A closing agreement, in which a taxpayer living and working in Australia waived his right under Sec. 911(a) to elect to exclude foreign earned income, was validly executed and could not be set aside due to malfeasance or misrepresentation of material fact by the IRS.
During the years at issue, Cory Smith was a U.S. nonresident citizen who worked at the U.S.–Australian Joint Defense Facility at Pine Gap, Alice Springs, Northern Territory, Australia (Pine Gap), a military surveillance facility. Generally, the United States taxes the worldwide income of its nonresident citizens, which creates the potential for their double taxation — in Smith’s case, the taxation of his income by both the United States and Australia.
U.S. law provides some relief from double taxation for U.S. citizens working abroad. Relevant to Smith is the relief provided by Sec. 911(a), which allows qualified individuals to elect to exclude foreign earned income from their gross incomes and treats that income as exempt from U.S. federal income taxation.
In addition to providing relief through U.S. law, to avoid double taxation for U.S. citizens working at Pine Gap, the United States and Australia entered into two agreements in 1966 and 1969 (the Pine Gap agreements) that generally provide that the income U.S. citizens earn at Pine Gap will be deemed not earned in Australia, so long as it is actually taxed by the United States. The United States and Australia signed a new income tax treaty in 1982. To the extent the Pine Gap agreements are read as giving U.S. citizens working at Pine Gap more favorable treatment, the 1982 treaty would seem to have left those arrangements intact.
For the United States and Australia, the relief provided under Sec. 911 presented a particular problem in resolving issues of potential double taxation for U.S. citizens working at Pine Gap. Sec. 911 provides that certain qualified individuals may elect to exclude from gross income and exempt from U.S. federal income taxation certain foreign earned income. However, the Pine Gap agreements provided that U.S. citizens could avoid Australian taxation on their Pine Gap income only if that income “is not exempt, and is brought to tax, under the taxation laws of the United States.” Australian domestic law similarly required that the relevant income not be “exempt from income tax imposed” in the United States for its sourcing recharacterization rule to apply. Moreover, the 1982 treaty preserved the benefits of the Pine Gap agreements only if those benefits are viewed as “any exclusion, exemption, deduction, rebate, credit or other allowance.”
To resolve these potential problems, the United States and Australia determined that U.S. citizens working at Pine Gap would need to forgo making a Sec. 911 election to avoid Australian taxation. The countries also determined Pine Gap employees could forgo the election by entering into a closing agreement with the IRS.
For decades, both U.S. citizen employees at Pine Gap and the U.S. and Australian tax authorities abided by this framework. As far as the interested parties were concerned, the closing agreements waiving U.S. taxpayers’ right to elect under Sec. 911(a) were sufficient to preempt potential issues of double taxation for U.S. citizens working at Pine Gap. But a few years ago, some U.S. citizens who worked at Pine Gap and had entered into closing agreements, including Smith, decided to ignore the agreements and made the Sec. 911(a) election on their original tax returns or on amended returns for earlier tax years.
Smith, a former Air Force engineer, received an offer in 2009 from Raytheon Corp. to work at Pine Gap. The onboarding process for the job was extensive, and it was approximately a year before Smith went to Pine Gap and began work.
During the onboarding process, Smith was given a copy of Raytheon’s Australian Operations Overseas Handbook. The handbook included a general discussion of U.S.–Australian taxation of employees working at the facility, including the effect of signing or not signing a closing agreement waiving their right to elect the Sec. 911(a) foreign earned income exclusion. The handbook indicated that signing this waiver was optional.
On his first day of work at Pine Gap, Raytheon gave Smith a blank form closing agreement. According to Smith, despite what was stated in the company handbook, Raytheon staff informed him that signing the agreement was not optional and that his employment was contingent on his signing the agreement. Smith claimed that he signed the agreement, which covered the years 2010 through 2012, because he was afraid of losing the job that he had prepared for over a year to take. No one from the IRS was present during Smith’s discussions with Raytheon staff about the agreement, and Smith did not communicate with the IRS before executing the agreement. During the following years while Smith was employed at Pine Gap, he signed an identical closing agreement (except for the tax years covered by the initial agreement) at least two more times. This included signing the agreement at issue in the case, which covered the years 2016, 2017, and 2018.
For all the agreements, after he executed them, Smith gave them back to Raytheon staff and Raytheon sent them to the IRS. Deborah Palacheck, director, Treaty Administration, in the IRS Large Business and International Division (LB&I), executed the 2016–2018 closing agreement in her official capacity. The IRS sent a fully executed copy of the agreement to Raytheon, which gave a copy to Smith.
Smith timely filed income tax returns for 2016 and 2017, on which, consistent with the terms of the 2016–2018 closing agreement, he did not make the Sec. 911(a) election. Later, he filed amended returns for both years on which he claimed the foreign earned income exclusion for his Pine Gap income. The IRS processed those returns and issued him a refund. For 2018, he filed an original return on which he claimed the foreign earned income exclusion for his Pine Gap income.
After realizing that the elections on Smith’s 2016 and 2017 amended returns and his 2018 return were not in line with the 2016–2018 closing agreement, the IRS issued him a notice of deficiency for 2016, 2017, and 2018, disallowing the claimed Sec. 911(a) elections and asserting that the previously issued refunds were in error.
Smith petitioned the Tax Court for a redetermination of the deficiencies. He claimed the agreement was invalid because the IRS official who executed it did not have the authority to do so. In the alternative, he argued that the closing agreement should be set aside under Sec. 7121(b) because the IRS committed malfeasance by disclosing confidential taxpayer information under Sec. 6103 and it misrepresented material facts in the terms of the closing agreement. In Tax Court, Smith and the IRS filed competing motions for partial summary judgment on these issues.
Sec. 7121 and closing agreements
Sec. 7121(a) authorizes the secretary of the Treasury (or, under Sec. 7701(a)(11)(B), the Treasury secretary’s delegate) to “enter into an agreement in writing with any person relating to the liability of such person ... in respect of any internal revenue tax for any taxable period.” These are called “closing agreements.”
Sec. 7121(b) prescribes the effects of an agreement made under Sec. 7121(a). If “approved by the Secretary,” that agreement “shall be final and conclusive.” Except upon a showing of “fraud or malfeasance, or misrepresentation of a material fact,” Sec. 7121(b)(1) states a case will not be reopened as to the matters agreed upon in the agreement, and the agreement will not be modified by any officer, employee, or agent of the United States. Sec. 7121(b)(2) further provides that the agreement “shall not be annulled, modified, set aside, or disregarded” “in any suit, action, or proceeding” or “any determination, assessment, collection, payment, abatement, refund, or credit made in accordance” with the agreement. As a general matter, a closing agreement is “approved by the Secretary” once it is signed by the taxpayer and executed on behalf of the secretary by an IRS official.
The Tax Court’s decision
The Tax Court held that the closing agreement was valid and could not be set aside. It concluded that Palacheck, in her capacity as director, Treaty Administration, had authority to execute the agreement for the IRS, and Smith had failed to show that the IRS had committed malfeasance or misrepresented the facts under Sec. 7121(b) with respect to the agreement.
Authority to execute the agreement
Through regulations and Treasury Order 150-07, the Treasury secretary has delegated the authority to sign closing agreements to the IRS commissioner. The commissioner, in turn, has further delegated his authority through regulations and delegation orders.
In the case of Smith’s closing agreement, the authority to sign the agreement was delegated in Delegation Order 4-12. This order delegates to the IRS commissioner, LB&I, the authority to act as “competent or taxation authority” for all matters encompassed by U.S. tax treaties. It further delegates to certain IRS employees other than the commissioner, LB&I, (including the director, Treaty Administration, of LB&I) a portion of this authority, delegating to those employees the power to act as “competent authority” under U.S. tax treaties with respect to specific applications of such treaties, including signing mutual and other agreements on behalf of the commissioner, LB&I, except as otherwise specifically delegated in the delegation order. Thus, the IRS asserted, Palacheck was authorized to execute the closing agreement.
After reviewing the 1982 treaty, the Pine Gap agreements, and the language of Smith’s 2016–2018 closing agreement, the Tax Court found that it was proper for Palacheck to execute the agreement. It noted that the closing agreement itself stated that the waiver of Smith’s rights under Sec. 911 was “pursuant to an agreement with and a determination by the Competent Authority for the United States after consultation with the Competent Authority for Australia in accordance with Article 24 of the [1982 treaty].” Further, according to the court, under the overall arrangement agreed upon by Australia and the United States for the Pine Gap employees, Palacheck was required to act as competent authority “with respect to specific applications” of the 1982 treaty under Delegation Order 4-12. In addition, because the arrangement called for the signing of a closing agreement on behalf of the United States in appropriate circumstances, that action was also covered by the delegation order as an act required with respect to a specific application of the 1982 treaty. Thus, Palacheck’s execution of Smith’s closing agreement was appropriate.
Absence of malfeasance
In essence, Smith maintained that the IRS committed malfeasance by disclosing confidential return information in violation of Sec. 6103 by each of three actions: (1) providing blank form closing agreements to Raytheon; (2) receiving the half-executed 2016–2018 closing agreement through Raytheon; and (3) transmitting the fully executed 2016–2018 closing agreement back to Smith through Raytheon. Whether these actions constituted a disclosure of return information were questions of first impression for the Tax Court.
Subject to exceptions, Sec. 6103 prohibits an “officer or employee of the United States” from “disclos[ing] any return or return information obtained by him in any manner in connection with his service as such an officer or an employee or otherwise.” A “disclosure” is defined as the “making known to any person in any manner whatever a return or return information” (Sec. 6103(b)(8)). Return information includes, among other things, “any agreement under section 7121, and any similar agreement, and any background information related to such an agreement or request for such an agreement” (Sec. 6103(b)(2)(D)). But return information “does not include data in a form [that] cannot be associated with, or otherwise identify, directly or indirectly, a particular taxpayer” (Sec. 6103(b)(2) (flush text)).
Blank forms: The Tax Court determined that sending the blank form was not malfeasance because, for three reasons, it was not return information under Sec. 6103. First, to be return information, the blank form would have to be an agreement under Sec. 7121, a similar agreement, or background information for the agreement or a request for an agreement. The court found that the blank form was not one of the first two because the unsigned form was not an agreement adopted by either Smith or the IRS. Smith argued that the blank form was a request for an agreement or background information for a request, but the court found that this argument failed because, by providing a form Smith could use, the IRS was not requesting Smith enter into a closing agreement.
Second, the blank form was not return information because it was not data that could be associated with or otherwise identify, directly or indirectly, a particular taxpayer. The court found that the form contained no identifying data or other sensitive information and merely contained interpretive legal statements regarding the generalized application of tax treaties, international agreements, and domestic tax laws. Furthermore, the IRS did not require Raytheon employees to sign the agreements, and there was no guarantee that the IRS would countersign even if an employee did sign.
Finally, the court determined the blank form was not return information because it was not information obtained from the IRS. The court explained that the form was just a document created by IRS officials in the ordinary course of their duties and did not include, nor was it premised upon, any particularized underlying information obtained from any specific taxpayer. Therefore, the court found that Sec. 6103 was not implicated by the provision of the blank form by Raytheon to Smith.
Partially executed closing agreement: Regarding whether Smith’s provision of the half-executed closing agreement form to Raytheon was a disclosure by the IRS of return information (to Raytheon), the court determined that the IRS had not made a disclosure of anything. The disclosure that resulted from that action was attributable to Smith. The IRS merely received the document from Raytheon, which had received it from Smith.
Fully executed closing agreement: Regarding the IRS’s transmitting the fully executed closing agreement to Smith through Raytheon, the court reasoned that the argument that malfeasance occurred due to this action was preempted by the execution of the agreement itself. The court observed that Smith logically could not have been induced into executing the 2016–2018 closing agreement by an action the IRS took after the agreement had become “final and conclusive” under Sec. 7121. Any malfeasance occurring after the validity (and finality) of a closing agreement is established, the court stated, is no ground for setting it aside.
Misrepresentation of material fact
Smith further argued that the closing agreement contained two recitals that were misrepresentations of material fact. Consequently, under Sec. 7121(b), the closing agreement should be set aside.
The Tax Court, however, concluded they were not material misrepresentations of fact that would justify setting aside the closing agreement. It found that one of the recitals was a legal conclusion regarding the application of U.S. treaty obligations and Australian domestic law to U.S. employees at Pine Gap, while the second was an accurate statement of the express terms of the Pine Gap agreements. Thus, in the court’s view, neither recital was a material misrepresentation of fact. While Smith argued that the recitals could be both a legal conclusion and a factual assertion, the court rejected this argument in the face of the long-standing distinction between the two in law generally and contract law specifically.
Smith also argued in his Tax Court petition that the 2016–2018 closing agreement should be set aside because it was signed under duress. He employed a lookthrough approach for this claim, asserting he signed the 2016–2018 closing agreement (which was the third closing agreement he signed during his Raytheon employment at Pine Gap) under duress because Raytheon had given him the first closing agreement he signed on his first day of work and said his employment was contingent on his signing the agreement. However, in Smith’s response to the IRS’s motion for partial summary judgment and his own cross-motion for partial summary judgment, Smith did not fully brief the argument. As a result, the court held that he forfeited the arguments, and it did not decide the issue.
Nonetheless, the Tax Court discussed the issue in its opinion. Under the standard for duress in the context of signing returns, the Tax Court stated a person must show that he or she was unable to resist the demands to sign the return and would not have done so except for the constraint applied to his or her will. Legally authorized actions by one person or party that limit another person or party from choosing between undesirable options do not constitute duress.
The Tax Court opined that it did not see how Smith had been put under duress by either the IRS or Raytheon. Smith conceded that he had no interaction with anyone from the IRS prior to executing the 2016–2018 closing agreement, which seemingly precluded the application of duress by the IRS. With regard to Raytheon, it was the company’s prerogative to require that Smith sign the closing agreement as a condition of employment, and its request that he choose between the consequences of signing or not signing the 2016–2018 closing agreement — i.e., between maintaining or losing his job at Raytheon — at most required a choice between two undesirable options that would not constitute duress.
Smith, 159 T.C. No. 3 (2022)
James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact firstname.lastname@example.org.