United States Held Liable for Making False Statements to Foreign Tax Authority
In a recent case, Aloe Vera of America Incorporated, et al. v. United States of America, the United States was found liable for making false statements to the Japanese tax authority during a joint audit of a group of taxpayers. The opinion also reports that, in connection with the joint audit, the Japanese National Tax Administration (“NTA”) leaked information concerning the audit to Japanese media, which caused the taxpayer’s Japanese subsidiary to experience a decline in sales. This case is notable, not only because it sheds light on the simultaneous examination program authorized by U.S. income tax treaties, but because it shows the potential hazards, to the IRS and U.S. taxpayers, of exchanging taxpayer information with treaty partners.
The Internal Revenue Code generally prohibits the disclosure of taxpayer information; however, there are numerous exceptions to this general rule. One of the exceptions is for the exchange of information pursuant to U.S. treaty obligations.
U.S. income tax treaties include provisions for the exchange of information between tax authorities. Some exchanges are automatic, while others are discretionary. The United States’ income tax treaty with Japan provides for both types of exchange of information. Periodically, the United States and a foreign country, such as Japan, may find it beneficial to jointly audit a multinational taxpayer. This is initiated through a Simultaneous Examination Proposal (“SEP”) issued by one country to the other.
Facts of the case
Aloe Vera of America (“AVA”) is a U.S. S corporation wholly owned by a U.S. taxpayer, Rex Maughan (“Maughan”). AVA buys bulk raw aloe vera gel and sells it to affiliated companies. During the years at issue, 1991 and 1992, AVA sold aloe vera gel to Forever Living Products Japan (“FLPJ”), a Japanese company jointly owned by Maughan and Gene Yamagata (“Yamagata”). FLPJ processed the raw gel and resold it to Japanese distributors. FLPJ paid a 3.5% royalty to AVA for certain proprietary processing and bottling processes. In addition, FLPJ paid a “commission/royalty” to AVA which it then paid, directly or indirectly, to Maughan and Yamagata.
Maughan and Yamagata are wealthy entrepreneurs. They also previously had engaged in tax planning that attracted the attention of the IRS: FLPJ had paid a royalty to certain foreign entities for the benefit of Maughan and Yamagata as part of a scheme to defer their U.S. income tax liability with respect to these amounts. After the scheme had been discovered, both individuals paid taxes due on that income for 1991 and 1992.
In May 1995, the IRS assigned an international examiner (“Smith”) to investigate whether the taxpayers had employed a similar scheme to avoid U.S. tax on other income for the years at issue. As part of that effort, Smith’s supervisor instructed Smith to draft an SEP to be sent to the NTA. The SEP requires the requesting tax authority to, inter alia, identify issues that could be mutually examined as well as to describe “estimated or potential additional tax” attributable to those issues. Smith’s early drafts of the SEP did not include estimates of additional tax due, and Smith told his supervisor that he could not “really put numbers in there.” Apparently under pressure from his supervisor, Smith showed an estimate of $32,116,000 on the SEP as the amount of unreported U.S. income for the period 1991-1992. The estimate lacked any supporting detail. With respect to FLPJ’s potential Japanese tax liability, the SEP also showed estimates of disallowed royalty expense, disallowed commission expense and withholding tax on dividends.
The SEP was sent to the NTA, and the IRS and NTA held two meetings as part of the joint audit. In January 1997, the NTA assessed additional tax to FLPJ for the years 1991-1996, including interest and penalties, of approximately $73 million. The tax adjustment was based on the NTA’s characterization of the commission/royalty paid by FLPJ to AVA as nondeductible directors’ bonuses.
In October 1997, a series of news reports appeared in Japanese media reporting that FLPJ had concealed more than ¥7.7 billion of income by inflating the price of raw aloe vera. FLPJ’s sales in Japan declined materially subsequent to the disclosures. An expert witness who examined the media reports concluded that the NTA was the source of that information.
FLPJ paid the assessed taxes, and then contested the assessment. Based on a transfer pricing study, the NTA and the IRS subsequently concluded that FLPJ had paid AVA an arm’s-length price for the raw aloe vera gel. The NTA then refunded the taxes and penalties.
The taxpayers brought suit in Federal District Court alleging that the United States had disclosed taxpayer information to the NTA contrary to section 6103(a). The taxpayers also asked the court to award $52 million of actual damages.
The district court’s opinion
The legal basis for this action is grounded in section 7431, which permits a taxpayer to bring a civil action for damages against United States in the event “any officer or employee of the United States knowingly, or by reason of negligence, inspects or discloses any return or return information with respect to a taxpayer in violation of any provision of section 6103.” In order to find for the taxpayers, the court needed to address several issues.
The United States disclosed return information
The government argued that no taxpayer information had been disclosed in the SEP. The District Court found, however, that the SEP contained return information of Maughan and Yamagata for several reasons. First, the statement concerning 32 million of unreported U.S. income was “a determination of the existence, or possible existence, of liability (or the amount thereof)” of tax for Maughan and Yamagata, which was taxpayer information as described in section 6103. The SEP also implied that both individuals had unreported commission income taxable by the United States in the amount of $32 million. Finally, the SEP made the statement that the commission income did not change as the cost of aloe vera gel to FLPJ changed. This also was information regarding the tax liability of Maughan and Yamagata.
The information disclosed was false
The government argued that the statements in the SEP concerning unreported income and the lack of variability of the commission were not knowingly false statements. They were simply good-faith estimates of possible unreported income, and an estimate cannot be false. The court found that an estimate carries “an implied assertion that its author knows facts to justify the selection of particular value chosen. Blind guesses are not good-faith estimates.”
The court concludes that the knowing disclosure of false return information is unauthorized by the income tax treaty with Japan. The United States, therefore, did not satisfy the applicable exception to section 6103(a).
The taxpayers were entitled to either statutory damages of $1000 per unauthorized disclosure or actual and punitive damages. The taxpayers asked the court to award $52 million in actual damages. The court, however, concluded that the taxpayers were entitled to only statutory damages. The court reasoned that the taxpayers had failed to prove by the preponderance of the evidence that the statement concerning unreported income in the SEP caused the NTA to enter into the simultaneous examinations.
The facts of the case are inherently interesting because they illuminate the foibles of both taxpayers and tax administrators. Moreover, the case points out the risks of exchanging information with treaty partners having less stringent rules than the United States concerning the disclosure of taxpayer information. This risk is especially pertinent because one of the OECD’s BEPS’s actions (Action 13 on country-by-country reporting ) would require the exchange of significant amounts of a taxpayer’s sensitive transfer pricing information pursuant to U.S. treaty obligations.
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