaction. The Administrative Procedures Act (APA) is “the legal authority for rulemaking and promulgation of procedures necessary to ensure fairness and equity in administration of the federal laws, including the income tax laws.” [102] The APA guidelines and requirements directly affect the affairs of the IRS, mandating strict requirements to protect the public at large. This includes IRS activities such as final regulations, temporary regulations, proposed regulations, revenue rulings, revenue procedures, orders, and notices. [103] These administrative agencies are held to a higher standard than would be necessary if Congress had given a legislative directive to a particular agency. [104] In recent court cases, administrative agencies, particularly the IRS, have come under attack regarding these procedures that have been mandated by the APA. One example is the listing of certain syndicated conservation easement transactions. Conservation easements were created to encourage people with certain types of property to donate property rights to a charitable organization, [105] typically a land trust. This ensures certain property remains in its current form, such as wetlands or forests to remain preserved for wildlife, while in return, the owner of the property will be able to take the donative value of the land as a tax deduction. [106] However, the IRS determined that certain taxpayers began abusing the system through a scheme that would generate a sizable charitable deduction which far exceeds the amount of their investment. [107] These transactions came to the attention of the IRS, who in turn published Notice 2017-10, declaring the scheme as a listed transaction, requiring investors and material advisors to declare their transactions on disclosure statement forms. [108] Then in the 2022 case of Green Valley Investors, LLC v. Commissioner, the U.S. Tax Court held that Notice 2017-10 was invalid because it failed to comply with the notice and comment requirements of the APA. [109] This requirement necessitates an agency not only issue a notice of proposed rulemaking, but also allow an opportunity for the public to comment either through written comments, or requests to speak at a public hearing. [110] The IRS contended that they do not have to comply with the APA because Congress delegated these powers specifically to the IRS in 2004 with the American Jobs Creation Act (AJCA). [111] The Tax Court did not agree, resulting in the invalidation of Notice 2017-10 and putting the IRS in the unfortunate position of trying to re-finalize the regulation as soon as due consideration of public comments is deemed completed. [112] Although the IRS disagrees with the Tax Court ruling and is still fighting to get the ruling overturned, the IRS has begun taking precautionary measures to ensure new regulations are in accordance with APA guidelines. The proposal for the Malta Personal Retirement Scheme to become a listed transaction includes the notice and comment requirement that was lacking in the syndicated conservation easement proposal. After the input is fully considered, the IRS may issue a final regulation or temporary regulation that is published in the Federal Register. Once the regulation is final and the Malta Personal Retirement transaction is a listed transaction, then taxpayers will have to comply with the regulation or pay the correlative fines.

Conclusion

For some time, the IRS has been able to freely “list” certain transactions as reportable on tax returns for American taxpayers without interference from the courts. Due to the recent Green Valley Investors, LLC v. Commissioner Tax Court decision, the IRS is discovering that there are limits on the power to list transactions. To mend this problem, the IRS is having to go back and provide proper notice-and-comment allocated time to the general public in order to properly “list” a transaction. In the case of the Malta Personal Retirement transaction, the IRS is addressing this problem, the issuance of the Proposed Regulations, to ensure that the scheme becomes a listed transaction. The listed transaction will apply to all transactions in which U.S. citizens or resident aliens: (1) transfer assets into and receive distributions from a personal retirement scheme established under Malta’s Retirement Pension Act of 2011; and (2) take a position on their U.S. federal income tax return that the income, gains, or distributions aren’t taxable in the United States because of the 2008 U.S.-Malta income tax treaty. [113] The United States may also have to address the Treaty, clarifying ambiguous language regarding pension funds and retirement accounts so there is no additional confusion amongst taxpayers and material advisors. From the time the Proposed Regulations becomes finalized, participant taxpayers and material advisors will be forced to report such participation on their respective listed transaction disclosure forms. Show Footnotes * Prof. Beckett Cantley (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997), teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, LLC. Prof. Cantley would like to thank Melissa Cantley and his law clerk, Adrienne Tauscheck, for their contributions to this article. ** Geoffrey Dietrich, Esq. (United States Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008, Loyola Law School, Los Angeles, LL.M. in Taxation 2023) is a shareholder in Cantley Dietrich, LLC.   [1] The History of the Pension Plan, DUE, 2023, https://due.com/pension/the-history-of-the-pension-plan/. (Accessed Oct. 19, 2023). [2] Id. [3] Id. [4] See id. [5] See id. [6] See id. [7] Jay Adkisson, The Grinch who Stole The Maltese Pension Plan, Forbes (Dec. 23, 2021), https://www.forbes.com/sites/jayadkisson/2021/12/23/the-grinch-who-stole-maltese-pension-plan/?sh=22d2e7c5660f. [8] Id. [9] Id. [10] Id. [11] Id. [12] Id. [13] Id. [14] IRS: Competent Authority Arrangements, https://www.irs.gov/individuals/international-taxpayers/competent-authority-arrangements (last visited May 23, 2023). [15] Id. [16] See Adkisson, supra note 9. [17] Prop. Treas. Reg. § 1.6011-12(b)(2), 88 Fed. Reg. 37186 (June 7, 2023). [18] Id. [19] Who Is The IRS? IRS Careers (2020), https://www.jobs.irs.gov/about-us/who-irs#:~:text=The%20IRS%20Mission,we%20should%20perform%20that%20role. [20] Id. [21] Id. [22] See EP Abusive Tax Transactions IRS (last updated Mar. 2, 2023), https://www.irs.gov/retirement-plans/ep-abusive-tax-transactions#:~:text=A%20%22listed%20transaction%22%20is%20a,other%20form%20of%20published%20guidance. [23] Id. [24] Id. [25] Id. [26] What is Tax Liability?, Ramsey Solutions (April 3, 2023), https://www.ramseysolutions.com/taxes/what-is-a-tax-liability#:~:text=Your%20total%20tax%20liability%20is,t%20paid%20from%20previous%20years. [27] See EP Abusive Tax Transactions, supra note 24. [28] Id. [29] Megan L. Brackney, A Crash Course on Reportable Transaction Penalties for Material Advisors, Journal of Taxation, 160, 160-61 (2017). [30] Instructions for Form 8918, IRS (Last updated Nov. 2021) https://www.irs.gov/instructions/i8918. [31] Id. [32] Brackney, supra note 31, at 161. [33] Id. [34] Id. at 162. [35] Id. [36] Id. [37] 26 C.F.R. § 301.611-3(g). [38] Brackney, supra note 31, at 162. [39] Id. [40] 26 C.F.R. § 6707(b)(1). [41] 26 C.F.R. § 6707(b)(2). [42] See 26 C.F.R. § 301.6707-1(a)(2). [43] See 26 C.F.R. § 6707(b)(2). [44] Id. [45] Penalty Relief for Reasonable Cause, IRS (Aug. 2, 2023) https://www.irs.gov/payments/penalty-relief-for-reasonable-cause#:~:text=You%20may%20qualify%20for%20penalty,natural%20disasters%20or%20civil%20disturbances. (Individual taxpayers, not material advisors, may qualify for a reasonable cause defense if they demonstrate they exercised ordinary care and prudence and were nevertheless unable to file the form or pay taxes on time. Examples of valid reasons for reasonable cause defenses can be fires, natural disasters, inability to get records, and death or serious illness of immediate family.) [46] 26 C.F.R. § 301.6707-1(e)(1). [47] 26 C.F.R. § 1.6011-4. [48] Ray A. Knight, Full Disclosure: When tax transactions must be reported, Journal of Accountancy, (Feb. 1, 2021), https://www.journalofaccountancy.com/issues/2022/feb/when-tax-transactions-must-be-reported.html#:~:text=A%20taxpayer%20has%20participated%20in,as%20a%20listed%20transaction%20(Regs. (citing 26 C.F.R 1.6011-4(c)(3)(i)(A)). [49] Id. [50] 26 C.F.R 1.6011-4(e). [51] 26 C.F.R § 1.6011-4(f). [52] Knight, supra note 50. [53] See id. [54] Id. [55] Id.; See also 20 C.F.R. § 301.7701-6(a) (defining natural persons as someone who has rejected or renounced United States citizenship because the taxpayers are citizens exclusively of a State, however these natural persons are still subject to federal taxes.) [56] Prop. Treas. Reg. § 1.6011-12, supra note 19, at 37189. [57] Id. [58] Id. [59] Id. [60] Proposed Regs Name Malta Pension Scheme as Listed Transaction, taxnotes (June 7, 2023), https://www.taxnotes.com/tax-notes-today-federal/tax-avoidance-and-evasion/proposed-regs-name-malta-pension-scheme-listed-transaction/2023/06/07/7gv7c. [61] Id. [62] Id. [63] Prop. Treas. Reg. § 1.6011-12, supra note 19, at 37190. [64] Id. [65] Id. [66] Id. [67] Proposed Regs Name Malta Pension Scheme as Listed Transaction, supra note 62. [68] Id. [69] Convention for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income, Malta-U.S., Aug. 8, 2008, TIAS 10-1123. [70] Id. [71] Id. [72] See id. [73] Id. [74] Id. [75] Prop. Treas. Reg. § 1.6011-12, supra note 19. [76] Id. [77] See id. [78] Id. [79] Dirty Dozen, IRS (last updated Apr. 5, 2023), https://www.irs.gov/newsroom/dirty-dozen (including Employee Retention Credit Claims, Phishing emails sent during filing season, third-party promoters of false fuel tax credit claims, and nine more make up the dirty dozen list). [80] Supra, note 54. [81] Id. [82] 26 U.S.C. § 408A. [83] Arrangements, IRS (IRAs) (last updated Apr. 6, 2023), https://www.irs.gov/taxtopics/tc451#:~:text=An%20individual%20retirement%20arrangement%20(IRA,company%2C%20or%20other%20financial%20institution. [84] Conventions for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income, supra note 71. [85] Irs: Arrangements (IRAs), supra note 85. [86] Id. [87] Id. [88] Id. [89] Id. [90] Id. [91] Prop. Treas. Reg. § 1.6011-12, supra note 19. [92] Id. [93] Id. [94] Irs: Arrangements (IRAs), supra note 85. [95] Id. [96] Id. [97] See id. [98] Id. [99] Id. [100] Id. [101] Id. [102] CCH AnswerConnect Editorial, Are syndicated conservation easements reportable transactions?, Walters Kluwer: Tax and Accounting (Dec. 22, 2022), https://www.wolterskluwer.com/en/expert-insights/are-syndicated-conservation-easements-reportable-transactions. [103] Id. [104] Id. [105] Jay Adkisson, The IRS Leaves a Lump of Coal for Syndicated Conservation Easements in Notice 2017-10, FORBES (Dec. 27, 2016), https://www.forbes.com/sites/jayadkisson/2016/12/27/the-irs-leaves-a-lump-of-coal-for-syndicated-conservation-easements-in-notice-2017-10/?sh=26db14c06eb3. [106] Id. [107] Id. [108] Id. [109] Jay Adkisson, The IRS Loses Notice 2017-10 Regarding Syndicated Conservation Easement Tax Shelters for APA Non-Compliance, FORBES (Nov. 14, 2022), https://www.forbes.com/sites/jayadkisson/2022/11/14/the-irs-loses-notice-2017-10-regarding-syndicated-conservation-easement-tax-shelters-for-apa-non-compliance/?sh=7faa5d8c3bab (citing Green Valley Investors, LLC v. Commissioner, 159 T.C. 5 (Nov. 9, 2022). [110] Rulemaking Process, Federal Communications Commission, https://www.fcc.gov/about-fcc/rulemaking-process#:~:text=In%20notice%2Dand%2Dcomment%20rulemaking,requirement%20for%20notice%20and%20comment. Accessed Oct. 19, 2023. [111] Adkisson, supra note 107. [112] CCH AnswerConnect Editorial, supra note 104. [113] Proposed Regs Name Malta Pension Scheme as Listed Transaction, supra note 62.

Coca-Cola v. Commissioner: A Major IRS Win

A Major IRS Win in the International Transfer Pricing Wars Beckett Cantley[1] Geoffrey Dietrich[2] Abstract In Coca-Cola v. Commissioner , the IRS won a major transfer pricing battle, successfully arguing that the Tax Court should apply the IRS’s pricing methodology over one of the methods recommended by Coca-Cola. The IRS argued the proper valuation methodology was the comparable profits method (“CPM”). Under the CPM, a court analyzes the profits of the company in question with the profits from an uncontrolled party. The court rejected the methodology recommended by Coca-Cola, leaving Coca-Cola with a significant tax liability. This decision opens the door for the IRS to pursue transfer pricing issues more aggressively and may affect other companies with pending transfer price cases, depending on how broadly other courts apply the holding in this case. This article will first provide a brief introduction of the case and the basic principles of transfer pricing. Next, Part II of the article will discuss Coca-Colav. Commissioner in-depth. This section will include a background into Coca-Cola’s unique business model, the arguments set forth by the IRS and Coca-Cola, and the findings and holdings of the Tax Court. Part III will examine several other transfer pricing cases that may be affected by the holding in Coca-Colav. Commissioner. Finally, Part IV will conclude this article.

I. Introduction

Coca-Cola Co v. Commissioner is a significant win for the IRS in a transfer pricing case, marking a possible turn in transfer pricing litigation.[3] In this case, the IRS successfully argued for the implementation of a CPM analysis despite Coca-Cola’s argument for a different set of transfer pricing methodologies.[4] Coca-Cola’s argument is based on its unique business model in which it licenses its intangible property to foreign supply points in order to create the concentrate which is the base for all Coca-Cola beverages.[5] The concentrate is then sold to independent bottlers who bottle and distribute the beverages to retailers.[6] The IRS’s success in this case should serve as a warning to many other multinational corporations to adjust their transfer pricing strategies by taking into account the narrow reading of prior settlements with the IRS and reasoning of the tax court.[7]

A. Transfer Pricing

In general, transfer pricing is the practice of a company charging another branch of their own company, usually an affiliate or subsidiary, for goods or services provided between the related parties.[8] Companies primarily use transfer pricing for goods and services, but it can also be used to value the use of the company’s intangible property.[9] Theoretically, when a company uses transfer pricing that company employs an arm’s length price. However, transfer pricing is susceptible to abuse when companies use it to shift income to jurisdictions with a lower corporate tax rate.[10] To combat the abuse of transfer pricing, the IRS can challenge transactions between related parties under IRC § 482.[11] In applying IRC § 482, the purpose is to ‘“place[] a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.”’[12] As a result, when courts are trying to discern the correct arm’s length pricing for a transaction between related parties, the courts will apply the “best method rule.”[13] When the transfer pricing transaction involves intangible property, the parties must decide which one of four methods will be used for determining the correct arm’s length pricing.[14] The four methods are: (1) the comparable uncontrolled transaction (“CUT”) method; (2) the comparable profits method (“CPM”); (3) the profit split method; (4) “an ‘unspecified method’ subject to constraints set forth in the regulations.”[15] The CUT method may be selected as the best method when “an uncontrolled transaction involves the transfer of the same intangible under the same or substantially the same circumstances as the controlled transaction.”[16] The CPM is “preferred where only one of two entities contributes meaningful intangible property.”[17] The profit split method “ evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is at arm's length by reference to the relative value of each controlled taxpayer's contribution to that combined operating profit or loss.”[18] If none of the foregoing methods are chosen an unspecified method can be used, but that method should take into account the general principle that “uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it.”[19] When looking at which method to select in a given case, “there is no strict priority of methods, and no method will invariably be considered to be more reliable than others.”[20] Thus, “[t]he reliability of any particular method depends on ‘the facts and circumstances’ of each case, especially on ‘the quality of the data and assumptions used in the analysis’ and ‘the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables.”’[21]

II. Coca-Cola v. Commissioner

A. The Transaction

To fully understand the transfer pricing transactions at issue in Coca-Cola Co. v. Commissioner, a brief background of Coca-Cola’s business structure is helpful to differentiate between the parties and to understand the relationship between the different entities involved in the transaction.[22] Known as the “Coca-Cola System,” The Coca-Cola Company (“TCCC”) owns immensely valuable intangible property, such as the secret formulas and proprietary manufacturing processes to produce Coca-Cola products.[23] In 1930, when Coca-Cola began to expand internationally, Coca-Cola created the Coca-Cola Export Corporation (“Export”), a wholly-owned domestic subsidiary of The Coca-Cola Company.[24] Coca-Cola licenses the intangible property to supply points[25] in order to manufacture the concentrate used by independent bottlers to bottle and distribute the final product.[26] Many of the supply points that manufacture the concentrate are owned by Export.[27] Independent bottlers then purchase the concentrate from these supply points, bottle the product, and distribute the final product to retail establishments.[28] Export also owns many local service companies (“ServCos”), which handle local advertising and in-country consumer marketing in foreign markets for Coca-Cola.[29] However, the supply points “had little or no direct ownership interest in the ServCos that served these national markets.”[30] The main issues in this case center on the IRS reallocating income from the supply points back to Coca-Cola under IRC § 482.[31] In order for the “Coca-Cola System” to operate, the company needs to license their intangible property, including trademarks, brand names, logos, patents, secret formulas, and proprietary manufacturing processes, to supply points for those supply points to manufacture the concentrate, which is later sold to independent bottlers.[32] The Coca-Cola Company reported income from the supply points using the “10-50-50 method,” in which the supply points retained “profit equal to 10% of their gross sales, with the remaining profit being split 50%-50%.”[33] However, the IRS concluded that the 10-50-50 method was not an accurate reflection of arm’s length pricing as it overcompensated the supply points and undercompensated petitioner for the use of petitioner’s intangible property.[34] As a result of the IRS’s transfer pricing adjustments, The Coca-Cola Company’s taxable income increased by over $9 billion over the tax years 2007, 2008, and 2009.[35]

B. IRS Argument

The main contention of the IRS in this case is that the transactions between Coca-Cola and its supply points did not represent arm’s length dealings, and in order to properly calculate arm’s length pricing in this scenario, the comparable profits method (“CPM”) should be used.[36] Under the CPM, the “determination of an arm’s length result is based on the amount of operating profit that the tested party would have earned on related party transactions if its profit level indicator were equal to that of an uncontrolled comparable.”[37] In examining transactions conducted by Coca-Cola and its different entities, the IRS concluded that the supply points underpaid Coca-Cola for the use of its valuable intangibles, while the ServCos conducted business with Coca-Cola at arm’s length for the most part.[38] For example, the expert witness that prepared the CPM analysis for the IRS compared the average returns on operating assets (ROA) for independent bottlers deemed comparable and stated its findings that the “Irish, Brazilian, Chilean, and Costa Rican supply points, with ROAs of 215%, 182%, 149%, and 143%, respectively, had ROAs higher than any of the 996 companies in the comparison group—literally off the high end of the bell curve.”[39] The IRS argued that supply points who only engaged in the manufacturing of concentrate should not be the most profitable beverage companies in the world, especially considering the profitability of these supply points “dwarf[ed]” that of Coca-Cola which owns the valuable intangibles and licensed such intangibles to the supply points.[40] The IRS further argued using CPM was the appropriate method to determine arm’s length pricing in part because, in controlled transactions implicating high-value intangibles, the most reliable transfer pricing method is often one that avoids any direct valuation of those intangibles.[41] Further, the “CPM will often be preferred where only one of two entities contributes meaningful intangible property.”[42] In this case, the supply points did not own any valuable intangibles, thus the only meaningful intangible property was contributed by Coca-Cola.[43] In arguing the CPM was the best method for determining arm’s length pricing, the IRS concluded the independent bottlers were “appropriate comparable parties for purposes of a CPM/ROA analysis.”[44]

C. Taxpayer Argument

  Coca-Cola employed several arguments to combat the IRS’s reallocation of income away from the supply points and back to Coca-Cola.[45] Coca-Cola argued the IRS acted arbitrarily by challenging the 10-50-50 method which the company had been using for years.[46] Further, Coca-Cola argued the supply points and the bottlers were not comparable in the CPM analysis because the supply points “own immensely valuable intangible assets that do not appear on their balance sheets or in any written contract.”[47] These intangible assets, or “marketing intangibles,” Coca-Cola argued were “created when the supply points financed consumer advertising in foreign markets.”[48] Further, Coca-Cola argued that “a comparable uncontrolled transaction (CUT) model and a residual profit split method (RPSM) as the best methods for determining the supply points’ true economic income.”[49] Coca-Cola reasoned the IRS should allow the 10-50-50 method because the two parties agreed to allow this method to be used for tax years 1987–1995 in a 1996 closing agreement.[50] A closing agreement is a contract between the IRS and a taxpayer, which can restrict the discretion of the IRS.[51] Further, Coca-Cola asserted the “closing agreement was predicated on certain ‘factual underpinnings,’ including a ‘recogni[tion]’ by the IRS that the supply points ‘were responsible for generating demand and were entitled to share in the resulting profits related to the... [Company’s] intangibles.”[52] Further, Coca-Cola said these factual underpinnings “are binding on the Commissioner unless he can show some material change in underlying fact.”[53] Thus, Coca-Cola argued the IRS should be required to adhere to the 1996 closing agreement which allowed the 10-50-50 method.[54] Coca-Cola further argued the supply points owned valuable marketing intangibles not taken into account when the IRS’s expert performed the CPM analysis.[55] Thus, the supply points should be able to retain more income than calculated by the IRS in determining the arm’s length pricing for the use of the intangibles.[56] Coca-Cola said that its intangibles were essentially “wasting assets” because “what kept TCCC’s products fresh in consumers’ minds, petitioner says, were the billions of dollars spent annually on television advertisements, social media, and other forms of consumer marketing.”[57] Coca-Cola said these intangibles would lose value over time had these supply points not invested into marketing, keeping these intangibles relevant and valuable.[58] Coca-Cola further argued under temporary regulations that “states that legal or contractual ownership is dispositive ‘unless such ownership is inconsistent with the economic substance of the underlying transactions.”[59] Additionally, Coca-Cola reasoned that the supply points and the independent bottlers were not comparable because they “occupied different points in the Company’s supply chain and did business at different ‘levels of the market...”’[60] Coca-Cola proposed several other transfer pricing methodologies which they contend would more accurately reflects arm’s length pricing between the parties.[61] One method proposed by a Coca-Cola expert witness was the CUT method, in which the expert compared the controlled transaction with the supply points to “‘master franchising transactions’ that companies like McDonald’s and Domino’s Pizza execute with regional franchisees abroad.”[62] In calculating the royalty rate in the uncontrolled transactions, the expert concluded “that the supply points at arm’s length would be entitled to keep 87.7% of the Company’s total revenues from the markets the supply points served.”[63] Another expert proposed the residual profit split method under Treas. Reg. 1.482-6(c)(3), in which “the combined operating profit or loss from the relevant business activity is allocated between the controlled taxpayers following the two-step process” described later in the regulations.[64] This expert concluded “that the supply points, at arm’s length, would pay TCCC a weighted average royalty rate of 5.4% for 2007, 4.9% for 2008, and 4.6% for 2009.”[65] Another Coca-Cola expert suggested using an asset management model, an unspecified method, as the best method for determining an arm’s length price.[66] Under this method, the expert made “numerous assumptions and an extremely complex series of calculations,” from which he derived “estimates for TCCC’s ‘assets under management’ and annual ‘net asset appreciation’ for 2007, 2008, and 2009.”[67] Based on his calculations, the expert came “up with a weighted average annual royalty rate of 9.3%.”[68]

D. Holding

The tax court found in favor of the IRS, upholding the IRS’s reallocation of income to Coca-Cola as well as the IRS’s use of the bottler CPM.[69] In addressing Coca-Cola’s argument regarding the closing agreement from 1996, the court noted, “[t]he short and (we think) the complete answer to petitioner’s argument is that the closing agreement says nothing whatever about the transfer pricing methodology that was to apply for years after 1995.”[70] Additionally, the court said, “[t]here is nothing within the four corners of the closing agreement to suggest that the Commissioner regarded the 10-50-50 method as the Platonic ideal of arm’s-length pricing for petitioner and its supply points.”[71] Additionally, “there is no evidence that the parties intended them to be binding for future years.”[72] The court further explained the parties could have intended for the document to agree to the 10-50-50 method for future tax years because the agreement provides for future penalty protection for Coca-Cola for using the 10-50-50 method, but the agreement does not explicitly establish the 10-50-50 method to be arm’s length pricing between the parties.[73] In other words, the “petitioner urges that it relied to its detriment on a belief that the IRS would adhere to the 10-50-50 method indefinitely,” but Coca-Cola “cannot estop the Government on the basis of a promise that the Government did not make.”[74] In regards to Coca-Cola’s proposed transfer pricing methodologies, the court found that Coca-Cola’s experts tried to group Coca-Cola’s foreign affiliates into one group which the experts called “the Field.”[75] The Coca-Cola experts sought “to frame the task before us as dividing income between HQ and ‘the Field’ on the basis of the ‘historical marketing spend’ by ‘the Field.’”[76] However, the tax court refused to group all the foreign entities together because this would lead to “duplication and inconsistency.”[77] In responding to Coca-Cola’s argument that the CPM is inferior to other transfer pricing methods, the court noted, “[t]reasury’s reference to the CPM as a ‘method of last resort’ is predicated on the assumption that ‘adequate data’ are available to apply the CUT method.”[78] Further, the court recognized the CUT method only has a high degree of reliability when ‘“an uncontrolled transaction involves the transfer of the same intangible under the same, or substantially the same, circumstances as the controlled transaction.”’[79] Thus, the court found “the circumstances that caused Treasury to refer to the CPM as a ‘method of last resort’ do not exist here.”[80] As a result, the court examined the bottler CPM set forth by the IRS, keeping in mind “[t]he reliability of any particular method depends on ‘the facts and circumstances’ of each case, especially on ‘the quality of the data and assumptions used in the analysis’ and ‘the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables.”’[81] In regards to using CPM and the independent bottlers as the comparable party to the supply points, the court held, “the Commissioner did not abuse his discretion by using the bottler ROA to reallocate income between petitioner and the supply points.”[82] Further, the court found the “CPM analysis was appropriate given the nature of the assets owned and the activities performed by the controlled taxpayers,” the independent bottlers were “appropriate comparable parties,” and “the Commissioner computed and applied his ROA using reliable data, assumptions, and adjustments.”[83] In fact, the court found “the bottlers in many respects enjoyed an economic position superior to that of the supply points, which would justify for the bottlers a higher relative return.”[84] The tax court then turned to whether the CPM was the best method in which to begin the transfer pricing analysis or if another method set forth by Coca-Cola was more reasonable.[85] The court began by saying the case at hand was “particularly susceptible to a CPM analysis because petitioner owned virtually all the intangible assets needed to produce and sell the Company’s beverages.”[86] As clarified in the regulations, the CPM is preferred where one party contributed most or all of the intangibles in a given transaction.[87] Further, in the agreements between the supply points and Coca-Cola, Coca-Cola licensed the intangibles to the supply points in order for the supply points to manufacture concentrate, but these agreements “were terminable by petitioner at will,” the supply points did not gain “any form of territorial exclusivity, and no supply point was granted any right, express or implied, to guaranteed production of concentrate.”[88] Additionally, the court found that Coca-Cola did not set forth any unrelated transactions that involved the same type of intangibles as in this case, and thus, “[t]he reliability of any CUT method is considerably reduced here.”[89] Further, once the CUT method was essentially set aside for this case, the court noted the CPM was preferable to the profit split method in cases where one party owns a majority of the intangibles in the transaction.[90] Next, the tax court analyzed whether the supply points and the independent bottlers were comparable under the factors set forth under the regulations, ultimately determining that the parties were comparable.[91] Under the regulations, “[t]he determination of the degree of comparability between the tested party and the uncontrolled taxpayer depends upon all the relevant facts and circumstances.”[92] In taking into account all relevant facts and circumstances, the factors which determines the degree of comparability are “(i) functions performed, (ii) contractual terms, (iii) risks, (iv) economic conditions, and (v) property employed or transferred.”[93] The court ultimately held the independent bottlers and the supply points were comparable because both entities “ operated in the same industry, faced similar economic risks, had similar (but more favorable) contractual and economic relationships with petitioner, employed in the same manner many of the same intangible assets (petitioner's brand names, trademarks, and logos), and ultimately shared the same income stream from sales of petitioner's beverages.”[94] Taking the factors in turn, the tax court analyzed each party’s functions performed and determined the supply points and the independent bottlers both manufactured and distributed beverage products “according to detailed protocols supplied by petitioner.”[95] Under contractual terms, the court looked to the agreements the supply points and independent bottlers had with Coca-Cola, finding the bottlers had more favorable terms than the supply points.[96] Because the independent bottlers had more favorable contract terms than the supply points, the court noted “the bottlers would be deserving of a higher ROA than the supply points.”[97] In regards to economic conditions, the supply points and the independent bottlers both earned revenue through the sale of beverage products stemming from Coca-Cola’s intangibles, but the bottlers were positioned better economically because the bottlers are not easily replaceable and have higher bargaining power.[98] In terms of resources employed, the court found the independent bottlers and the supply points “used a similar mix of resources to discharge” their functions as beverage manufacturers.[99] The tax court also noted that both the supply points and the independent bottlers shared very similar risks because both parties were reliant on the success of Coca-Cola products and both operate within the same market.[100] In response to Coca-Cola’s argument that the supply points had marketing risk, the tax court found the supply points “did not have ‘marketing-intensive operations,”’ because, for all but the Brazilian supply point, the supply points “engaged in no marketing operations.”[101] Next, the tax court analyzed the “selection and quality” of the data used by the IRS’s expert as well as the “assumptions employed to bridge any gaps” in the data.[102] The court found that the IRS expert did not err in selecting bottlers to be used in the CPM analysis and agreed with most of the assumptions made by the IRS’s expert.[103] The court did note, however, that the parties needed “to adjust the allocations of income set forth in the notice of deficiency to exclude income attributable to trademarks owned by the supply points, as identified by petitioner’s experts and accepted by Dr. Newlon” in their Rule 155 computations.[104] In addressing Coca-Cola’s argument the IRS’s expert did not take into account marketing intangibles held by the supply points, the tax court said, “[w]e find no support for petitioner’s argument in law, fact, economic theory, or common sense.”[105] The tax court explained under the regulations “legal ownership is the test for identifying the intangible.”[106] The legal owner of the intangibles is Coca-Cola, and the marketing costs sustained by the foreign entities “enhanced the value of the trademarks and other intangible assets that were legally owned by TCCC.”[107] Further, in addressing Coca-Cola’s argument “that legal or contractual ownership is dispositive ‘unless such ownership is inconsistent with the economic substance of the underlying transactions,’” the court found that: (1) “only the Commissioner, and not the taxpayer, may set aside contractual terms as inconsistent with economic substance,” and (2) “even if the petitioner could set aside the terms of its own contracts, it has failed to establish that the economic substance differs from the contractual form.”[108] In addressing the other proposed transfer pricing methodologies set forth by Coca-Cola, the tax court found that the expert which proposed the CUT method grouped all the foreign entities into “the Field,” which the court rejected.[109] Further, the court said of the expert’s CUT analysis, “[t]here are so many flaws in Dr. Unni’s construct that it is difficult to know where to begin.”[110] A few of the main issues the tax court found in the CUT analysis were: the expert selected data from a completely different industry than the beverage industry; the expert did not compare contractual terms in comparing the different parties; and “many of his adjustments were shown by respondent’s experts to be mathematically and economically unsound.”[111] The court also found the proposed profit split method and unspecified method to be inadequate for similar reasons as the CUT method.[112]

III. Analysis:

A. Precedent for Other Companies

The Coca-Coladecision may have a widespread effect on large multinational corporations if the decision is upheld on appeal. [113] As of right now, Coca-Cola appears to be preparing an appeal of the Tax Court’s decision and recently hired a new attorney to advise the company on matters relating to the ongoing litigation.[114] As a result of the Coca-Cola decision, the IRS will likely be more aggressive in challenging transfer pricing transactions where foreign entities are earning high percentages of profit based on intangibles owned by the US corporation.[115] Now that the IRS has won its first major transfer pricing case more multinational corporations may enter into advance pricing arrangements where the IRS and the company agree on an arm’s length price, thus reducing transfer pricing litigation.[116] On the other hand, some corporations may still challenge the IRS stance on transfer pricing methodology because of the unique fact pattern present in the Coca-Cola case. [117] The Coca-Cola case may be more susceptible to CPM analysis than other cases because the independent bottlers served as a very comparable party to the supply points, which is a result of Coca-Cola’s unique business model.[118] Other companies with different business models may not have such a comparable party and thus other transfer pricing methodologies may be more appropriate under a different fact pattern.[119] Additionally, the Coca-Cola decision “casts serious doubt on taxpayers’ ability to seek more favorable results than their own intercompany contracts allow.” [120]

A. Related Cases

1. Altera v. Commissioner

In Altera v. Commissioner, the Ninth Circuit reversed the decision of the tax court, which had reached five holdings: (1) the 2003 amendments to C.F.R. § 1.482-7A(d)(2) fall under the requirements of the Advance Pricing Agreement (APA); (2) found the standards set forth in Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co.was the correct standard of review because the “standard set forth in [Chevron] incorporates State Farm’s‘reasoned decision making’ standard;” (3) the IRS “did not support adequately its decision to allocate the costs of employee stock compensation between related parties;” (4) the IRS’s “procedural regulatory deficiencies were not harmless;” and (5) under the APA, § 1.482-7A(d)(2) is invalid.[121] In this case, Altera Corporation and its foreign affiliate Altera International entered into a cost-sharing agreement where Altera licensed intangible property to the foreign affiliate and both parties agreed to share research and development costs for new projects.[122] For the tax years 1997–2003, Altera and the IRS entered into an APA, and under this agreement “Altera shared with Altera International stock-based compensation costs as part of shared R&D costs.”[123] However, after the underlying regulations were amended in 2003, the IRS ultimately challenged Altera because the company “did not account for R&D related stock-based compensation costs on their consolidated 2004–2007 federal income tax returns.”[124] In finding in favor of Altera, the tax court made several determinations regarding transfer pricing methodologies and the underlying regulations.[125] The court found “that the Commissioner’s allocation of income and expenses between related entities must be consistent with the arm’s length standard.”[126] The tax court further determined “that the arm’s length standard is not met unless the Commissioner’s allocation can be compared to an actual transaction between unrelated entities.”[127] In holding Treasury’s decision making process was flawed, the tax court noted Treasury “rested on speculation rather than on hard data and expert opinions” and “failed to respond to significant public comments.”[128] In determining the validity of the 2003 amendments, the Ninth Circuit analyzed the regulations under both Chevronand State Farm.[129] In apply Chevron, the Ninth Circuit found that IRC § 482 did not directly speak to the issue at hand, which was “whether the Commissioner may require parties to a QCSA to share employee stock compensation costs in order to receive the tax benefits associated with entering a QCSA.”[130] In moving to the second step in the Chevronanalysis, the Ninth Circuit found Treasury’s interpretation of the regulations to be reasonable.[131] The court noted, “Treasury reasonably concluded that doing away with analysis of comparable transactions was an efficient means of ensuring that §482 would ‘operat[e] to assure adequate allocations to the U.S. taxable entity of income attributable to intangibles in [QCSAs].”[132] In addressing the State Farmanalysis, the Ninth Circuit found, “[t]hough it could have been more specific, Treasury ‘articulated a rational connection’ between its decision and these industry standards.”[133] The Ninth Circuit concluded, “we disagree with the Tax Court that the 2003 regulations are arbitrary and capricious under the standard of review imposed by the APA.”[134] Thus, the Ninth Circuit reversed the decision of the tax court.[135] The decision by the Ninth Circuit upheld the Treasury regulations which requires that related companies share R&D related stock-based compensation costs under cost sharing arrangements.[136] However, despite the ruling by the Ninth Circuit, taxpayers in other circuits may still be successful in arguing the Treasury Regulations should not be upheld.[137] Although the IRS will try to extend the reasoning from the Ninth Circuit to other circuit courts, taxpayers may be able to succeed in other circuits due to the widespread disagreement on the enforceability of the Treasury Regulations from Altera.[138] The issues presented in Alterawere somewhat narrow in scope and application, whereas the holding in Coca-Colahas the potential to affect more transfer pricing cases moving forward.[139]

2. Medtronic, Inc. v. Commissioner

In Medtronic v. Commissioner, the Eight Circuit reversed and remanded the tax court’s ruling which held Medtronic’s CUT method was the best method to determine arm’s length pricing because the tax court’s “factual findings are insufficient to enable us to conduct an evaluation of that determination.”[140] Medtronic, a medical device company, used the CUT method to “determine the royalty rates paid on its intercompany licenses,” and allocated income between Medtronic US, Med USA, and Medtronic Puerto Rico.[141] The IRS challenged Medtronic’s allocation of income. The two parties ultimately entered into a Memorandum of Understanding in which Medtronic Puerto Rico “agreed to pay royalty rates of 44% for devices and 26% for leads on its intercompany sales.”[142] A few years later, however, the parties disagreed again on the correct method to determine the intercompany royalty rates.[143] The IRS argued the CPM was the best method, while Medtronic argued for using the CUT method.[144] The tax court rejected both parties’ calculations as to the correct royalty rate, determined that the CUT method was the best method for determining the royalty rates, and made adjustments to Medtronic’s calculations.[145] The tax court held the IRS’s “allocations were arbitrary, capricious, or unreasonable.” The tax court further found that: the CPM “‘downplayed’ Medtronic Puerto Rico’s role in ensuring the quality of the devices and leads”; “did not reasonably attribute a royalty rate to Medtronic’s profits”; “used an incorrect return on assets approach”; and “ignored the value of licensed intangibles.”[146] Under the § 482 regulations, ‘“there is no strict priority of methods’ when determining an arm’s length result of a controlled transaction.”[147] Further, an “arm's length result may be determined under any method without establishing the inapplicability of another method, but if another method subsequently is shown to produce a more reliable measure of an arm's length result, such other method must be used.”[148] Additionally, when choosing between methods to determine an arm’s length price, the court may consider “the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis.”[149] The Eighth Circuit, however, found that the tax court’s factual findings were insufficient in comparing the uncontrolled action with the controlled action.[150] For example, the Eighth Circuit said “the tax court did not analyze the degree of comparability of the Pacesetter agreement’s contractual terms and those of the Medtronic Puerto Rico licensing agreement.”[151] The Eighth Circuit held that “[i]n the absence of findings regarding the degree of comparability between the controlled and uncontrolled transactions, we cannot determine whether the Pacesetter agreement constituted an appropriate CUT.”[152] This decision by the Eighth Circuit leaves the door open to allow the tax court to make more detailed factual findings and still uphold the use of the CUT method.[153] However, especially in light of the Coca-Coladecision, the tax court may be more likely to find in favor of CPM, deferring to the IRS so long as the method is applied correctly.[154]

1. Facebook Case

Facebook has been in ongoing litigation challenging the IRS’s position that Facebook undervalued its intangible assets and transferred the value of the intangible assets to low corporate tax rate jurisdictions.[155] Even though the amount at controversy in the current litigation is only $1.73 million, a finding in favor of the IRS’s position could expose Facebook to tax liability for subsequent years.[156] Facebook estimates, if the IRS’s position prevails, the company could be liable up to $9 billion plus interest and penalties for other years currently not at issue.[157] The Coca-Colacase may impact how the tax court views the issues in the Facebook case as Facebook is also arguing to use the CUT method, despite the fact that Coca-Cola was unsuccessful in setting forth that argument.[158] In arguing against the IRS’s position, Facebook argued “that the Dublin headquarters received investment, developed its own technology, and took risks in 2010, making the case it was fair to book some profits there.”[159] Further, Facebook is arguing “that the updated cost-sharing regulations are subject to the same fundamental restrictions as the 1995 regulations and that any regulatory provision that states otherwise is invalid.” [160] However, other experts note that the Coca-Colacase may not be a factor in the Facebook litigation because, ‘“Facebook has zero in common with Coca-Cola in terms of its business, its business model, etc.”’[161] Interestingly, Facebook has sold three of its subsidiaries in Ireland which were holding some of these intangibles at issue in the current litigation.[162]

IV. Conclusion

In conclusion, the IRS received a very favorable ruling in the Coca-Colacase, which means that it will continue to challenge transfer pricing transactions it deems to fail arm’s length pricing. As we have seen with domestic IRS litigation matters—like its prosecution of syndicated conservation easements and § 831(b) micro-captive insurance companies—courtroom wins often become administrative bully pulpits for forcing settlements favorable to Treasury.[163] However, the case will still most likely be appealed, but considering the IRS has also received a few favorable results in the circuit courts the last few years, the IRS may prevail on appeal as well. If the IRS prevails on appeal, this may cause large multinationals to change their transfer pricing practices in order to avoid large tax bills, such as the tax liabilities seen in the Coca-Cola case and the Facebook case. This Article was originally slated for publication in Fall of 2021. Additional fluctuation in the law may have occurred in the intervening time. [1] Prof. Beckett Cantley (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997), teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C. Prof. Cantley would like to thank Melissa Cantley and his law clerk, Austin Schley, for their contributions to this article.

Severity Under Scrutiny: The U.S. Supreme Court Battle Over the FBAR Penalty

Abstract In recent years, Congress strengthened federal regulation of foreign bank accounts held by United States citizens. In 1970, Congress passed the Bank Secrecy Act (BSA), requiring U.S. citizens to report their foreign bank accounts using a form called the Foreign Bank Account Report, or “FBAR.” However, the Treasury Department rarely enforced this requirement. After the Patriot Act’s passage came the Bank Secrecy Act 2004 amendment, allowing the Treasury Department to delegate enforcement of U.S. foreign bank account reporting to the Internal Revenue Service (IRS) through the FBAR. The amendment’s major change to the law concerned new penalties for non-willful FBAR non-compliance. The language of the amendment created ambiguity concerning how the IRS should penalize taxpayers whose non-compliance was not willful. The BSA language failed to specify whether the failure to report penalties should be calculated per account or per unreported FBAR form. The United States government argued for the calculation of penalties to be per account, and those faced with the penalties argued the calculation should be done per form. The Ninth and Fifth U.S. Circuit Courts of Appeal differed on this issue, with the Ninth Circuit ruling in favor of per form and the Fifth Circuit ruling in favor of per account. The Supreme Court ultimately granted certiorari of the case from the Fifth Circuit and ruled in favor of per form. This article examines: (1) the history of U.S. taxpayer foreign bank account reporting requirements; (2) the changes to reporting requirements over the years; (3) the decision on what penalties the IRS could impose passed down by both the U.S. Ninth and Fifth Circuit Court of Appeals; (4) the Ninth and Fifth Circuits’ arguments regarding per form versus per account; (5) an overview of the Supreme Court’s decision in Bittner v. United States; and (6) the future effects of the Supreme Court’s decision.

I.          Introduction

Many United States citizens hold interests in financial accounts in foreign countries, but up until recently many of those account holders preferred not to disclose those holdings.[3] In fact, this has been a major source of frustration for the U.S. Treasury Department.[4] However, no one in the Treasury Department is more frustrated than the department tasked with enforcing the regulation, the IRS.[5] When Congress passed the BSA in 1970, they thought they solved this problem.[6] The BSA required U.S. taxpayers to report their foreign financial accounts using the FBAR.[7] The BSA also required taxpayers to keep records of their foreign accounts.^[8] Willful failure to comply could lead to both civil and criminal penalties.^[9] Most taxpayers knew of, but rarely complied with, this requirement through the early 2000s.[10] All that was about to change.[11] In 2004, Congress amended the BSA to include new penalties for non-willful violations and increased penalties for willful violations.^[12] Before this amendment, there had been no penalties for non-willful non-compliance.[13] After the amendment’s passage, the Treasury Department tasked the IRS with enforcing these regulations, including the new requirement from the amendment.[14] Since then, IRS efforts to penalize non-willful FBAR noncompliance have come under judicial review in at least two U.S. circuit courts.^[15] Both cases centered around whether the IRS could assess its annual penalty for non-willful violations (1) per bank account the taxpayer failed to report or (2) per FBAR form not properly filed.^[16] Imposing penalties per account can produce very large aggregate penalties.[17] Penalized taxpayers argue that penalties thus imposed can quickly become excessive.^[18] However, the IRS argues that the statute requires the reporting of each foreign bank account and, therefore, imposing penalties per FBAR is far too narrow an interpretation.^[19] Such a narrow reading of the statute would—in the eyes of the IRS—reduce compliance penalties to the point of defeating Congress’s intention to deter tax evasion and fraud.[20] The Ninth Circuit held with the taxpayer, ruling in favor of a per-form penalty.[21] However, the Fifth Circuit later held with the IRS, ruling in favor of per-account penalties.[22] The United States Supreme Court ultimately agreed with the Ninth Circuit and ruled in favor of a per-form penalty.^[23] Part I of this article provides the history of the FBAR filing requirement and the statute authorizing the requirement. Part II explains current FBAR statutory regulations and details the filing requirements more specifically. Part III discusses the analysis behind the Ninth Circuit’s ruling that the IRS can only penalize non-willful noncompliance on a per-FBAR basis. Part IV discusses the Fifth Circuit’s disagreement with the Ninth Circuit, the reasoning behind its holding, and its subsequent ruling, which favored per-account penalties as the correct interpretation of 31 U.S.C. § 5314. Part V explains the arguments behind the Fifth Circuit and Ninth Circuits’ arguments regarding per form versus per account. Part VI outlines the Supreme Court’s decision in Bittner v. United States and the implications of the Court’s decision going forward.

II.         The History of the BSA of 1970 and Its FBAR Reporting Requirements

A.  The Inception and Intent of the BSA of 1970

The BSA of 1970—codified in Title 31 (Money and Finance) of the U.S. Code—contains the statutory language establishing the filing requirement that U.S. citizens must report their foreign bank accounts and financial interests.^[24] With the BSA of 1970, Congress sought to require taxpayers to file disclosure reports and retain financial records that might later help the Treasury Department successfully prosecute criminal, tax, and regulatory investigations.[25] These reports are included as part of the FBAR.[26] The BSA, as codified in 31 U.S.C. § 5314, provides, in pertinent part: [T]he Secretary of the Treasury shall require a resident or citizen of the United States or a person in, and doing business in, the United States, to keep records, file reports, or keep records and file reports, when the resident, citizen, or person makes a transaction or maintains a relation for any person with a foreign financial agency.^[27] Essentially, § 5314 creates two requirements: (1) filing an annual report detailing each foreign bank account and financial interest held by U.S. citizens,[28] and (2) retaining those financial account records for five years.[29] Each requirement brings its own mandates. The first reads, in pertinent part: Each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship . . . for each year . . . and shall provide such information as shall be specified in a reporting form . . . to be filed by such persons.^[30] While the requirement to retain records reads, in pertinent part: Records of accounts . . . shall be retained by each person having a financial interest in or signature or other authority over any such account. Such records shall contain the name in which each such account is maintained, the number . . . of such account, the name and address of the foreign bank . . . with whom such account is maintained, the type of such account, and the maximum value of each such account during the reporting period. Such records shall be retained for a period of 5 years . . . .^[31] 31 CFR § 1010.306(c) says: “Reports required to be filed by § 1010.350 shall be filed . . . on or before June 30 of each calendar year with respect to foreign financial accounts exceeding $10,000 maintained during the previous calendar year.”[32] Thus, according to the above statute and regulations, a person must file an FBAR if the person is a U.S. person with any financial interest in—or signature or other authority over—any financial accounts located outside the United States with an aggregate value exceeding $10,000 at any time during any calendar year.^[33] U.S. citizens who willfully fail to comply with the FBAR filing requirement could face steep penalties.[34] However, proving willfulness in court has historically been difficult[35] and thus has limited the ability of the IRS to enforce these penalties.[36] As the U.S. Supreme Court noted in Cheek v. United States, the government must overcome a high evidentiary standard to prove willfulness.^[37] It requires proving (1) “the law imposed a duty on the [taxpayer],” (2) “the [taxpayer] knew of this duty,” and (3) the taxpayer “voluntarily and intentionally violated that duty.”[38] Carrying this burden requires defeating any claim of ignorance, misunderstanding of the law, or “a good-faith belief that [the taxpayer] was not violating any of the provisions of the tax laws.”^[39] If the IRS can prove willfulness, increased legal penalties become available.[40] In the case of willful transactional violations, the maximum penalty is the greater of $100,000 or fifty percent of the amount of the transaction (not to exceed $100,000).[41] Similarly, when a taxpayer willfully “fail[s] to report the existence of an account or any [of the] identifying information required,” the maximum penalty is the greater of $100,000 or fifty percent of “the balance in the account at the time of the violation.”[42] In summary, if the IRS can establish willful noncompliance with § 5314, the penalty could range from $100,000 to fifty percent of a theoretically unlimited amount.^[43] While the BSA codified these provisions, the IRS rarely enforced them.[44] There were numerous reasons for the lack of enforcement.[45] “First, the government found it difficult to gather sufficient admissible evidence of undisclosed foreign financial accounts.”[46] Taxpayers hiding money overseas often put their money in financial “institutions located in countries with [very] strong [bank] secrecy laws and no tax treaty with the United States.”[47] This creates a thoroughly difficult discovery process.[48] Second, even if a foreign country has “a mutual legal assistance arrangement in place with the United States,” obtaining the right information is a “cumbersome, time-consuming process.”^[49] Third, the target taxpayers who avoid filing FBARs often commit other violations, such as “money laundering, tax evasion, and fraud.”[50] Prosecutors often bring these other charges rather than FBAR violations in court.[51] In many cases, prosecutors could charge taxpayers with both fraud and failing to file an FBAR, but only pursue a fraud charge because it is easier to prove in court.[52] Prosecutors find it too difficult to meet the evidentiary standard established in Cheek.[53] Simply put, proving a taxpayer acted “willfully” in not filing an FBAR is incredibly difficult, so prosecutors often do not prosecute FBAR violations.[54] Therefore, the Treasury Department estimated FBAR compliance at less than twenty percent before the 2004 changes.^[55] Between 1993 and 2002, the U.S. government only considered imposing monetary penalties in twelve cases.^[56] Of this dozen, only two taxpayers received penalties.^[57]

B.   The 2004 Amendment and Its Impact on BSA and FBAR Enforcement

After the terrorist attacks of September 11, 2001 and the subsequent passage of the Patriot Act, everything changed.[58] The U.S. government expanded its powers in every direction and decided to address the deficiencies in the Executive Branch’s enforcement abilities.[59] With this expansion of powers came the ability to enforce FBAR violations.[60] First, in April 2003, the U.S. Treasury Department Financial Crimes Enforcement Network (FinCEN) delegated enforcement of civil violations (such as failing to properly file an FBAR) to the IRS.^[61] Then, on October 22, 2004, Congress passed the American Jobs Creation Act of 2004 (Jobs Act).^[62] Under the Jobs Act, the Treasury Secretary (and the IRS) may impose a civil penalty on any person who violates § 5314.^[63] As discussed, this violation encompasses both failures to file an FBAR properly and failures to retain all of the necessary records concerning those foreign financial accounts.[64] In the case of non-willful violations, the IRS may now impose a maximum penalty of $10,000 per violation.^[65] However, the IRS cannot impose such a penalty if both of the following conditions are met: (1) the “violation was due to reasonable cause”; and (2) “the amount of the transaction or the balance in the account at the time of the transaction was properly reported.”^[66] The new law also allows for a higher maximum penalty for willfulness.[67] For willful violations, the IRS could now impose a penalty of $100,000 or fifty percent of the transaction amount, whichever is greater.^[68] In situations “involving a failure to report the existence of an account” or any required account information, the IRS may assess a penalty of $100,000 or 50% of the account balance when the violation occurred, whichever is greater.^[69] The 2004 amendment made three changes.[70] First, it added a new penalty for cases involving non-willful violations of 31 U.S.C. § 5314.^[71] Second, it changed the burden of proof in certain situations.[72] Previously, the IRS needed to demonstrate the violator’s willfulness.[73] Under the new law, the IRS could assess a penalty anytime a taxpayer failed to properly file an FBAR or maintain the required records.^[74] Third, the amendment increased the maximum assessable penalty for willful violations.[75] The previous penalty ranged from $25,000 to $100,000, depending upon the transaction amount or the account balance.[76] Now, the lower limit of the penalty range has increased to $75,000 per violation, and the range has no monetary ceiling—just a cap of half the account balance ^[77] The amendment made failing to file an FBAR a serious offense with major financial consequences for taxpayers holding large sums of money in undisclosed foreign financial accounts.[78] Congress’s intent is clear: “taxpayers must disclose, disclose, disclose, or suffer the consequences.”^[79]

III.       Ninth Circuit Interpretation of the IRS Ability to Assess Penalties

A.  United States v. Boyd

On September 1, 2020, the U.S. Ninth Circuit Court of Appeals heard United States v. Boyd.^[80] Jane Boyd, an American citizen, held financial interests in fourteen accounts in the United Kingdom.[81] After her father died in 2009, she deposited her inheritance into those various accounts, increasing the balances significantly.[82] Boyd then received interest and dividend income from those accounts but did not report the income on her 2010 return, file the required 2010 FBAR, or disclose the accounts to the IRS.[83] In 2012, she disclosed her income from those accounts and filed an accurate FBAR for each of the years and accounts the IRS required her to report.[84] The filed FBAR for 2010 listed fourteen foreign accounts, with a total balance exceeding $10,000.[85] The IRS concluded Boyd committed thirteen non-willful violations of the reporting requirement under 31 U.S.C. § 5314, and assessed one violation per account she failed to timely disclose for 2010.^[86] The issue in Boyd was whether the IRS should assess non-willful violations of 31 U.S.C. § 5314 per FBAR (i.e., per noncompliant year) or per undisclosed account on the incorrectly filed FBAR.[87] In this instance, the IRS counted the violations per account the taxpayer failed to disclose for that particular year.[88] The taxpayer argued the IRS should asses the penalties only per FBAR, so she would only be noncompliant for filing the 2010 FBAR untimely.[89] Although she accurately completed the form, she filed it late.[90] The Ninth Circuit ultimately held that the IRS could not count violations per undisclosed account.[91] Instead, the Court held that the IRS could only penalize the taxpayer per FBAR improperly or untimely filed for each year, and not per account the taxpayer failed to properly disclose.^[92]

B.   Parties’ Arguments of Per Account v. Per Form and the Ninth Circuit’s Analysis

Boyd argued that the statutory language of 31 U.S.C. § 5314 did not support a separate penalty for each account on the 2010 FBAR she filed untimely.[93] Rather, Boyd argued that the statutory language provides that a non-willful, untimely, but accurate FBAR constitutes a single violation subject to the maximum penalty of $10,000.[94] As such, Boyd asserted the IRS’s $47,279 penalty was incorrect and the IRS should have assessed a $10,000 penalty.[95] The government disagreed, arguing that a single late but accurate FBAR may generate multiple non-willful violations since the 31 U.S.C. § 5314 reporting requirements extend to each foreign account.[96] In the government’s view, Boyd’s interpretation of the 31 U.S.C. § 5314 amendment is incompatible with the original statute’s language.[97] Even in relation to the penalties for non-willful violations, the language addresses the specific accounts held, and not simply the filing of the FBAR.^[98] The court opined that while the language of the penalties for willful violations is clear, the language used for penalties of non-willful violations is vague.[99] The language in 31 U.S.C. § 5321(a)(5)(A) provides for the assessment of a monetary penalty on any person “who violates, or causes any violation of[,] any provision of section 5314.”^[100] The court contends that “Congress did not define ‘provision.’”[101] The court thereby interpreted “provision” as meaning the regulatory mechanisms by which § 5314 would be enforced.[102] The language says that a U.S. citizen with foreign financial accounts must report them to the IRS and maintain records. The mechanism for doing so is the FBAR, which discloses these accounts; without the FBAR, there is no way for the taxpayer to comply with the statute.[103] The court then reviewed the nature of Boyd’s violation.[104] Though she had failed to disclose her foreign financial accounts in a timely manner, she did disclose them, and her FBAR was accurate.[105] The court stated that Boyd did not violate 31 C.F.R. § 1010.350(a), the regulation that delineates the content of the report (FBAR).[106] Though she was not timely in filing her 2010 FBAR, the FBAR and its contents were accurate.[107] The court thereby disagreed that she had committed multiple non-willful violations of § 5314, simply because she failed to file the 2010 FBAR in a timely manner.^[108] The government then argued that the word “any” before “violation” in § 5321(a)(5)(A) indicates that several violations may occur.[109] The court was unpersuaded, and again referred to the provision prescribing the FBAR as the mechanism for enforcing § 5314.[110] The court found that since the statute cannot be enforced without filing the FBAR, the violation the taxpayer committed was the failure to use the mechanism to comply with § 5314.[111] The new penalty provision in § 5321(a)(5)(B)(i) does not expressly authorize multiple non-willful violations, while the willful violation language is very clear.[112] The court therefore held that if non-willful violations were meant to be enforced in the same manner as willful violations, then the language authorizing that would be plainly stated, as it was for willful violations.[113] The court stated, “Congress generally acts intentionally when it uses particular language in one section of a statute but omits it in another.”^[114] Therefore, the court “presume[d] that Congress purposely excluded [any] per-account language from the non-willful penalty provision” while keeping per-account language in the willful violation section of § 5314.[115] Based upon that presumption, the court further presumed that Congress acted intentionally in omitting that language.[116] Therefore, the IRS did not follow the statutory intent of Congress when it penalized Boyd per account.[117] As the court said, “[w]e decline to read into the statute language that Congress wrote in the willful penalty provision but omitted from the non-willful penalty provision.”^[118]

C.   The Dissent

Of the Ninth Circuit panel’s three judges, two judges held in favor of Boyd and one judge dissented.[119] The dissent argued that the creators of the Bank Secrecy Act and 31 U.S.C. § 5314 intended to combat the “widespread use of foreign financial institutions . . . [to violate or evade] domestic criminal, tax, and regulatory enactments.”^[120] The dissent went on to state that IRS penalties are an extremely effective enforcement tool, and that the majority’s interpretation of the statute narrows the scope to the point of limiting the statute’s ability to deter these criminal acts.[121] The dissenting judge opined that the clearest interpretation of 31 U.S.C. § 5314 was that a non-willful violation could be penalized per account, and declared “[the majority’s] interpretation is contrary to the language of the relevant statutes and regulations as well as being implausible in context . . . .”^[122] The dissent believed the court should consider the source of the penalties to be the language of 31 U.S.C. § 5314, as opposed to the provision which created the mechanism for enforcing it.[123] The statute clearly states that it addresses U.S. taxpayers hiding foreign financial accounts, not violating the reporting requirement.[124] Since penalties arise from the government’s interest in the accounts rather than the mechanism for reporting them, the statute should take precedence over the provision.[125] As such, the IRS should assess penalties per account instead of per form.[126] The dissent also disagreed on the relevance of whether a violation is willful or non-willful.[127] Regardless, the violation is the same: the failure to report a single account or a single transaction.^[128] As the court noted, “the applicable statute and regulations make clear that any failure to report a foreign account is an independent violation, subject to independent penalties.”^[129] In the dissent’s view, the majority conflates the reporting form (the FBAR) with the contents that are required to be reported (the foreign bank accounts themselves).^[130]

IV.       Fifth Circuit Interpretation

A.  United States v. Bittner

On November 30, 2021, the Fifth Circuit Court of Appeals decided United States v. Bittner.^[131] Bittner, a Romanian-American dual citizen, moved back to Romania in 1990 and lived there until 2011 after living in the United States for eight years.[132] He never renounced his American citizenship.[133] While living in Romania, Mr. Bittner generated considerable income and opened numerous foreign bank accounts.[134] His investment ventures revealed him to be a sophisticated businessman.[135] In addition, the district court highlighted that “Mr. Bittner demonstrated at least some level of awareness about his tax obligations as a United States citizen, as he filed United States income tax returns for 1991, 1997, 1998, 1999, and 2000” despite living in Romania during those years.[136] The government assessed $2.72 million in civil penalties against him—$10,000 for each of the 272 bank accounts he had failed to disclose for all the years he had not filed an FBAR.^[137] However, Bittner did not return to the United States until 2011.[138] Upon learning of his § 5314 obligations, he hired a CPA, who then filed his FBARs for the years 2007–2011.[139] Bittner, at first, argued in court for a reasonable-cause defense.[140] The BSA imposes no penalty for a non-willful violation of § 5314 if the violation results from reasonable cause and the individual filed the FBAR accurately.^[141] However, the court rejected his reasonable-cause defense, as Bittner was a sophisticated businessman with businesses all over the world.[142] He even admitted he did not see a reason to file an FBAR while he was living in Romania.[143] That admission confirmed his awareness of the FBAR requirement and directly refuted any possible claim of reasonable cause.[144] The court saw through this argument, rejected his reasoning, and affirmed that it was unreasonable for Bittner to claim he had reasonable cause for not filing his FBARs for the five years in question.^[145] After rejecting his reasonable-cause defense, the issue became whether the IRS should penalize non-willful violations of § 5314 on a per account or per FBAR basis.[146]

B.   The Fifth Circuit’s Reasoning and Analysis in Bittner

Just as in the Ninth Circuit case, the Fifth Circuit debated which portion of § 5314 should take precedence when applying penalties.[147] In this case, the Fifth Circuit held that the IRS could penalize per account, rejecting the Ninth Circuit’s per form interpretation.[148] The Fifth Circuit instead agreed with the Ninth Circuit's dissenting judge and held that each failure to report a qualifying foreign account constitutes a separate reporting violation subject to its own penalty.[149] The court began its proceeding by looking at the statutory text of § 5314.[150] The court used a stricter interpretation, opining that “[i]nterpretation of a word or phrase depends upon reading the whole statutory text, considering the purpose and context of the statute, and consulting any precedents or authorities that inform the analysis.”^[151] In court, the Department of Justice argued against the Ninth Circuit’s position, disputing that the regulations take precedence over the statutory language of 31 U.S.C. § 5314.[152] The Fifth Circuit agreed, finding the per-form interpretation inconsistent with the text of the BSA and its regulations.^[153] Because § 5321(a)(5)(A) penalizes a violation of any provision of § 5314, the court analyzed application of the penalty.[154] The Fifth Circuit once more affirmed that the language of the statute should take precedence by stating, “Congress generally acts intentionally when it uses particular language in one section of a statute but omits it in another.”^[155] The filing of reports only comes after one has foreign financial accounts exceeding $10,000.[156] The Fifth Circuit opined, “The regulations themselves distinguish (1) the substantive obligation to file reports disclosing each account from (2) the procedural obligation to file the appropriate reporting form.”^[157] It continued, “The regulations thus consistently implement the distinction between the reports themselves (substance) and the reporting forms (procedure).”[158] The Fifth Circuit went further in clarifying its argument that the statutory provisions of § 5314, rather than its corresponding regulations, are the source of penalties.[159] “The district court reasoned that a violation of section 5314 attach[es] directly to the obligation that the statute creates”, which is the filing of a single report.[160] The Fifth Circuit disagreed, stating that 31 U.S.C. § 5314 “does not create the obligation to file ‘a single report.’”[161] “Rather, it gives the Secretary discretion to” determine how best “to fulfill the statute’s requirement of reporting [all] qualifying accounts.”^[162] By the Fifth Circuit’s logic, the U.S. government could replace the FBAR entirely with another instrument.[163] The statute requiring U.S. citizens to disclose foreign accounts held overseas remains intact, regardless of what method or form the IRS determines best fulfills the statute’s intended purpose.[164]

C.   Bittner’s Arguments Addressed on Appeal

The Fifth Circuit affirmed that Bittner’s reasonable-cause defense lacked merit.[165] Bittner argued that a per-account reading would lead to exorbitant fees, which would be an absurd result.[166] The Fifth Circuit disagreed.[167] The court again pointed to Congress’s original intent: for the U.S. government to fight the use of foreign financial accounts as a means to evade taxes and hide wealth.[168] The court affirmed “[i]t is not absurd—it is instead quite reasonable—to suppose that Congress would penalize each failure to report each foreign account.”[169] Finally, “[a]s a last resort, Bittner turn[ed] to legislative history,” which, according to the court, is “highly disfavored in the Fifth Circuit.”^[170] The court concluded: The text, structure, history, and purpose of the relevant statutory and regulatory provisions show that the “violation” of section 5314 contemplated by section 5321(a)(5)(A) is the failure to report a qualifying account, not the failure to file an FBAR. The $10,000 penalty cap therefore applies on a per-account, not a per-form, basis.^[171]

V.        The Fifth and Ninth Circuits’ Arguments to the Supreme Court

While the Fifth Circuit favored per account and the Ninth Circuit favored per FBAR, both circuits raised important reasons for siding with its preferred method.[172] Understanding the arguments for per FBAR versus per account will clarify how the Supreme Court arrived at its decision.[173]

A.  The Argument for Punishment Per FBAR and Deference to Provision

The central question in Bittner is how a non-willful violation of 31 U.S.C. § 5314 should be penalized.[174] Failure to disclose foreign financial accounts may result in a non-willful violation of 31 U.S. § 5314, for which willfulness is not required.^[175] To prove willfulness, the government must show the defendant committed a “voluntary, intentional violation of a known legal duty” beyond mere ignorance.[176] That is likely why Congress amended the BSA and expanded its enforcement powers.[177] A taxpayer who commits a non-willful violation can still be penalized, even if they claim ignorance.[178] The penalties for willful violations are far greater than for non-willful violations, so Congress likely did not decide to replace one word with another when the punishment is the same.[179] Presumably, Congress intended to make a distinction between willful and non-willful violations. However, the penalties for willfully violating § 5314 are clearly spelled out, and taxpayers can be penalized per account.[180] That is presumably why the Ninth Circuit held that if Congress intended for non-willful violations to be penalized in the same manner, the amendment would state as much.[181] Since it did not, the Ninth Circuit seemingly inferred that the penalty must be different.[182] The only determinable difference would be if the non-willful violators were penalized per FBAR rather than per account, as willful violations would be.[183] Punishment per account would make non-willful violations no different from willful violations, which the Ninth Circuit found to be contrary to Congress’s intent.[184] One also must consider the mechanism of action. In both the Fifth and Ninth Circuit cases, the defendants disclosed their foreign financial accounts to the IRS.[185] While they filed the FBAR late, they still provided an accurate assessment of their foreign accounts.^[186] Non-willful violators are presumably not often tax evaders, terrorists, or money launderers, as these individuals do not intend to break the law.[187] The purpose of non-willful disclosures is to promote unwilling compliance through required disclosure.[188] Criminals, terrorists, and tax evaders likely have no interest in complying.[189] Since willful and non-willful violators are viewed differently, one can infer that their penalties should be viewed as separate and based upon a different standard.[190] It may make more sense to penalize willful violators per account because they are willfully defying 31 U.S.C. § 5314.[191] Non-willful violators ultimately comply  through disclosure; therefore, it is just a matter of when compliance occurs, as in Boyd and Bittner.[192] While non-willful violators have accounts subject to the § 5314 filing requirements, they have limited interactions with actual regulations because of the requirement to file their annual FBAR.[193] Non-willful violators need not fear IRS investigation, as they are generally not tax evaders, terrorists, or money launderers, for whom the law was presumably intended to deter.[194]

B.   Argument for Per Account Penalties and the Expansion of Executive Power

The Fifth Circuit disagreed with the Ninth Circuit’s reasoning, holding that U.S.C. § 5321(a)(5) is the origination of the penalties for both willful and non-willful violators.[195] If Congress intended willful and non-willful violators to have different penalty standards, Congress would have stated as much.[196] Since Congress did not, the Fifth Circuit followed precedent and used the statute as the basis for the penalties.[197] If holding foreign financial accounts are the basis of the statute’s regulatory power, then any penalty should be based on the holding of undisclosed foreign financial accounts rather than the single FBAR.[198] To interpret the statute to mean that the single FBAR determines the penalties, and not the holding of undisclosed foreign financial accounts is to read the statute too narrowly.[199] When Congress amended the BSA in 2004, its focus was broad, not narrow.[200] Congress added the non-willful violation and expanded the enforcement powers of the IRS, specifically to reach individuals taking advantage of the difficulty in proving willfulness in court.[201] Before this, the IRS tried enforcing the regulation with one proverbial hand tied behind its back.[202] Now, it possessed the tools to do its job.[203] There is a serious and contentious debate over the congressional intent behind the language used in the 2004 amendment.[204] Those on the side of the provisions say that if Congress intended non-willful violations to be punished the same way as willful violations, the statute would state so clearly.[205] Those with this position grapple with the fact that Congress likely added the non-willful violation language to expand the Executive Branch’s enforcement powers and tools.[206] As the Fifth Circuit opined, “[t]he government argues the district court erred in determining what constitutes a ‘violation’ under [§] 5314 by focusing on the regulations under [§] 5314 to the exclusion of [§] 5314 itself. We agree.”^[207] This goes straight to the core of the penalty per account argument.[208] The per FBAR penalty circumvents § 5314 itself, essentially rendering it toothless. The sole purpose of the penalty per account interpretation could then be attributed to the FBAR itself and its filing as opposed to the foreign financial accounts disclosed through the FBAR.[209] To penalize per FBAR is to exclude § 5314 altogether and assume the regulation stemming from it is a self-standing statute, instead of a regulation deriving its power from § 5314.[210] As the Fifth Circuit further enumerated, “A per-form interpretation is inconsistent with the text of the BSA and corresponding regulations.[211] Here, the Court rejected the “contention that [a] single statement by the Supreme Court, taken out of context, should be used . . . to reject the clear and express provisions of the [statute].”^[212]

VI.       The Supreme Court’s Decision of Bittner and Future Implications

On February 28, 2023, the Supreme Court released the decision to answer the contentious issue over whether non-willful violators are penalized on a per account or per FBAR basis.[213] In a 5-4 decision, the Court held for per FBAR.[214] The slight majority used the tools of plain language, administrative guidance documents, the history of the BSA, and the rule of lenity.[215] However, the dissenters argued for per account using plain language and alluding briefly to the administrative documents but avoided any discussion over the history of the BSA and the rule of lenity.[216]

A.  Majority Decision

The majority looked at four factors: (1) the plain language of §§ 5314 and 5321; (2) the government’s handling of the BSA to the public; (3) the history of the non-willful provision and the BSA’s purpose; and (4) the rule of lenity.[217] While most of the Court agreed with these principles, Justice Gorsuch and Jackson were the only justices to join the rule of lenity portion of the opinion.[218]

1.                   Plain Language of §§ 5314 and 5321

Beginning with the language of §§ 5314 and 5321, the Court kept it plain and simple.[219] The word “reports” appears in § 5314, not “accounts.”[220] There is not a single mention of “accounts” until § 5321(B)(ii) under the reasonable cause exception within the non-willful provision.[221] The lack of the word “accounts” and inclusion of “reports” demonstrates that a § 5314 violation is binary, dependent on the filing of a report.[222] The information regarding the accounts is irrelevant for purposes of violating § 5314 under its filing requirement.[223] Therefore, a taxpayer is a violator for failing to file a report, not incorrectly reporting information over an account.[224] Whether a taxpayer makes a mistake on the account information or does not file willfully or non-willfully is not a determining factor.[225] The only consideration under § 5314 for the filing requirement is the FBAR filing.[226] The majority furthered this argument by noting that § 5321 lays out the potential types of violators for incompliance with § 5314—the non-willful and willful violators.[227] Before discussing the types of violators, the Court pointed out how Congress in § 5321(a)(5) allows civil penalties for “any violation. . . of Section 5314.”[228] If “any violation” under § 5314 depends on “reports,” then the exact language of “any violation” under § 5321 would also depend on reports unless stated otherwise.[229] Further, the non-willful provision does not change the violations of § 5314 by tailoring penalties per account; however, the willful provision does tailor penalties per account.[230] Therefore, the non-willful provision would remain per FBAR as in § 5314, while the willful provision would change to per account.[231] However, the dissent harped on how the language of “accounts” is mentioned in the reasonable exception under the non-willful provision specifically to tailor penalties per account.[232] The majority rejected the dissent’s argument using “expressio unius est exclusio alterius.”[233] This common law principle echoes that Congress uses different and particular language in sections of the same statute “to convey a difference in meaning. . . .”[234] Notably, Congress did not use the word “accounts” in the same manner under non-willfulness as it did in the willful provision.[235] The willful provision looks to Subsection (D)(ii) to tailor penalties upon the amount dependent on the balance of the foreign “accounts.”[236] Under the non-willful provision, Congress uses “accounts” to demonstrate that giving accurate information will prove there was no intended deception, allowing taxpayers to use the reasonable cause exception.[237] Ultimately, the majority finds the language of these two statutes as plain in its similarities and differences, and thus the majority cannot ignore them.[238]

2.                   The Government’s Handling of the BSA to the Public

The majority then looked at how the Government has handled the enforcement of the BSA through its issuance of public documents.[239] While the majority admitted that these documents are not controlling in statutory interpretation, the Court could use the agency’s interpretation to find an undermining by its inconsistent application “with [an agency’s] earlier pronouncements.”[240] The Court looked at several public documents such as an IRS letter, IRS tax form, and issuance of notice from the Department of the Treasury.[241] Each document had language that signified to the public that failure to file an FBAR could lead to a penalty not exceeding $10,000.[242] The Court reasoned that the government’s now-interpretation of a per-account basis for failure to file an FBAR is incongruent with how they have previously handled the current penalties for non-willful violation.[243] Therefore, the government’s prior publication of non-willful violations demonstrated that there has always been a different penalty structure depending on the type of violator.[244]

3.                   History of the Non-willful Provision, the BSA’s Purpose, and Logical Implications

The majority then examined the history of the BSA’s willful provision, Congress’ statement of purpose, and several illustrations with implications for the BSA.[245] Congress adopted the BSA in 1970, but willful violations for failure to file FBARs were not per-account. Congress did not even implement per-account penalties until 1986 for the willful provision.[246] Yet, the non-willful provision did not manifest until 2004, which did not replicate the language of per-account penalties in the willful provision.[247] Since Congress already knew how to create a per-account penalty, Congress could have simply mirrored the same 1986 language for the non-willful provision.[248] Since Congress did not do so, the majority argued that Congress did so intentionally.[249] Additionally, the Court looked at Congress’ statement of purpose under 31 U.S.C. § 5311.[250] Congress declared “that the BSA’s ‘purpose’ is ‘to require’ certain ‘reports’ or ‘records’ that may assist the government in everything from criminal and tax to intelligence and counterintelligence investigations.’”[251] Since Congress’ purpose was filing the “reports,” § 5314 should be per FBAR as this would be congruent to the goal in § 5311.[252] Finally, the majority had several illustrations to denote that a per-account basis under the non-willful provision would hurt the BSA’s purpose due to illogical implications.[253] However, one of the examples seems to demonstrate the confusing consequences.[254] If one individual had 12 million dollars in one account and another individual had an aggregate of $10,001 over 12 accounts and both non-willfully violated by failing to file an FBAR, the individual with $12 million would be subject to a $10,000 fine.[255] In contrast, the individual with $10,001 would be subject to a potential $120,000 penalty.[256] Logic would seem to insinuate that Congress would not attribute penalties in a fashion whereby the smaller taxpayer is paying exorbitantly more solely because of more accounts.[257] Therefore, Congress’ purpose of the BSA on “reports” would only be furthered per FBAR to avoid illogical penalties.[258]

4.                   Rule of Lenity

Finally, Justice Gorsuch, joined by only Justice Jackson in the majority, agreed to use the rule of lenity, which justices use to construe a statute “imposing penalties . . . ‘strictly’ against the government and in favor of individuals.”[259] The Court gave two reasons for rejecting per account under the rule of lenity.[260] First, the rule of lenity protects taxpayers’ due process by giving them a fair warning with clarity to understand the law.[261] Second, the government’s ability to impose civil penalties in § 5321 and criminal penalties in § 5322 leads to higher scrutiny to ensure fair penalties for the taxpayer.[262] With the principle of fair notice, the Court discussed the public guidance documents.[263] The issued guidance demonstrated that non-willful violators would face penalties per FBAR.[264] However, professional tax accountants were confused and unaware of the FBAR penalties.[265] This confusion showed that an ordinary individual would not have received fair notice since professional accountants did not even understand the penalties from the public tax documents.[266] With § 5322, this Section handles criminal penalties and uses “violation” in the same manner as § 5321.[267] Therefore, the violations would be focused on filing reports unless stated otherwise.[268] With the criminal penalties under § 5322, the Court used the facts of Bittner to demonstrate the ramifications of a per-account basis creating impossible criminal penalties.[269] For each misstated or late-reported account rather than a late or deficient FBAR, this per-account basis would give rise to the “possibility of a $250,000 fine and five years in prison.”[270] In the facts of Bittner, which involved five reports and 272 accounts, that would mean that he would face “a $68 million fine and 1,360 years in prison rather than a $1.25 million fine and 25 years in prison.”[271] The Court opined that 25 years of prison alongside the $1.25 million fine would be more aligned with “common sense” in penalizing a non-willful violator.[272] Therefore, this type of reading of § 5322 would require an interpretation that follows the suit of § 5321 to favor the taxpayer and ensure common sense penalties.[273]

B.   The Dissenting Opinion

The four dissenting justices conclusively agreed that the plain language of § 5314 should lead any reader of the BSA that a per-account basis is also for non-willful violators.[274] The dissenters understood the requirements under § 5314 to attach to each account.[275] Section 5314 requires firstly filing when there is a “relation to” a foreign individual account, which means each separate account acts as a trigger to file an FBAR.[276] And if any particular account is missing, the taxpayer fails the reporting requirement because they missed a trigger for filing, which, in the eyes of the dissenters, is the sole concern of § 5314—the foreign accounts.[277] The dissent also looked at the second requirement for record-keeping under § 5314.[278] The dissenting justices noted that taxpayers can only record-keep per account because there are records for each account.[279] And if record keeping is per account, then the other requirement under § 5314 should follow suit.[280] Since the duties are parallel, each requirement begins once a “relation” exists to an individual foreign account.[281]

C.   The Effects of the Supreme Court’s Decision in Bittner

The implications of the Bittner decision are seemingly advantageous for non-willful violators but also lead to new questions. While there is an immediate answer for non-willful violators, there are questions regarding refunds for wrongfully penalized non-willful violators, the standard for willfulness, and the potential higher scrutiny from the IRS on FBAR filings.[282]

1.       The Immediate Effect and the Continued Issue of Per-Account

Immediately, non-willful violators of the BSA will solely be penalized on a per-FBAR basis regardless of the account number.[283] However, the government argued how the Treasury could turn the now-per-FBAR analysis for non-willful violators into a per-account basis.[284] The government noted how, theoretically, the Treasury could request that a taxpayer file an FBAR filing per bank account.[285] If an individual had ten accounts, the Treasury could make a new rule requiring ten FBAR filings.[286] This new rule would essentially be the Treasury disguising per account under per FBAR. While the Court side-stepped this potential issue, this interesting hypothetical opens the door for a potential per-account basis under the non-willful provision.[287] Additionally, there may be a potential argument for per FBAR in the willful provision due to its two-prong requirement where the first prong does not mention “accounts.”[288] Theoretically, taxpayers could argue the majority’s analysis to demonstrate that “accounts” was not mentioned to keep the per FBAR basis.[289] While the Supreme Court would presumably echo that Congress created per account specifically for the willful provision, there is still, nonetheless, an argument available.

2.       Refunds for Past Non-Willful Violators

Past non-willful violators who have already paid any amount exceeding the $10,000 penalty for the annual FBAR filing are left wondering if they will be refunded.[290] While the IRS may create a refund program, the IRS may not have the authority or be obligated to do so.[291] Yet, the answer remains likely a yes to refunds for two reasons. First, the Supreme Court has held that States have had to remedy incorrect tax impositions due to basic due process.[292] Second, the taxpayers may make claims under the Tucker Act of 1887.[293] In Harper v. Virginia Dep’t of Taxation, the Supreme Court held that when a State imposed an impermissible tax, “the Due Process Clause of the Fourteenth Amendment obligate[d] the State to provide meaningful backward-looking relief to rectify any unconstitutional deprivation.”[294] The States have discretion in handling the process for this remedy, but a remedy is required.[295] Similarly, the federal government would likely have to rectify this issue because the government imposed an impermissible tax.[296] With the Tucker Act, taxpayers who paid these excessive taxes may file a claim in the Court of Federal Claims, arguing that the government collected money illegally.[297] Unfortunately, this pathway of recovery would be barred unless the taxpayer made a claim within six years of accrual.[298] Therefore, non-violators making a claim under the Tucker Act before 2017 may have an issue with statutory limitations.[299] Ultimately, the handling of refunds remains an issue whereby the IRS has not given any sense of how they may handle these overpaid penalties. Time will tell how the IRS may address the potential problems with statutory of limitations and who may be entitled to a refund.

3.       Higher Scrutiny on “Willful” Violators

The IRS will have lost money due to the inability to penalize non-willful violators at more than $10,000 per FBAR compared to per account.[300] The IRS will seemingly become more stringent in finding willfulness in violators to recover some of the lost money. However, how will the IRS handle the standard for “willfulness”? The Federal Circuit has already found willfulness by failing to review one’s tax returns that would reveal the FBAR requirement.[301] Further, in Bedrosian v. United States Department of Treasury, the Third Circuit expanded willfulness where a taxpayer “ought to have known” or “was in a position to find out for certain very easily.”[302] How the IRS will judge willfulness will be an interesting aspect to focus upon going forward.

VII.      Conclusion

With the 2004 BSA Amendment, the Legislative Branch chose to expand the Executive Branch’s power to enforce compliance with 31 U.S.C. § 5314.[303] Before this change, the Secretary of Treasury estimated that less than 20% of U.S. citizens complied with § 5314.[304] Many U.S. citizens did not comply due to the government’s difficulty in proving willful non-compliance in court.[305] After the September 11, 2001 terrorist attacks, the Patriot Act gave the government a way to enforce § 5314 compliance.[306] They simply created a new kind of violator: the non-willful.[307] The non-willful violator is now compelled to reveal themself through their disclosures or face penalties.[308] However, Congress failed to clearly spell out penalties for the non-willful violator.[309] The statute could be interpreted to read that non-willful violations should be penalized according to the number of foreign accounts the non-willful violators hold or the number of FBARs that they fail to file; however, the latter potentially leads to serious and far-reaching consequences.[310] In Boyd, the Ninth Circuit decided upon the per FBAR interpretation of the debate.[311] The Court opined that the statute did not express penalties for non-willful violations, so if Congress intended to have the same penalty (per account) as willful violations, Congress would state such clearly.[312] They decided upon enforcement of the provision of § 5314, permitting penalties according to their failure to file the document maintaining compliance with the IRS rather than to the accounts you held that would make you a party to § 5314.[313] The Court’s narrow focus limited the ability of the IRS to execute its newfound power.[314] In United States v. Bittner, the Fifth Circuit held that the per account side of the argument should apply and struck down the reasoning in Boyd.[315] The Court used precedent to determine that the statute must take precedence over the statutory provision.[316] A provision cannot exist without first having a statute from which it arises.[317] A penalty should be determined by the statute from which it arises, as the statute is the point of origin in the matter at hand.[318] The provision, FBAR, is only a means of enforcing the statute.[319] The Fifth Circuit also clarified the intent of Congress.[320] Congress intended the 2004 BSA amendment to solve the problems preventing BSA enforcement.[321] Narrowing the focus of the new penalties subverts the Congressional intent of the amendment.[322] The Supreme Court decision in Bittner has ultimately clarified the ongoing disagreement between assessing penalties per account versus per FBAR.[323] Finally, the fate of non-willful penalties has been decided. The Supreme Court favored the per FBAR assessment of penalties. One would think that this decision would clear all problems for non-willful violators. Yet, new questions have arisen. The main question for past non-willful violators will be when they get refunds, if any. While past non-willful violators may not receive refunds soon, all non-willful violators will receive safety from a per-account basis.[324] [sc name="notes1569"][/sc]

Proposed Regs Could Cast a Wider Net for Microcaptive Scrutiny

by Chandra Wallace The microcaptive reportable transaction regulations proposed April 10 mean a whole new set of transactions are now listed transactions — considered abusive by the IRS and subject to challenge — tax advisers warn. The proposed regs ( REG-109309-22 ) designate two microcaptive transaction types as “listed transactions” and one as a “transaction of interest” — categories that require disclosures to the IRS Office of Tax Shelter Analysis. But the proposal defines transactions subject to its requirements to include transactions “substantially similar to” those described in the notice. Transactions structured to get around a prior version of disclosure obligations for microcaptives — the now-obsolete Notice 2016-66 , 2016-47 IRB 745 — may fall within the scope of these proposed regs if the IRS considers them substantially similar to those described in the regs, according to David J. Slenn of Akerman LLP. “Now that this is a listed transaction, you’d better be really confident” that a transaction isn’t “wrapped up into the ‘substantially similar’ designation, because if it is, you’re going to be facing pretty stiff penalties,” Slenn said.

Sequencing New Regs

In prior years, Treasury and the IRS issued notices on reportable transactions under existing regulations at reg. section 1.6011-4(b)(2) through (b)(6), but those notices were challenged on procedural grounds, Slenn explained. Notably, Notice 2017-10 for syndicated conservation easement transactions and Notice 2016-66 for microcaptive transactions were both sidelined by court rulings that the government failed to comply with the formal notice and comment process mandated by the Administrative Procedure Act. The government put “those notices out there under those categories and thought that was okay — and obviously it wasn’t,” Slenn said. Slenn expects the IRS to continue adding to the regulations defining reportable transactions under section 6011 . The IRS is “now sequentially going, starting with dash 9 for conservation easements . . . dash 10 for listed [ microcaptive transactions], and dash 11 for” microcaptive transactions of interest, he said. In December 2022 Treasury and the IRS issued proposed reg. section 1.6011-9 defining and identifying syndicated conservation easements as listed transactions. The current proposed regulations add reg. section 1.6011-10 and reg. section 1.6011-11, setting out microcaptive transactions that the government now considers to be listed transactions and transactions of interest, respectively. “You can expect the same sequential process to occur for other transactions” the IRS considers to be abusive or potentially abusive, Slenn said. Issuance of proposed regs moves the IRS and Treasury away from fighting over the procedural validity of their scrutiny of microcaptives and into focusing on the substance of the transactions, according to David J. Warner of Holtz, Slavett & Drabkin APLC.

Loan Backs

One substantive characteristic of some microcaptive transactions that the government spotlighted for listed transaction treatment is the inclusion of a financing element. “IRS is clearly more concerned with microcaptive transactions involving financing like loans or other means of returning deducted premiums to related parties and, as such, has made these listed transactions that will be challenged by IRS,” Beckett G. Cantley of Cantley Dietrich told Tax Notes . “They’ve determined that you’re in the worst category automatically if you’ve made a loan back within the last five years,” Charles J. Lavelle of Dentons said. He noted that such loans are probably significantly less common than before Notice 2016-66 was issued, and that there have been cases in which microcaptive arrangements that included loans back to the insured company passed muster with the IRS. Cantley, who chairs the Captives Subcommittee of the American Bar Association Section of Taxation, noted that “the e^ect of the splitting of microcaptive transactions into listed transactions and transactions of interest generally sorts transactions into ‘bad guys’ and ‘maybe bad guys.’” Despite that sorting, Cantley expects microcaptive reporting “to be looked at with heavy skepticism inside IRS for both transaction categories.” The IRS “intends to challenge” the microcaptive listed transactions described in reg. section 1.6011-10 and “may challenge” the transactions of interest identified in reg. section 1.6011- 11, according to the proposed regs. The government “may also challenge the purported tax benefits from these transactions based on the economic substance, business purpose, or other rules or doctrines if applicable based on the facts of a particular case.”

Captive Insurance

Captive insurance arrangements depend on the intersection of two tax treatments. First, companies can generally claim tax deductions for the cost of insurance coverage premiums. Second, nonlife insurance companies that meet the criteria in section 831(b) can elect to pay an alternative tax based on their taxable investment income only — not including premium income received. The statute caps the amount of premium they can receive and still qualify to make the election at $2.2 million, indexed for inflation. In captive insurance arrangements, companies enter into insurance (or reinsurance) contracts with related entities that elect alternative tax treatment under section 831(b) . The related entity is referred to as a “captive” or “ microcaptive ” because it is at least partially owned by the company it is insuring, and the premium cap under section 831(b) means that the related entities are generally small companies. The insured company deducts its payments to the related entity as insurance premium — reducing its taxable income — but the related entity doesn’t include the payments it receives in its taxable income. And while some companies use the section 831(b) election as a tax benefit to reduce the cost of insurance, according to Treasury, others abuse the election to claim a tax benefit without any true insurance activity or purpose underlying the arrangement.

What Is Insurance?

This leaves regulators with the difficult task of parsing what a true insurance arrangement is for federal income tax purposes. Neither Congress nor Treasury has formulated a definition of insurance in this context, despite acknowledgement by IRS officials of the long-term problem. Courts look to whether the arrangements bear hallmarks of what people commonly consider to be insurance, whether there is an insurance risk, and whether there is a shifting or distribution of risk. But the case that defined that analysis, Helvering v. LeGierse , 312 U.S. 531 (1941), was decided more than 80 years ago.

Civil War II : The Constitutionality of California’s Travel Bans

Abstract

California, along with a few other states leaning toward the liberal side of America’s political system, enacted a series of laws banning state-funded or state-sponsored travel to other states identifying more as conservative. While other states enacted these mandates through gubernatorial executive orders, California legislated its ban. Multiple states have attempted Supreme Court challenges to California’s law under the Court’s Article III original jurisdiction. Yet, the Court twice declined the opportunity to hear the issue. Justice Thomas and Justice Alito wrote extensive dissents against the majority’s rejection, arguing that the Court must exercise its jurisdiction in controversies between the states. This Article analyzes the Court’s history of original jurisdiction cases and seeks to answer why the Court likely did not address the constitutionality of California’s laws. Further, this Article analyzes whether California’s statute is unconstitutional under Article I of the U.S. Constitution and the Dormant Commerce Clause. Finally, this Article concludes with an analysis of possible likely outcomes of California’s laws and other states’ reactions.

Introduction

“Two households, both alike in dignity . . . from ancient grudge break to new mutiny.” [1] Much like the Houses of Montague and Capulet, the individual states within the United States often find themselves diametrically opposed to each other’s political views. While America’s political divide has undeniably grown deeper over the years, it seems to be widening at a staggering pace recently. Of late, this higher level of political grudge appears in the form of California’s legislation banning state-funded or state-sponsored travel to twenty-two sister states. [2] At the forefront of this political showdown is Texas. California and Texas are not only America’s two most populous states, but they are also economic and political giants sitting on fundamentally opposite ends of the political spectrum. Sharing a history of fiery disagreements and political clashes, the two states are the exemplification of a country so dangerously divided it is almost reminiscent of a Shakespeare play. The scene opens with California, a Democrat exemplar, escalating historically political disagreements to the economic stage by prohibiting state-funded or state-sponsored travel to any state failing to meet California’s civil rights standards regarding sexual orientation, gender identity, or gender expression. [3] Unsurprisingly, the Republican stronghold of Texas is cast as the villain by California and thus made the top of California’s list of travel ban states. [4] The metaphorical stage is now set. If California were a nation, it would be one of many nations banning state-funded travel to countries with whom they have political hostilities. [5] The United States has similar bans for Venezuela, Cuba, and North Korea, just to name a few. [6] But California is not an independent nation. It is only a state, albeit an influential one, and its legislative lashings are setting an exceedingly dangerous precedent for the nation as a whole. The image of an America in which each state freely imposes state-funded travel bans to other states with whom they have political disagreements is a somber picture to imagine, and one that questions the textual meaning and purpose of a United States. With the days of both Texas’s and California’s independent nationhood long past, their legislative and ideological clash must be confined to the limits of the U.S. Constitution and federal law. However, when Texas challenged California’s bans in the U.S. Supreme Court, the motion for leave to file a bill of complaint was denied, despite the Court’s majority consisting of Republican justices. [7] This Article examines Supreme Court precedent in deciding cases under its original and exclusive jurisdiction of controversies between two or more states. [8] Additionally, this Article analyzes the possibility of the Court hearing such controversies under the Dormant Commerce Clause instead. [9] Ultimately, the question is not whether the Supreme Court can resolve this inter-state brawl, but whether it will choose to do so or instead let the people seek out their own resolutions. As of August 2022, California’s travel ban prohibits state-sponsored or state-funded travel to twenty-two states, effectively targeting roughly 44% of the nation. [10] Although the Texas challenge is the most recent, Arizona’s motion for leave to file a bill of complaint on this same issue was denied by the Supreme Court in February of 2020. [11] Justice Thomas and Justice Alito disagreed with the interpretations of the majority, which reads Article III’s “[i]n all Cases . . . in which a State shall be [a] Party, the supreme Court shall have original Jurisdiction” to mean that the Court may have original jurisdiction. [12] Justice Thomas explained that if the Court does not exercise jurisdiction over a controversy between two states, then the complaining state has no judicial forum in which to seek relief. [13] Yet, in five years of these issues being brought to the Court, Justice Thomas and Justice Alito have failed to persuade other Supreme Court Justices to hear these inter-state issues. Justice Thomas previously held a different opinion, but now “has since come to question” that opinion and believes the Court should accept Arizona’s and Texas’s invitation to reconsider its discretionary approach. [14] This Article will review the Court’s discretionary approaches, comparing Texas and Arizona’s precedent. If Article III is not enough for the Court to exercise jurisdiction, this Article explores the alternative of raising the issue through Article I’s Dormant Commerce Clause instead. The U.S. Constitution grants Congress the power to “regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” [15] Although the Commerce Clause only addresses the power given to Congress, the Supreme Court has long recognized that the Commerce Clause also limits states from enacting statutes affecting interstate commerce. [16] This limitation on state power is known as the Dormant Commerce Clause. The Clause’s purpose is to prevent a state from “retreating into economic isolation or jeopardizing the welfare of the Nation as a whole” by burdening the flow of commerce across state borders. [17] If any of the affected states were to bring challenges to California’s bans through the Dormant Commerce Clause, it could give the Court a window to hear cases in an area with which the Court has a history of frequent involvement. As author Levon Kalanjian warns, these unanswered issues may escalate to an economic civil war between the states. [18] However, it is likely that citizens and U.S. businesses in particular will be at the forefront of either convincing the Court to hear these issues or resolving them through alternative means, like legislation. This Article explores those possibilities as well.

I. Article III’s Discretionary Precedent

The Supreme Court’s discretion to hear cases is wide. Under 28 U.S.C.A. § 1254, the Supreme Court may review cases from a court of appeals by either granting a writ of certiorari to review a party’s petition in any civil or criminal case, or by certifying questions of law from the courts of appeals. [19] Not every petition is granted a writ of certiorari, and the Supreme Court can deny certifications for questions of law. Similarly, 28 U.S.C.A. § 1257 gives the Court the ability to review decisions from the highest court of any state. [20] Article III of the U.S. Constitution states that, “[i]n all Cases . . . in which a State shall be [a] Party, the Supreme Court shall have original Jurisdiction.” [21] The Court also has exclusive power to hear disputes between two states, which leaves no other court in the country to opine on cases brought between the states. [22] There are also protections in place against the Court exercising jurisdiction to hear a case when it should not. The Supreme Court is the only court in the country which can hear cases between California and the states on California’s travel ban list. Thus, the question becomes whether the Court has mandatory jurisdiction over cases when the Supreme Court has declined to do so. In America’s relatively brief existence, the Court has addressed this issue many times. However, as the Arizona and Texas cases demonstrate, there is still disagreement on the Court’s duty in these kinds of cases.

A. Cohens v. Virginia

In Cohens v. Virginia, [23] the parties, one of which was the State of Virginia, sought to have their claims heard by the Supreme Court, so they asked the Court to exercise its original jurisdiction instead of its appellate jurisdiction. The case placed a question of law before the Supreme Court, [24] arriving at the Supreme Court through a writ of error in which one party accused the lower courts of misinterpreting the U.S. Constitution. It was argued that in circumstances in which a case can be heard by the Court through either of the two methods, then the Court must exercise original jurisdiction to hear the case. [25] The Court extensively analyzed when it should or must hear a case brought under the Court’s original jurisdiction. Ultimately, the Court declined to exercise original jurisdiction. [26] Chief Justice Marshall, writing for the Court, stated, “It is most true that this Court will not take jurisdiction if it should not: but equally true, that it must take jurisdiction if it should.” [27] He opined that, unlike the legislature, the judiciary cannot, “avoid a measure because it approaches the confines of the Constitution.” [28] Chief Justice Marshall further stated that the Court “[w]ith whatever doubts, with whatever difficulties, a case may be attended” must still hear and decide the case. [29] He was adamant that the Court cannot avoid questions out of a simple preference not to address them. [30] However, Article III does not extend the judicial power to every violation of the Constitution which may possibly take place, only to a case in law or equity. [31] So with this language, it is puzzling when the Supreme Court turns away cases in law or equity in which it has original jurisdiction, as it did with Texas and Arizona. While quarrels between states are to be expected, these disputes often come at a cost to the American people. In Cohens, Chief Justice Marshall wrote that American people “believe[] a close and firm Union to be essential to their liberty and to their happiness” and are “taught by experience, that this Union cannot exist without a government for the whole.” [32] He opined that Americans are also taught that “this government [is] a mere shadow, that must disappoint all of their hopes, unless invested with large proportions of that sovereignty which belongs to independent States.” [33] In Cohens, the Court acknowledged that states have a degree of independence to enact their own laws, while still operating within the constitutional constraints designed to protect against abuse of power by any state. [34] The California travel ban may potentially be such an abuse of power. In many other instances, the Court had little restraint in deciding when states have stepped over the line, but the Court’s decision not to do so with the travel ban issue is noteworthy and yet not completely unfounded. However, Cohens primarily addressed the Court’s appellate jurisdiction. Other precedent is more enlightening on the Court’s decision not to take on the assignment to rule in the Texas and Arizona cases.

B. Louisiana v. Texas

Nearly a century after Cohens, the Supreme Court reluctantly decided to hear Louisiana v. Texas. The Governor of Louisiana asked the Court for leave to file a bill of complaint against the State of Texas, its Governor, and its Health Officer. [35] Louisiana was permitted to file the bill of complaint because the Court decided that it was the best course of action for the case. [36] Demurrer to the bill was sustained, and then subsequently dismissed. [37] The case concerned two lines of railroad, the Southern Pacific and the Texas & Pacific. [38] The railroads ran directly from New Orleans through Louisiana and Texas, and into other states and territories of the United States and Mexico. [39] The Texas Legislature enacted laws granting the Texas Governor and Health Officer extensive power “over the establishment and maintenance of quarantines against infectious or contagious diseases, with authority to make rules . . . for the detention of vessels, . . . and property coming into the state from places infected, or deemed to be infected, with such diseases.” [40] At the time, Texas was increasingly concerned about viruses, like yellow fever, spreading through the import of various goods from port cities, including New Orleans. [41] Yellow fever first appeared in the United States in the 1700s and rampaged through cities for nearly two hundred years, killing hundreds and sometimes thousands of people in a single summer. [42] The virus was especially devastating for Eastern seaports and Gulf Coast cities. [43] The cause of the spread was unknown and occurred in epidemic proportions. In August of 1899, “a case of yellow fever was officially declared to exist in the city of New Orleans.” [44] In response, Texas immediately placed an embargo on all interstate commerce between the City of New Orleans and Texas, consequently prohibiting “all common carriers entering the state of Texas from bringing into the state any freight or passengers, or even the mails of the United States coming from the City of New Orleans.” [45] Louisiana accused Texas of trying to destroy commerce from New Orleans, taking “away the trade of the merchants and business men of the city,” and transferring that trade to “rival business cities in the state of Texas.” [46] The question before the Court was whether the Texas law granting the Governor such extensive power over commerce constituted a controversy between the states. [47] The Court decided that a mere “maladministration” of the laws of a state, to the injury of the citizens of another state, does not constitute a controversy between states, and is therefore not justiciable in the Supreme Court. [48] Primarily, the Court looked to Article III of the U.S. Constitution to adjudicate the Louisiana case. Clauses 1 and 2 of Article II read as follows: The judicial power shall extend to all cases, in law and equity, arising under this Constitution, the laws of the United States, and treaties made, or which shall be made, under their authority; to all cases affecting ambassadors, other public ministers, and consuls; to all cases of admiralty and maritime jurisdiction; to controversies to which the United States shall be a party; to controversies between two or more states; between a state and citizens of another state; between citizens of different states; between citizens of the same state claiming lands under grants of different states; and between a state, or the citizens thereof, and foreign states, citizens, or subjects. In all cases affecting ambassadors, other public ministers, and consuls, and those in which a state shall be party, the Supreme Court shall have original jurisdiction. In all the other cases before mentioned, the Supreme Court shall have appellate jurisdiction, both as to law and fact, with such exceptions and under such regulations as the Congress shall make. [49] The Court interpreted the words “controversies between two or more states” to mean that “the Framers of the Constitution intended that they should include something more than controversies over territory or jurisdiction.” [50] In the Court’s words, Louisiana’s complaint did not plead enough facts to show that Texas had “authorized or confirmed the alleged action of her health officer as to make it her own, or from which it necessarily follows that the two states are in controversy within the meaning of the Constitution.” [51] In his concurrence, Justice Harlan noted that the Court has often declared that “the states have the power to protect the health of their people” through regulations. [52] Since Louisiana’s complaint was brought against not just Texas, but also the Health Officer and the Governor, the Supreme Court could not deem that this was a suit between two states, and dismissed Louisiana’s bill. [53] With this case, the Court began unveiling a pattern of preference in avoiding exercising its jurisdiction on issues between two states.

C. Massachusetts v. Missouri

Several decades later, the Supreme Court opined on an estate and tax related controversy between two states in Massachusetts v. Missouri. [54] Massachusetts filed a motion for leave to file the proposed bill of complaint against Missouri asking the Court for an adjudication concerning the right of the respective states to impose inheritance taxes on transfers of the same property. [55] The Supreme Court, predictably, denied the Massachusetts motion. [56] Unlike the Texas and Arizona cases, the Court provided insight into its decision in Massachusetts. The Court found that Massachusetts’s proposed bill of complaint did not present a justiciable controversy between the states: “To constitute such a controversy, it must appear that the complaining state suffered a wrong through the action of the other state, furnishing ground for judicial redress.” [57] Otherwise, it appear that the state is asserting a right against the other state which is susceptible to judicial enforcement. [58] Massachusetts’s prayer for relief was for the Supreme Court to determine which state had jurisdiction to impose inheritance taxes on transfers of property covered by trusts which were created by deceased residents of Massachusetts, including securities held by trustees in Missouri. [59] The Court held that Missouri did not harm Massachusetts by claiming a right to recover taxes from the trustees or in proceedings for collection of taxes. [60] When both states have individual claims, one of them exercising their rights should not impair the rights of the other. [61] The Court decided to deny the bill of the proposed complaint, reasoning that the claims could be litigated in state courts in either Massachusetts or Missouri and thus the Supreme Court did not need to exercise its original jurisdiction over the matter. [62] Article III Section 2 grants the Supreme Court original jurisdiction in cases where a “state is a party, . . . [meaning] those cases in which, . . . jurisdiction might be exercised in consequence of the character of the party.” [63] Here, the Supreme Court did not think that Missouri would close its courts to a civil action brought by Massachusetts to recover the alleged tax due from the trustees. [64] However, the Attorney General of Missouri argued against Massachusetts filing such an action in Missouri state courts or a Missouri federal district, saying that such a suit would present a justiciable case or controversy, therefore requiring adjudication from the Supreme Court instead. [65] The Court reasoned that any objections that the courts in one state will not entertain suit to recover taxes due to another state’s claim goes to the merits of the case, not the jurisdiction, and therefore raises a question district courts are competent to decide. [66] As a result, the Court avoided yet another instance in which it was asked to settle a question of law between two states.

D. Ohio v. Wyandotte Chemicals Corp.

The 1970s saw the continuation of many liberal movements that started in the 1960s. [67] For example, when Americans voiced a growing concern about the environment, the country legislated the National Environmental Policy Act, the Clean Air Act, and the Clean Water Act all within one decade. [68] With this national trend in the background, the State of Ohio moved for leave to file a bill of complaint seeking to invoke the Supreme Court’s original jurisdiction against citizens of other states regarding the pollution of Lake Erie from mercury dumping. [69] The Court denied the motion. [70] Although the Supreme Court has original and exclusive jurisdiction over suits between states, for suits between a state and citizens of another state, the Court is granted original jurisdiction but not exclusivity. [71] The Court stated that while Ohio’s complaint does state a cause of action falling within the compass of original jurisdiction, the Court nevertheless declined to exercise that jurisdiction. [72] The Court explained that it had jurisdiction and the complaint on its face revealed the existence of a genuine case or controversy between one state and citizens of another. [73] Previously, the Court declined to review similar cases if a party sought to embroil the tribunal in political questions. [74] Although the question in Wyandotte did not involve the political question doctrine and the Court could hear the case, the Court looked to policy rationales to deny Ohio’s motion. [75] The Court recognized that it is a “time-honored maxim of the Anglo-American common-law tradition that a court possessed of jurisdiction generally must exercise it.” [76] Yet, the Court was convinced of changes in the American legal system and American society, which make it untenable, as a practical matter, for the Court to adjudicate all or most legal disputes arising “between one State and a citizen or citizens of another even though the dispute may be one over which the Court does have original jurisdiction.” [77] Primarily, the Court noted that its responsibilities in the American legal system have evolved to bring “matters to a point where much would be sacrificed, and little gained by [the Court] exercising original jurisdiction over issues bottomed on local law” and not federal law. [78] The Court based its reasoning on an analysis of the Court’s structure and general functions. The Court explained that it is “structured to perform as an appellate tribunal” but is ill-equipped for fact-finding in original jurisdiction cases. [79] While it is true that the Court most commonly exercises its appellate powers, it is clear the Court is not structured for information-gathering in original jurisdiction cases. It has declined multiple opportunities to exercise original jurisdiction in cases like Wyandotte. The Court further clarified that its denial to hear the case was backed by more than just a lack of structural capability. Its decision was compounded by the fact that, for every case in which it might be called upon to determine the facts and apply unfamiliar legal norms, it would unavoidably reduce the attention the Court could give to matters of federal law and national import. [80] Stated in simpler words: the Court did not want to spend its time and judicial resources on such matters. Because the Court “found even the simplest sort of interstate pollution case an extremely awkward vehicle to manage” and the case was extraordinarily complex, the Court decided not to burden itself with the fact-finding required to adjudicate Ohio’s claims. [81] The Court’s policy analysis of the ever-changing American judicial system and its preference for appellate jurisdiction foreshadowed its decision to decline Arizona’s and Texas’s bills decades later.

E. Arizona v. New Mexico

Just a few years later, the Supreme Court once again denied a state’s motion for leave to file a bill of complaint, this time against another state. The Court denied Arizona’s request to invoke the Supreme Court’s original jurisdiction when Arizona sought declaratory judgement against New Mexico’s electrical energy tax. [82] Arizona argued that the tax was unconstitutionally discriminatory and a burden upon interstate commerce, that the tax denied Arizona due process and equal protection under the law in violation of the Fourteenth Amendment, and that the tax abridged the privileges and immunities secured by the U.S. Constitution. [83] Regardless, the Supreme Court thought that a state court would be a more appropriate forum. [84] The State of Arizona (as a consumer) and its citizens (as consumers) regularly purchased electrical energy generated by three Arizona utilities operating generating facilities within New Mexico. [85] In 1975, New Mexico passed the Electrical Energy Tax Act, which imposed a tax on the generation of electricity. [86] The Supreme Court explained: “ The tax is nondiscriminatory on its face: it taxes all generation regardless of what is done with the electricity after its production. However, the 1975 Act provides a credit against gross receipts tax liability in the amount of the electrical energy tax paid for electricity consumed in New Mexico.” [87] Other states consuming energy produced within New Mexico, including Arizona, did not receive such credit. [88] Arizona argued that (1) the economic incidence and burden of the electrical energy tax fell upon the state and its citizens and that (2) the tax discriminated, as intended, against the citizens of Arizona. [89] The three Arizona utilities involved chose not to pay the new tax and instead sought a declaratory judgement in an action filed in the District Court for Santa Fe County. [90] That action raised the same constitutional concerns as the State of Arizona had in the instant case. [91] In deciding whether to grant Arizona’s motion, the Supreme Court noted that its original jurisdiction should be invoked sparingly. [92] The Court considered the seriousness and dignity of the claim and whether there was another forum available with jurisdiction over the named parties in which the issues could be litigated and in which appropriate relief could be had. [93] In this case, the Court was persuaded to deny Arizona’s motion because of the pending action before the New Mexico Supreme Court, which was an appropriate forum for the dispute. [94] Further, the U.S. Supreme Court found it wise to wait to hear the case on appeal if the state court held the energy tax unconstitutional. If the tax was held unconstitutional, then Arizona would be vindicated, and if it was held constitutional, the issues could be appealed to the Court through the direct appeal process. [95] Accordingly, the Court chose not to exercise original jurisdiction because it felt the state courts were able to adjudicate the issues and were the better forum for addressing Arizona’s claims. [96]

F. Maryland v. Louisiana

In 1981, the Supreme Court finally chose to exercise original jurisdiction in Maryland v. Louisiana. [97] Several states, joined by the United States and several pipeline companies, challenged the constitutionality of Louisiana’s “First-Use Tax” imposed on certain uses of natural gas brought into Louisiana. [98] Due to the nature of the case participants, a Special Master was appointed to facilitate the handling of the suit. [99] The Special Master filed a report, but exceptions to the Master’s Report were filed as well. [100] Justice White, writing for the Supreme Court, held that: (1) the individual states, as major purchasers of natural gas whose cost increased as a direct result of the tax, were directly affected in a real and substantial way so as to justify the exercise of the Court’s original jurisdiction; (2) jurisdiction was also supported by the individual states’ parens patriae; and (3) the case was an appropriate exercise of the Court’s exclusive jurisdiction even though state court actions were pending in Louisiana. [101] After establishing the Court’s intention to exercise original jurisdiction, the Court found the First-Use Tax to be unconstitutional under the Commerce Clause. [102] The analysis of the tax’s constitutionality under the Commerce Clause will be discussed later in this Article. Louisiana argued that the states lacked standing to bring the suit under the Court’s original jurisdiction and that the bare requirements for exercising original jurisdiction were not met. [103] The Special Master rejected both arguments. [104] The Court agreed with the Special Master. [105] In order to constitute a true controversy between two or more states under the Court’s original jurisdiction, [I]t must appear that the complaining State has suffered a wrong through the action of the other State . . . or is asserting a right against the other State which is susceptible of judicial enforcement according to the accepted principles of the common law or equity systems of jurisprudence. [106] Rejecting Louisiana’s arguments that the tax was imposed on pipeline companies and not directly on consumers, the Court reasoned that standing to sue “exists for constitutional purposes if the injury alleged ‘fairly can be traced to the challenged action of the defendant, and not injury that results from the independent action of some third party not before the court.’” [107] In the instant case, the First-Use Tax was “clearly intended to be passed on to the ultimate consumer,” despite it being imposed on pipeline companies. [108] The Court found it “clear that the plaintiff States, as major purchasers of natural gas whose cost has increased as a direct result of Louisiana’s imposition of the First-Use Tax, are directly affected in a ‘substantial and real’ way so as to justify their exercise of this Court’s jurisdiction.” [109] The Court also found support for exercising jurisdiction “by the “States’ interest as parens patriae.” [110] States cannot “enter a controversy as a nominal party in order to forward the claims of individual citizens.” [111] However, a state can “act as the representative of its citizens in original actions where the injury alleged affects the general population of a State in a substantial way.” [112] The Court held that the states “alleged substantial and serious injury to their proprietary interests as consumers of natural gas as a direct result of the allegedly unconstitutional actions of Louisiana.” [113] Further, such a direct injury is reinforced “by the States’ interest in protecting its citizens from substantial economic injury presented by imposition of the First-Use Tax.” [114] The Court explained, “[I]ndividual consumers cannot be expected to litigate the validity of the First-Use Tax given that the amounts paid by each consumer are likely to be relatively small.” [115] Instead, the states should represent their citizens in such litigation––a point which supported the Court’s choice to exercise original jurisdiction. [116] The Court deemed the case appropriate for exercise of its exclusive jurisdiction, despite similar claims pending in state courts. [117] The Court elaborated that it determines whether exclusive jurisdiction is appropriate by weighing “not only ‘the seriousness and dignity of the claim,’ but also ‘the availability of another forum with jurisdiction over the named parties.’” [118] Exclusive and original jurisdiction are exercised sparingly. [119] In choosing to exercise exclusive jurisdiction, the Court distinguished Maryland from New Mexico. Specifically, in New Mexico, it was “uncertain whether Arizona’s interest as a purchaser of electricity had been adversely affected,” but in Maryland, the adverse effect upon the plaintiff states’ interests were far more certain. [120] The issue in the New Mexico case did not “sufficiently implicate the unique concerns of federalism forming the basis of [the Court’s] original jurisdiction.” [121] In Maryland, the magnitude and effect of the tax was far greater because the anticipated 150 million dollars in annual tax was being passed on to millions of American consumers in over thirty states, exactly as intended. [122] The Supreme Court was willing to set the Maryland case apart from precedent and justify the use of original jurisdiction. Therefore, when examining recent actions brought by Arizona and Texas, the question becomes: why did the claims of Arizona and Texas fall within the Court’s pattern of refusing to exercise original jurisdiction rather than the approach followed in Maryland?

G. Texas and Arizona’s Place Within the Precedent

In denying Texas and Arizona’s motions for leave to file a bill of complaint, the Court did not provide its reasoning for denial as it did in Maryland, Wyandotte, New Mexico, Massachusetts, Cohens, and Louisiana. Although Justice Thomas and Justice Alito wrote detailed dissents on why the Court should hear the cases, there was little insight into the majority’s decision-making. However, with decades of precedent explaining the need to exercise original jurisdiction sparingly, [123] perhaps the Court’s reasoning is not needed. Following the analysis of prior case law, Texas and Arizona’s claims would be first judged on their “seriousness and dignity.” [124] Essentially, the two states would have to show that they are directly and negatively affected by California’s travel bans. [125] The states also would need to persuade the Court that the injury alleged affects the general population of their states in a substantial way. [126] Finally, the states would have to show that there is no other forum that could adjudicate the claims. [127] Turning to the first point, the states would illustrate their alleged injury: California law bans state-funded travel to over twenty-two states, except under limited circumstances. [128] Specifically, California will not: Approve a request for state-funded or state-sponsored travel to a state that . . . has enacted a law that voids or repeals, or has the effect of voiding or repealing, existing state or local protections against discrimination on the basis of sexual orientation, gender identity, or gender expression, or has enacted a law that authorizes or requires discrimination against same-sex couples or their families or on the basis of sexual orientation, gender identity, or gender expression, including any law that creates an exemption to antidiscrimination laws in order to permit discrimination against same-sex couples or their families or on the basis of sexual orientation, gender identity, or gender expression. [129] The travel ban has exceptions, which include travel for: litigation; meeting contractual obligations; complying with the federal government committee appearances; participating in meetings or training required by a grant or required to maintain grant funding; completing job-required training necessary to maintain licensure or similar standards; and protecting the public health, welfare, or safety. [130] Given these exceptions, when does California’s travel ban actually apply? It is difficult to imagine an instance where state-funded travel would be banned given the relatively lengthy list of exceptions. California intended the ban to frame the state as a leader in protecting civil rights and preventing discrimination, but even LGBTQ groups accuse California of using the ban as “a cheap political trick to make some headlines for vote-hungry politicians in the blue state.” [131] The law’s extensive exceptions also make it difficult for the plaintiff-states to illustrate their injury. College sports provide the most likely example of state injury, but even that has proven difficult. In 2017, California’s ban included travel to the State of Tennessee. [132] That same year, the UCLA Men’s Basketball Team made it to the “Sweet 16” in the NCAA Tournament. [133] According to the ban, California should have refused to let the team play in the game against Kentucky held in Tennessee, unless the game was moved to another state not on the travel ban list, since UCLA is a state-funded school. [134] Instead, California used “non-state” funds to send the team to Tennessee. [135] Non-state funds are comprised of money that comes from donations and other resources. [136] California keeps these “non-state” funds separate from state funds. [137] Essentially, when travel does not fit into one of California’s many exceptions, the state will still find a way to permit the travel if there is substantial state interest. [138] Imagine the following hypothetical: Texas or Arizona host a major sports tournament, California denies funding for its own public university team to travel and compete in the tournament, and the denial causes the tournament to be moved to another state simply to accommodate California’s travel ban. One can then imagine the plethora of economic and political injuries to Texas or Arizona. However, a dilemma like this hypothetical has yet to happen. And the U.S. Supreme Court will not exercise its original jurisdiction in a case in which a state’s injuries are unclear. [139] The complaints filed by Texas and Arizona demonstrate the exact type of cases the Court detailed as its preference to avoid in Wyandotte. [140] Next, it would have been difficult for the Supreme Court to find that the alleged injury affected the general population of Arizona and Texas. [141] The California travel ban does not target state-funded business with the plaintiff-states or individual businesses or people within the plaintiff-states. [142] Additionally, the travel ban does not in any way restrict the flow of goods or people between California and these states. [143] Aside from knowing the state received California’s stamp of disapproval, citizens of Texas and Arizona are not affected by California’s travel ban. In Maryland, Louisiana’s tax affected more than thirty different states, and the burden of the tax was directly passed to the taxpayers in those states. [144] Although there are many states on California’s travel ban list, [145] the burden of California’s law is not upon the people of those states. Finally, the Supreme Court likely denied the plaintiff-states’ request for adjudication under original jurisdiction in Arizona v. California and Texas v. California because the states can challenge California’s laws in another forum. [146] In New Mexico, the Court mentioned its preference of hearing the case on appeal upon the plaintiff-state’s loss in defendant-state’s courts. [147] In Maryland, the Court did not think that a state forum was more appropriate for the claims because it was abundantly clear that the interests of the plaintiff-states were adversely affected. [148] The same is not true in the Arizona and Texas cases. The Court likely aligned the plaintiff-states’ claims with those in New Mexico. Even Justice Alito, writing in the dissent for Texas, mentioned that the Court would likely reverse if a lower court found in favor of California. [149] Perhaps filing in a different forum is a path the current plaintiff-states should contemplate. It is clear a controversy exists between two states in both Arizona and Texas. It is also clear the controversy is mostly political, based solely on California’s condemnation of a number of states in the nation who will not align with California’s political ideals. The Court can invoke the political question doctrine when there is a lack of judicially manageable standards which prevent the case from being decided on the merits. [150] Although the Court did not explicitly invoke the doctrine, California’s politically charged statutory language could have added to the Court’s reluctance to exercise original jurisdiction. Ultimately, the Court had a long list of precedent supporting the decision to decline exercising original jurisdiction in both Texas and Arizona. While actual injury to the travel ban states is not abundantly clear, the plaintiff-states should consider challenging California’s law under Article I instead of Article III in federal court.

II. The Article I Alternative [151]

The Constitution grants Congress the power to “regulate Commerce with foreign Nations, and among the several states, and with the Indian tribes.” [152] The U.S. Supreme Court has long recognized that the Commerce Clause also restricts states from enacting law which may affect interstate commerce. [153] This limit on state power is often referred to as the Dormant Commerce Clause. The Dormant Commerce Clause prevents economic protectionism by prohibiting states from enacting laws designed to benefit in-state economic interests as the expense of out-of-state competitors. [154] State-implemented travel bans are likely to affect interstate commerce, since their sole purpose is to cause negative economic impact on the targets of the ban. Although the earlier discussion about the travel ban’s exceptions and practice raise questions as to whether the California law is truly effective, there are still colorable arguments supporting the law’s interference with interstate commerce. The U.S. Supreme Court’s approach for analyzing the Dormant Commerce Clause is a balancing test in which the burden on interstate commerce may not be greater than the benefits to the state. [155] The weight of the balancing depends on whether a state statute is facially discriminatory or facially neutral. [156] State statutes are facially neutral if they treat their residents and other states’ residents alike, although the statute may still affect interstate commerce. [157] Facially neutral statutes only violate the Dormant Commerce Clause if the burdens they impose on interstate trade are clearly excessive in relation to local benefits. [158] State statutes that distinguish between residents in their jurisdiction and residents outside their jurisdiction are facially discriminatory. [159] Since California’s travel ban explicitly names other states, the statute is facially discriminatory. Even though the ban is facially discriminatory, there are three exceptions to when states may pass facially discriminatory laws , outlined below.

A. Exceptions to Facially Discriminatory Statutes, Applied to California’s Ban

Facially discriminatory statutes are generally deemed unconstitutional but can still be upheld under three exceptions: (1) Congress authorized them; (2) they serve a legitimate state or local purpose; or (3) the state is acting as a market participant. [160] Below is an analysis of these three exceptions as applied to California’s travel ban. The first exception is Congressional authorization. It is clear from the statute language that California is not relying upon any kind of congressional authority. When Congress permits states to regulate commerce in ways that would otherwise be impermissible, authorization must be unmistakably clear. [161] The legislative history behind California’s travel ban clearly shows there was no Congressional authorization to enact such a ban. [162] The legislative history shows reliance upon Obergefell v. Hodges to support validation of the ban. [163] This Supreme Court case upheld marriage equality for LGBTQ individuals, [164] but there is no mention of anything close to the possibility of states enacting travel bans for state-funded travel. [165] In summary, “Congress did not grant California the authority to prohibit other states from discriminating against LGBTQ individuals.” [166] Thus, California’s travel ban law fails the first exception for facially discriminatory statutes. Second, for facially discriminatory statutes to be constitutional, they must serve a legitimate local purpose. States must show not only that the regulation serves a legitimate local purpose, but also that the local purpose could not be achieved by any other nondiscriminatory means. [167] Essentially, California would have to prove their clearly punitive travel ban serves a local purpose which could not otherwise be achieved. [168] The California legislative history lists two reasons for enacting the statute: (1) to prevent the use of state funds to benefit a state that does not adequately protect the civil rights of certain classes of people; and (2) to prevent a state agency from compelling an employee to travel to an environment in which he or she may feel uncomfortable. [169] However, punishing other states for not meeting California’s civil rights standards does not serve a local purpose in California. [170] On the one hand, California may argue that the law protects state employees who could experience—or fear—LGBTQ discrimination in travel ban states. On the other hand, critics argue that the travel ban does little to protect LGBTQ interests and does “nothing more than exacerbate political divisions.” [171] Even if California argues that the statute protects its state employees, California ignores the fact that it must prove there are no other nondiscriminatory alternatives. [172] California’s legislative history indicates that the statute was not developed to protect state employees and that other alternatives were not considered. Instead, the legislative history makes it abundantly clear that California intended the statute to punish other states. [173] The final exception is if a state acts as a market participant, rather than a market regulator. [174] For example, if a city law specifies that construction projects funded by the city must employ a percentage of city residents, then the law does not violate the Dormant Commerce Clause because by funding the city projects the government is acting as a participant. [175] However, if a state is selling timber and its laws require the successful bidder to partially process the timber within the state before shipping, then this law goes further than simply burdening the market in which it operates. [176] California could attempt to argue that the Dormant Commerce Clause does not apply because the state government is participating in the market for travel. But because the ban imposes restrictions intended to reach beyond California by banning commercial transactions in target states, this argument fails, and the Dormant Commerce Clause applies. California’s travel bans are facially discriminatory and are therefore unconstitutional under Article I of the Constitution. Only the U.S. Congress can regulate the nation’s commerce, not the individual states. [177] There is a long history of restricting states from enacting laws that interfere with federal commerce or benefit in-state economic interest by discriminating against other out-of-state actors. California’s ban on state-funded travel openly discriminates against almost half of the country by banning state-funded travel to states with whom California disagrees over standards regarding treatment of the LGBTQ community. [178] The desire to be a leading state in the protection of LGBTQ civil rights does not fit into any of the three exceptions that would allow California to enact such a law. California’s ban was not authorized by Congress. It serves no local purpose. No nondiscriminatory alternatives were ever discussed or considered. California, in enacting the statute, is acting as a market regulator and not as a market participant. That is unconstitutional. This analysis leaves critics with disagreements in predicting how, when, or whether California’s unconstitutional travel ban will be addressed. Some believe that other states will follow California’s example and enact similarly discriminatory laws until the country is entwined in a social and economic civil war. [179] The less dramatic and more likely outcome is a continued lack of enforcement of the statutes, or a demand in statutory change from residents of the states who are legislating such bans.

III. Power By The People: The Likely Outcome

As previously explained, the U.S. Supreme Court is unlikely to intervene on behalf of states that have found themselves on California’s travel ban. The states will likely need to bring their claims in other forums first and then pursue the appeals route to the U.S. Supreme Court. Given the extensive list of exceptions and lack of enforcement in practice, the overarching economic effect (and therefore success) of California’s ban is, at best, unclear. It is still disheartening to see that one of our states opted to single out twenty-two sister states seemingly without reason. There are a few consequences that may result from such actions. The first possibility is other states will enact retaliatory bans or similar bans against states with whom they disagree politically. California’s first bans were seen in 2017, and in the past few years, several other states and territories have legislated travel bans. [180] Although New York issued executive orders in 2015 similarly banning state-funded travel to Indiana for LGBTQ discrimination issues, [181] and several other states joined New York in banning state-funded travel to North Carolina for its controversial “bathroom law,” [182] there is little indication that these bans have actually achieved their purpose of negatively impacting the economies of the targeted states. For example, it is calculated that Indiana lost about $60 million in revenue after passing an anti-gay law. [183] Notably, this loss of revenue stemmed from a cut in tourism and the migration of businesses out of Indiana, not because of a lack of state-funded travel from places like California. [184] Further, when corporations or businesses condemn perceived anti-gay state laws, the ramifications are much more profound than any ban on state-funded travel. California state-funded travel likely has very limited presence in the Texas economy, and so its effect is similarly unnoticed. However, when companies like Apple make business decisions while considering states’ laws impacting its LGBTQ population, the results would be felt much more profoundly than the loss of California’s state-funded travel. Additionally, if corporations were to act in this arena, they would not be challenging the U.S. Constitution in the same way as California. Yet, Texas has not lost business because of its anti-discrimination laws. On the contrary, Texas has seen an explosion of migration of California businesses to Texas. [185] Though these business migrations are linked to lower housing costs, lower tax rates, and fewer regulations, it is still noteworthy that Texas’s LGBTQ laws did not deter California tech giants from moving operations to the red state. [186] Texas’s experience with tech migration may be unique compared with the other states on California’s ban list, but it remains unclear whether California’s ban has influenced any state’s economy in a substantial way. All things considered, California’s legislation purpose is less of an attempt to weaken Texas’s or other states’ economies and more of an attempt to pander to voters within California. The true danger of California’s travel ban stems from power-hungry and vote-hungry politicians’ dedication to making headlines. The ban provides such a plethora of exceptions that its actual effect is severely curtailed to the point of virtual nonexistence. Meanwhile, the political chatter surrounding the law only grows. With such minimal economic effect, even if all the states decide to pass similar laws, then the only thing achieved is more of the political animosity already so prevalent between the two political parties. Another possible consequence is that the law will largely go unenforced, as it is now, and its purpose will diminish and subside out of the nation’s attention. A third possible consequence is a challenge to the statute’s constitutionality from within California or a repeal of the statute through the legislature. Of the possible outcomes, an economic civil war is truly unlikely. This is a political game with very little economy in the equation. A political civil war might be a different story.

Conclusion

California’s travel ban now effectively targets about 44% of the nation by prohibiting state-sponsored or state-funded travel to twenty-two sister states. [187] Other states have followed California’s example. [188] The challenges to the ban came from the States of Texas and Arizona, which would ordinarily place the cases within the original jurisdiction of the Supreme Court. However, the Supreme Court declined the opportunity to adjudicate the matter in both cases. The Court has a history of avoiding political questions [189] and exercising its original jurisdiction only in extremely limited circumstances. [190] Based on the analysis of Article I, California’s statute is facially discriminatory. It does not fall within one of the exceptions, so the law is unconstitutional. [191] With the Supreme Court refusing to hear arguments brought by Texas or Arizona, the states will need to seek another path to Supreme Court adjudication. If the states desire a judicial ruling on the issues, they should find other forums in which to challenge California’s law and then appeal any unfavorable decision to the Supreme Court. However, the judicial path may prove problematic for the states, as the lack of true economic effect makes it difficult if not impossible to argue actual damages. California’s law failed to impact the economies of the target states, but it succeeded in widening the political divide in the nation. It is no secret that for the past few years, Americans have lived in an increasingly divided country. As LGBTQ organizations have noted, the travel ban does little to promote equality for LGBTQ individuals in red states. [192] Instead, California’s legislation serves as a political platform for politicians’ reelection campaigns. From a birds-eye-view, the result is something of a Shakespearean play: it’s funny, it’s tragic, and it’s oh-so-dramatic. Hopefully, the nation can end the narrative of the travel ban as a Shakespearean comedy with a happy ending, instead of a Shakespearean tragedy currently looming on the horizon for a divided and weary nation with our collective patience wearing thin.

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* Professor Beckett Cantley University of California, Berkeley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation 1997. Teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C. Professor Cantley would like to thank Melissa Cantley and his law clerk, Leela Orbidan, for their contributions to this Article. ** Geoffrey Dietrich, Esq. U.S. Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008. Shareholder in Cantley Dietrich, P.C.

The Ruling on Reserve Mechanical Corp. v. Commissioner, and Impact to Captive Insurance Tax Benefits

Beckett Cantley  Geoffrey Dietrich This article provides an overview of the May 13 th , 2022, U.S. Tenth Circuit Court of Appeals decision in Reserve Mechanical Corp. v. Commissioner ,  and analyzes its likely impact on the aggressive captive insurance company (“CIC”) industry. A much longer and broader discussion of this topic will be published in our forthcoming article in the U.C. Davis Business Law Journal.

How Reserve Mechanical Corp v Comm affects captive insurance tax benefits

A storm has been brewing in the tax world, and there may be no safe harbor in sight for participants in aggressive captive insurance schemes. On May 13th , 2022, the U.S. Tenth Circuit Court of Appeals handed down a major defeat to one of these aggressive captive insurance schemes.  In a landmark case, Reserve Mechanical v. Commissioner , the Court found that the transactions that the Captive Insurance Company (CIC) Reserve Mechanical had engaged in were not insurance and therefore Reserve Mechanical was not an insurance company. As a result, Reserve Mechanical could not take advantage of the federal income tax exemption under Internal Revenue Code (“IRC”) Section 501(c)(15). This tax exemption allows a CIC to not pay tax on whatever premiums are paid to it, up to a certain threshold.  Tax planners would be paid to set up CICs for business owners and the business owners would then pay premiums to the new CIC while the CIC books those premiums as tax exempt income. These premiums are often determined without actuarial data and with a poorly produced risk pool consisting of other CICs managed by the tax planners engaged in the scheme.

The benefits of Captive Insurance Companies (CICs)

With correct planning CICs stand to obtain favorable tax treatment under IRC Sections 501(c)(15) and 831(b). This creates a tax exemption for insurance companies whose gross receipts for the tax year do not exceed $600,000 under IRC Section 501(c)(15) or $2.3 Million under IRC Section 831(b).  These exemptions are treated identically with the only difference being the level of exemption permitted under the statute. The use of CICs for businesses with a true and real economic need for them does not, in and of itself, constitute an abusive tax transaction. However, despite the real economic circumstances that would call for the use of CICs, the practices of several tax planners in the CIC world have become flagrantly abusive. This abuse has colored CICs in the IRS’ eyes such that even those who have a very real need for the use of CICs may become potential targets of IRS audits.

As a CIC, Reserve was owned by the same people that owned Peak.

The original Reserve Mechanical Corp. v. The Commissioner case came down before the U.S. Tax Court on June 18 th , 2018. Reserve Mechanical Corp (“Reserve”) was a CIC formed to insure Peak Mechanical & Components Inc. (“Peak”). As a CIC, Reserve was owned by the same people that owned Peak. The three issues at hand in this case were

1. whether the transactions that Reserve engaged in were insurance resulting in the right to the IRC Section 501(c)(15) exemption;
2. whether Reserve was a domestic corporation under IRC Section 953(d); and
3. if Reserve was not an insurance company and did not make a valid IRC Section 953(d) election, whether it could be taxed 30%.

This article will only address the first question as to whether or not Reserve was an insurance company. In the IRS’s view, Reserve was solely created so that the owners of Peak could take advantage of the tax deduction and Reserve could take advantage of the tax exemption, rather than because Peak needed insurance that it could not get elsewhere, and thus the transactions Reserve engaged in lacked economic substance.

Factors that drove IRS’s assessment that Reserve was not an insurance company

The IRS’s assessment that Reserve was not an insurance company was based on several factors.

• The first, was that the transactions that Reserve engaged in constituted a circular flow of funds. Peak would pay premium payments to Reserve for direct coverage.
• Reserve would then take these premiums and pay them to the CIC risk pool, PoolRe, as reinsurance by attempted risk distribution across a number of other CICs also paying into the risk pool. Peak would then also pay premiums to PoolRe in exchange for stop-loss insurance from PoolRe.
• Lastly, PoolRe would pay the same stop-loss premium amount it received from Peak to Reserve to insure the same stop-loss coverage it had with Peak.

The court determined that the flow of premiums between these three entities constituted an improper circular cash flow of funds. Next, the IRS focused on how the premiums that Reserve charged were determined. Several experts testified that they had used actuarial tables to calculate them but could not provide those tables and could not explain how Reserve somehow managed to charge each year the exact amount of premiums that would result in the greatest tax exemption for the CIC.  The IRS argued that premium calculation method used was bogus. The Tax Court ruled in favor of the IRS and held that Reserve did not issue insurance contracts. Thus, Reserve was not an insurance company, and was thereby ineligible for the Section 501(c)(15) exemption. Therefore, the premiums that Reserve received were now treated as investment income and could be taxed at a 30% withholding rate. The Tax Court determined that the premiums that were paid to Reserve by Peak and then to PoolRe and vice versa constituted a circular cash flow of funds. They also determined that the premiums paid were determined by what would produce the greatest tax deduction rather than based on actuarially determined insurance need. The Tax Court noted the strangeness of some of the facts of Reserve. For instance, after Peak formed Reserve its insurance costs went up 400%.  In the Tax Court’s estimation there is no reasonable and ordinary explanation for why a company would increase its insurance costs by such a staggering amount. After the Tax Court decision, Reserve was appealed to the Tenth Circuit Court of Appeals.

IRS ruled in favor of the IRS on all issues.

The Tenth Circuit ruled in favor of the IRS on all issues. The Tenth Circuit’s ruling against Reserve was damning. In the words of the court:

• Reserve has not presented any argument as to why a factfinder could not infer that Peak’s intent was simply the intent to create a plausible insurance company through which Peak could obtain a substantial tax deduction without reducing the funds available to its two owners. The intent behind the act does not change just because the act failed to achieve its purpose.  [Emphasis added]
• The Tenth Circuit’s comments make it clear that it does not see Reserve as being run like a legitimate business. The court found that there was no evidence of any reasonable risk assessments to determine whether Peak needed any of the additional policies. The court noted that Reserve prepared policies that only lasted for a month in a rush to obtain a large business deduction for Peak in 2008, and that this behavior was “laughable”.
• The Tenth Circuit also held that the re-insurance policies that Reserve held with PoolRe did not distribute risk and that if anything the previous Tax Court decision understates the compelling evidence that these re-insurance arrangements were a “sham”.
• The Tenth Circuit held that they would have emphasized different evidence than the Tax Court, but that the Tax Court’s conclusions were supported by overwhelming evidence in the record.

Reserve raised no persuasive challenges to the Tax Court’s conclusion.

No experience, expertise, or studies supported the need for Peak to obtain the issued policies.  Further, the Tenth Circuit found that Reserve raised no persuasive challenges to the Tax Court’s conclusion.  Despite one of Reserve’s expert witness’ testimony that commercial insurance policies were available as an alternative to several of the Reserve policies, Reserve provided no evidence that anyone compared the rates on such policies or otherwise considered industry standards in determining its premium rates. Instead, the record suggests that Reserve based the rates on the premiums charged by other captive insurers managed by Capstone.

Inconsistencies in Reserve’s business practices created doubt in perception as a bonafide insurance company

The Tenth Circuit doubted the actuarial methodology used to determine the premiums, and determined that these insurance contracts were not negotiated at arm’s length.  The many inconsistencies in Reserve’s business practices made it impossible for the Tenth Circuit to take seriously Reserve’s claim that it was a bonafide insurance company engaged in the business of insurance. As a result, the Tenth Circuit’s decision that Reserve’s policies were not actual insurance feels like a layup and the intensity of the court’s contempt for this aggressive CIC program should be very concerning to other similarly situated CIC owners.

Decision in Reserve Mechanical Corp. – a major boost in the IRS’s overall attack on aggressive CIC tax programs

The 10 th Circuit decision in Reserve Mechanical was a major boost in the IRS’s overall attack on aggressive CIC tax programs. If Reserve had won on appeal, then the aggressive CIC industry would have at least one major case to stand on. The IRS’s Reserve Mechanical win was the biggest in a line of IRS wins in cases on similar grounds. As such, the aggressive CIC industry must either change its ways or close up shop, because the IRS appears determined to shut it down one way or another, and the judiciary is giving it all the ammunition it needs to do so. View Original Document

Biden Signs $1.5 Trillion Spending Bill Without Tax Offsets

Are The "Build Back Better" Taxes Lurking?

By Beckett Cantley ¹ & Geoffrey Dietrich ² On March 10, 2022, the U.S. Senate voted 68-31 to pass the Fiscal Year (FY) 2022 omnibus appropriations bill, the Consolidated Appropriations Act of 2022 ( H.R. 2471 , hereafter, the “Omnibus Bill”), providing $1.5 trillion in federal discretionary spending across all 12 appropriations bills. The passage of this massive stop-gap spending bill averts the shutdown of the government until the end of September and was accompanied by the usual fanfare and much Congressional high-fiving—The Wall Street Journal quipped that one might think “it was the 1964 Civil Rights Act … for all the self-congratulation." ³ Conspicuously absent from the Omnibus Bill’s 2,700 pages are any tax provisions that would normally be part of such omnibus spending (and most legislation) to pay for the new spending provisions in the Omnibus Bill. This article briefly discusses the tax provisions from the Build Back Better Act (“BBB Act”) that Congress failed to pass earlier this year and analyzes what the absence of these tax provisions in the Omnibus Bill means and whether their absence is just a delayed reprieve for U.S. taxpayers.

What was in the Biden Administration’s Proposed BBB Act Tax Changes?

The Biden Administration entered office riding promises of increased taxation against wealthy Americans and businesses. We looked at several key tax provisions in depth in our article, “ Uncovering Four Ways that Biden’s American Families Plan Attacks Your Wealth ,” passage of which would have reconfigured wealth and provided a host of social programs. The BBB Act contained numerous tax provisions that theoretically would have increased tax revenue to fund a significant number of spending programs as well as continued COVID-19 pandemic-related expenditures. According to the White House’s “Build Back Better Framework” these ambitious goals were “fully paid for” through the following tax provisions:

1. the repeal of most of the Trump Administration’s tax cuts;
2. increasing corporate income taxes, including taxes on global income of corporations while penalizing corporations that hire and produce overseas;
3. increasing taxes on everyone making more than $400,000 annually (Married Filing Jointly); and
4. increasing tax enforcement by providing $80 billion in funding to the IRS. ⁴

The BBB Act died earlier this year when Senator Joe Manchin (D-W.Va.) voted against the new legislation. Sen. Manchin determined that the $2 trillion price tag was excessive spending that would lead to increased inflation in the U.S. economy. Amazingly, after gnashing teeth and screaming about fraud and waste over the $2 trillion in the BBB Act, enough Republicans voted with Sen. Manchin and the Democrat majority to pass the $1.5 trillion Omnibus Act which contained a government spending spree that came just half a trillion shy of the original goal.

How Congress Uses Omnibus Spending

As the legislative branch of the government, Congress is granted the “power of the purse” under Article I of the Constitution. ⁵ As the federal government has grown in prominence or bloat, the amount of internal funding required to be appropriated by Congress to specific agencies, departments and programs within the federal government has grown quite massive. ⁶ When you have pennies, dimes sound like a lot. Once you’ve earned a couple quarters, those pennies seem worthless. Once Congress warmed up to the idea of spending a cool trillion, how can we ever go back to mere billions? Looking back, we just can’t seem to fund the government for less anymore. Congress approves funding to the various departments, agencies, and programs in the federal budget through appropriations bills. Although everyone knows there are twelve different appropriations bills—one for each Congressional sub-committee—that need to be passed each year, Congress sometimes struggles to produce and approve each of the twelve appropriations individually. The term “omnibus” denotes a spending bill which packages two or more of the individual appropriations bills into one. Disagreement over spending and packages leads to difficulty approving an individual appropriation on the merits. To shortcut the process and obtain buy-in, members of Congress will engage in “buying” the votes needed for an omnibus package. Since the 1980’s both sides of the aisle have used omnibus packages because “party and committee leaders can package or bury controversial provisions in one massive bill to be voted up or down.” ⁷ According to Senate Majority Leader Chuck Schumer (D., N.Y.), “This funding bill is awash with good news for our country.” ⁸ Just over half goes to defense spending and the remainder (a mere $730 billion) goes to non-defense spending, including $13.6 billion in humanitarian assistance to Ukraine. The Ukraine spending was the lever that pushed the Omnibus Bill through. While it would prove both enlightening and enraging to list all the separate pork projects included in the Omnibus Bill, we choose to focus on what is conspicuously absent from the Omnibus Bill: tax provisions. One of the BBB Act’s hallmark provisions was increased funding (to the tune of $80 billion) to the IRS as a blank check to focus on enforcement and chasing down corporations and wealthy people. We will discuss in a separate forthcoming article the increased IRS budget.

Peering Into the Tax Provision Future

Although we see an appropriate amount of handwringing by both sides of the aisle on the lack of tax provisions within the Omnibus Bill, the revenue raising void remains. Without tax provisions, the means for funding the entirety of this $1.5 trillion package falls on the existing funds (or credit) of the U.S. government. As we have seen, there is no shortage of money that can be printed, but with inflation at forty-year highs, that may not be the desired way out. Pres. Biden has seen his previously “completely paid for” BBB Act halt and cannot possibly hope to resurrect his agenda without significant tax increases. If not in the Bill, where are they? The president will likely throw his declining weight toward including some tax items in future legislation, breaking what would have been incredible pain into more manageable—read, passable—chunks. Smaller bills that attempt to do less may be the path forward for many tax provisions in BBB Act. Only time will tell if Sen. Manchin and others will pay attention to the unaccounted-for costs attached to every future bill. However, failing to pass the BBB Act prior to the confluence of bad luck, bad timing, and arguably bad policy leaves the Democrats in the unenviable position of facing Congressional elections in 2022 with eroding support. Even the mainstream media has started to admit Democrats are in trouble heading into this election cycle. Raising taxes before the mid-term elections with significant seats in jeopardy could very well prove strategically suicidal. Additionally, despite the pipe dream that Sen. Manchin would ally himself with his Democrat colleagues, Manchin further indicated his independence of thought through his recent opposition to the Biden administration’s nominee for the Federal Reserve chair. ⁹ One of the most likely scenarios for the reappearance of tax provisions should the Democrats lose their majority in November, is Congress passing significant legislation during the lame-duck sessions. While lame-duck sessions were historically used to wrap up the business of Congress, the lame-duck session ending Jan. 3, 2021, was historic in that nearly 44% of bills passed by the 116th Congress occurred during the final two months of its term. ¹⁰ Could much of this Congress’ hoped-for legislation become a reality in the waning hours of its’ session? Arguably, yes. In the last fifty years, no other Congress has passed as much legislation as this one during that period. For a party moving out of power, it’s highly likely such a move would be used to push as much legislation through as possible. Should that not be the case, the only route left to tax provision package occurs in the final year of Biden’s term. A difficult proposition as most election strategists predict that the GOP will likely take both houses in November. At this point, the GOP needs only to turn over one Democratic Senator seat and eleven Democratic House member seats with thirty-one Democrats having announced they will not seek reelection. ¹¹ As such, if they do not pass legislation in a lame duck session, they will have no chance after the next Congress is seated. + Citations

¹ Prof. Beckett Cantley (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997), teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C..² Geoffrey Dietrich, Esq. (United States Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008) is a shareholder in Cantley Dietrich, P.C.³ The Spending Earmarks Return, Do They Ever, The Editorial Board, The Wall Street Journal (Mar. 12, 2022) (available at: https://www.wsj.com/articles/the-earmarks-return-do-they-ever-11647042054 , last accessed March 14, 2022). ⁴ The White House, Build Back Better Framework, (available at: https://www.whitehouse.gov/build-back-better/ , last accessed March 14, 2022). ⁵ Art. I, U.S. Const. ⁶ Jessica Tollestrup, The Congressional Appropriations Process: An Introduction, Congressional Research Service (February 23, 2012), https://sgp.fas.org/crs/misc/R42388.pdf last accessed March 14, 2022. ⁷ Oleszek, Walter J. (2007). Congressional Procedures and the Policy Process, p.34 CQ Press ⁸ Wall Street Journal, Siobhan Hughes & Teresa Mettela, Senate Passes $1.5 Trillion Spending Bill that Includes Aid for Ukraine, (Mar. 10, 2022) available at: https://www.wsj.com/articles/senate-democrats-see-ukraine-aid-speeding-passage-of-omnibus-spending-bill-11646935157 ⁹ Andrew Ackerman & Andrew Duehren, Sen. Joe Manchin Signals Opposition to Sarah Bloom Raskin for Fed Post (available at: https://www.wsj.com/articles/sen-joe-manchin-signals-opposition-to-sarah-bloom-raskin-for-fed-post-11647275446?mod=Searchresults_pos3&page=1 , last accessed March 15, 2022). ¹⁰ Drew Desilver, Nothing lame about this lame duck: 116th Congress had busiest post-election session in recent history, Pew Research Center (Jan. 21, 2021(available at: https://www.pewresearch.org/fact-tank/2021/01/21/nothing-lame-about-this-lame-duck-116th-congress-had-busiest-post-election-session-in-recent-history/ , last accessed March 15, 2022). ¹¹ In 2018, only 28 Republicans did not seek reelection and during that election lost forty-one seats.

CIC Services v. IRS: the Supreme Court Hands the IRS a Major Loss

The Constitutionality and Application of New York’s Proposed Mark-To-Market Tax