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On November 23, 2015, the District Court for the Western District of Washington issued its decision in one of the most closely watched summons enforcement cases in recent years: United States v. Microsoft Corp., Case No. C15-00102-RSM.  The case drew attention not only because of the taxpayer involved, Microsoft Corporation, but also because Microsoft challenged the summonses based on the IRS’s unusual action in retaining the law firm of Quinn Emanuel Urquhart & Sullivan “as a private contractor to assist in the IRS’s examination of Microsoft’s 2004 to 2006 tax years.”

Under United States v. Clarke, 134 S.Ct.2361 (2014), a district court is to hold an evidentiary hearing in a summons enforcement case if the taxpayer can point to specific facts from which the court can infer that the summons was issued for an improper purpose.  Based on the Clarke standard, the Court granted Microsoft’s motion for an evidentiary hearing.  The Court held a one-day evidentiary hearing, where Microsoft’s only witness was an IRS agent, Eli Hoory.  The parties then filed extensive briefing on the issue of whether the summonses were issued for an improper purpose.  The Court was “troubled by Quinn Emanuel’s level of involvement in this audit.”   This was, however, insufficient to defeat enforcement of the summons.

The IRS was auditing Microsoft’s income tax returns for 2004 to 2006. The audit has been ongoing since 2007.  It focused on cost-sharing arrangements Microsoft had with subsidiaries in Puerto Rico and Asia.  During the audit, the IRS issued over 200 Information Document Requests to Microsoft and interviewed a number of Microsoft employees informally.

Microsoft agreed to several extensions of the statute of limitations on assessment. In November 2013, Microsoft agreed to extend the statute on more time, to December 31, 2014.  The IRS also sent timelines for completion of the audit to Microsoft that were consistent with the IRS’s “roadmap” for transfer pricing audits.  In early 2014, Microsoft signed the statute extension.

In May 2014, the IRS awarded Quinn Emanuel a $2,185,000 contract to act as a “professional expert witness” to assist the IRS in investigating the cost-sharing arrangement. This marked the first time that the IRS is known to have hired a private civil litigation firm to participate in an income tax audit.  In June 2014, the IRS issued a temporary regulation, without notice and comment, allowing an outside contractor to participate in the summons process.  Among other things, the regulation allowed outside contractors to “receive books, papers, records, or other data summoned by the IRS and take testimony of a person who the IRS has summoned as a witness to provide testimony under oath.” Quinn Emanuel began work under the contract on July 15, 2014.  In August 2014, the IRS informed Microsoft that Quinn Emanuel attorneys would attend previously scheduled consensual interviews of Microsoft personnel.  At the interviews, the Quinn Emanuel attorneys’ role was limited to asking follow-up questions.  The IRS admitted that Quinn Emanuel attorneys reviewed documents and interview transcripts, did an independent assessment of the positions of the IRS and Microsoft with respect to the cost sharing arrangement and commented on the summonses at issue before they were served on Microsoft.  When Microsoft failed to comply with the additional summonses, the Government filed petitions to enforce.

To enforce a summons, the IRS must show that a) the summons was issued for a legitimate purpose, b) that the information sought is relevant to that purpose, c) that the information is not already in the IRS’ possession, and d) that all administrative steps required by the Internal Revenue Code have been followed. Because summons enforcement cases are summary proceedings, this showing is normally made by a declaration from the IRS agent who issued the summons.  If the IRS makes the requisite showing, the district court issues an order to the summoned party to show cause why the summons should not be enforced.  To be entitled to an evidentiary hearing, the taxpayer must allege specific facts that support an inference that the summons was issued in bad faith or for an improper purpose.  To defeat enforcement, however, it is not enough to establish an improper purpose.  The taxpayer must also establish that the summons was not issued for any legitimate purpose.  Thus, if the summons was issued for both an improper and a proper purpose, the court will order the summons enforced.

At the evidentiary hearing, IRS agent Hoory testified that while there was a possibility that the case could end up in Tax Court, the summonses in question, “are supposed to help us get to the right number” just “like in any examination.” He also testified that the case had not been designated for litigation and that, when the summonses were issued, the IRS was “still seeking information to get to the right number.”  Microsoft asserted that the summonses were issued in bad faith or an improper purpose because a) the IRS deceived Microsoft into extending the statute of limitations, b) enforcement of the summonses would allow Quinn Emanuel attorneys to “take testimony” in contravention of Internal Revenue Code §7602, c) t enforcing the summons would allow Quinn Emanuel to impermissibly conduct a tax examination and d) the IRS would use the summonses to prepare the case for litigation rather than to conduct an audit.

Microsoft’s basis for claiming that the IRS deceived it into extending the statute was that at the time it sought the extension, the IRS was considering hiring Quinn Emanuel but did not disclose this fact to Microsoft. As Microsoft admitted, the IRS was not legally required to disclose to Microsoft that it was planning to hire Quinn Emanuel and that the IRS’ “hiding the ball” did not constitute bad faith.  The Court, as a result, found that Microsoft did not establish that the statute extension was for an improper purpose or in bad faith.

The Court also rejected Microsoft’s claim that enforcement of the summonses would allow Quinn Emanuel attorneys to “unlawfully take testimony.” Section 7602 empowers the Secretary to conduct investigations, examine books, papers, records or other data, and to take testimony.  “Secretary” is defined in the Internal Revenue Code as “the Secretary of the Treasury or his delegate.”  Microsoft conceded that Quinn Emanuel attorneys could suggest questions for the IRS to ask, but argued that they could not ask questions.  The IRS countered that asking questions was not “taking testimony” and that nothing in the Internal Revenue Code requires the Secretary to “take testimony”; it just authorizes him to do so.

During argument, Microsoft’s attorneys admitted that the Code did not prohibit Quinn Emanuel from examining books and records, formulating questions to ask witnesses, attending interviews of witnesses and handing the IRS personnel pieces of paper with questions to ask the witnesses. It found that there was nothing in the statute that prohibited the IRS from going one step further and having the contractor ask the questions.  Finding that having Quinn Emanuel attorneys ask questions did not establish bad faith or improper purpose, the Court stated:

“The Court is troubled by Quinn Emanuel’s level of involvement in this audit. The idea that the IRS can ‘farm out’ legal assistance to a private law firm is by no means established by prior practice, and this case may lead to further scrutiny by Congress.  However, Microsoft has failed to convince the Court that §7602, which empowers the Secretary to take certain actions, actually limits the IRS’ ability to delegate the asking of certain questions to contractors like Quinn Emanuel attorneys.”

Because Microsoft failed to establish that the IRS lacked the authority to delegate, the question of whether the temporary regulation was valid was moot and did not have to be addressed.

The Court also found that Quinn Emanuel’s role in the case was not so great that it was performing the “inherently governmental function” of conducting the audit or assessing tax. The facts showed only that Quinn Emanuel was gathering information under the direction of IRS personnel.  Nor was there evidence that the IRS issued the summonses for the sole purpose of preparing a case for Tax Court.  While Quinn Emanuel specializes in civil litigation, there was no evidence that the it was retained for purposes of trying the case in Tax Court or that the summonses were issued to circumvent the Tax Court’s discovery procedures.

The Court concluded that Microsoft failed to meet the “heavy” burden of proof necessary to prevent the enforcement of the summonses in question. The Court therefore ordered the summonses enforced.

This case underlines the difficulty a taxpayer faces in seeking to prevent enforcement of an IRS administrative summons. Despite the existence of the unprecedented facts that the IRS had contracted with a private litigation law firm to assist in the examination and that it had issued a temporary regulation shortly afterwards to allow contractors to participate in the summons process, this was not enough to show that the summonses did not have a proper purpose or that they were issued in bad faith.  As long as the IRS can establish that a summons was issued during an audit to assist in gathering evidence to determine the taxpayer’s correct tax liability, it will be able to establish a proper purpose.  A taxpayer can nonetheless prevail if he can show that the information sought is privileged, that the IRS has failed to follow all procedures required for issuing and enforcing a summons or that the summons is vague, overbroad or unduly burdensome.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal)  and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at www.taxlitigator.com

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