Procedure & Administration
The Federal Circuit held that audit tests and related information of third-party taxpayers pertaining to the assessment of the ozone-depleting chemicals excise tax was return information not subject to disclosure under Sec. 6103(a).
Background of ODC Excise Tax
To discourage the use of chlorofluorocarbons and halons (ozone-depleting chemicals or ODCs), Sec. 4681 imposes an excise tax on any product imported for consumption, use, or warehousing that is sold or used in the United States and in which any ODCs were used as material in the manufacturing or production of the product. Manufacturers are allowed to self-determine the excise tax owed based on the weight of each ODC used as a material in the imported product and to submit as supporting proof a letter signed by the manufacturer that adequately identifies the product and states the weight of each ODC used as a material in the product’s manufacture. (For more on the tax, see Karet and Hoffman, “Are You Properly Paying the Ozone-Depleting Chemicals Excise Tax?” 41 The Tax Adviser 377 (June 2010).)
The IRS, however, found that many foreign manufacturers were not paying the tax and were instead submitting letters claiming to have never used ODCs or to have eliminated their use to avoid the costs of switching to non-ODC manufacturing processes. This led the IRS to contract with the Pacific Northwest National Laboratory (PNNL), a federally funded research center, to develop a test to determine whether ODCs were being used in the manufacture of imported items and to assist the IRS in auditing reporting companies.
According to the IRS’s Ozone Depleting Chemicals (ODC) Excise Tax Audit Techniques Guide, after placing the electronic circuit board of an item being tested in a sterile environment, PNNL subjects it to various levels of heat. The gases released from the board at each temperature level are captured and analyzed to test for the presence (although not the actual quantity) of ODCs in the board.
Background of This Case
Panasonic manufactured and imported for sale in the United States consumer telephones assembled in Tijuana, Mexico. Panasonic reported that it owed no excise tax and submitted a certified letter from its overseas manufacturers and suppliers stating that they used no ODCs in the manufacture of the phones.
In 2005, the IRS audited Panasonic’s imports. As part of the audit, PNNL purchased Panasonic’s phones from retail stores and tested the phones’ circuit boards. After completing its audit, the IRS assessed Panasonic over $10 million in excise taxes, penalties, and interest. Panasonic paid the assessment and later filed a refund suit in the Court of Federal Claims, claiming that it did not use ODCs in manufacturing the phones and that the test used by PNNL was scientifically invalid and unreliable.
During litigation, Panasonic sought to compel the IRS to turn over information about its activities with respect to unrelated third-party taxpayers that also had ODC tax liabilities, including the ODC testing methods used, the results of the test, the amount of excise tax assessed against these taxpayers, and whether they appealed or contested the assessment. The court found that, while the information Panasonic sought was return information under Sec. 6103(a) that was generally prohibited from disclosure, in this case the exception in Sec. 6103(h)(4)(B) authorized disclosure. Under Sec. 6103(h)(4)(B), tax information on a tax return can be disclosed in a judicial or administrative proceeding pertaining to tax administration “if the treatment of an item reflected on such return is directly related to the resolution of an issue in the proceeding.”
The court determined that PNNL’s testing activities relating to other taxpayers were derivatively part of the “treatment” of ODC tax liability, which was the “item” identified by Panasonic. The court also found that PNNL’s testing of other taxpayers’ products met the “directly related” requirement of Sec. 6103(h)(4)(B) because Panasonic’s discovery was directed at “the validity of the scientific testing for ODCs employed by PNNL, not to a direct comparison of its excise tax assessment with that of other taxpayers.” Thus, the court held that the information Panasonic sought was subject to the exception in Sec. 6103(h)(4)(B) and that the IRS was required to turn over the information (Panasonic Communications Corp., No. 09-cv-793 T (Fed. Cl. 4/20/11)). The IRS appealed the court’s decision to the Federal Circuit.
The Federal Circuit Decision
The Federal Circuit reversed the Court of Federal Claims and held that the Sec. 6103(h)(4)(B) exception to the Sec. 6103(a) prohibition on the disclosure of return information did not apply and that the IRS was not required to turn over the information. The Federal Circuit found that the lower court had incorrectly determined the information sought was directly related to the resolution of an issue in the proceedings and was reflected on the third-party taxpayers’ returns as required by Sec. 6103(h)(4)(B). It further found that the lower court had incorrectly focused on whether the return information was relevant to the issue in contention in deciding whether the exception applied.
The Federal Circuit determined that the term “directly related” in the statute was ambiguous and looked to the statute’s legislative history for clarification. The court found that examples in the legislative history showed that the treatment of an item on a third party’s return is not related, much less directly related, “to the resolution of a taxpayer’s issue when the only link between the third party and the taxpayer is the same treatment of a similar item.” According to the court, the only link between Panasonic and the third parties that the company sought return information from was the treatment of the ODC tax liability, and thus, the information was not directly related, and Sec. 6103(h)(4)(B) should not apply.
The court next addressed how the information sought failed to meet the requirement in Sec. 6103(h)(4)(B) that it be “the treatment of an item reflected on such return.” As the court noted, the PNNL testing results and related information did not exist at the time the third-party taxpayers prepared their returns, so the information logically could not be reflected on their returns. To avoid this problem, Panasonic argued that the treatment of an item referred to the IRS’s treatment of the item during the audit process. The court stated that this interpretation made no sense because the IRS does not submit a return on which the treatment of an item could be reflected. The court maintained that the phrase referred only to the taxpayer’s handling of an item as shown on the face of the return submitted by the taxpayer whose return information is being sought.
Finally, the Federal Circuit found that whether return information should be disclosed under Sec. 6103(h)(4)(B) depended on the relevance of the treatment of the item on the return being sought to the issue in the proceeding. The court found that the lower court’s decision to disclose the information instead improperly focused on the relevance of the return information sought to the issue in the proceeding.
Panasonic made an interesting and creative argument for the application of the Sec. 6103(h)(4)(B) exception, but the Federal Circuit wisely declined to follow it. Even without the clear evidence of congressional intent provided by the legislative history, the language of the statute does not support the expansive interpretation given to it by the lower court.
This issue was one of first impression for the Federal Circuit, and the appeals court noted some inconsistency in the way the Court of Federal Claims has handled the issue in cases before it. In this case and in Shell Petroleum, Inc., 47 Fed. Cl. 812 (Fed. Cl. 2000), the lower court had broadly construed the Sec. 6103(h)(4)(B) exception to allow discovery of the tax treatment of similarly situated third parties. However, in Vons Cos., Inc., 51 Fed. Cl. 1 (Fed. Cl. 2001), the court had read the Sec. 6103(h)(4)(B) exception more narrowly to deny discovery for similarly situated third parties.
The Federal Circuit noted that the scope of the Sec. 6103(h)(4)(B) exception is “vital to matters of taxpayer confidentiality and proper tax administration.” To bring uniformity, and “[i]n view of the lack of anything in the language or history of these provisions that even suggests, let alone establishes, that Congress intended to authorize disclosure of information such as the information sought in this case,” the court made clear that a narrow construction of the exception is correct.
In re United States, Misc. Dkt. No. 992 (Fed. Cir. 1/20/12)