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Anti-Injunction Act blocked challenge to micro-captive transaction reporting requirements

A district court has dismissed a challenge by taxpayers, who were managers of captive insurance companies, to Notice 2016-66 because the court lacked subject-matter jurisdiction. Notice 2016-66 treats micro-captive transactions as transactions of interest and thus subjects them to various reporting requirements.

Background—micro-captive transactions. Broadly speaking, a micro-captive transaction is a transaction in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The related company that the parties treat as a captive insurance company elects under Code Sec. 831(b) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.

Background—Notice 2016-66. In Notice 2016-66, 2016-47 IRB (the Notice), IRS expressed concern that “micro-captive transactions” had the potential for tax avoidance or evasion and classified these transactions as “transactions of interest” for the purposes of Reg. § 1.6011-4, Code Sec. 6011 and Code Sec. 6012. Based on this classification, the Notice directs that: (1) persons entering into these transactions must disclose the transaction to IRS; and (2) material advisors who make a tax statement with respect to transactions have disclosure and maintenance obligations under Code Sec. 6111 and Code Sec. 6112. The Notice further provides that taxpayers and material advisors are required to file a disclosure statement regarding these transactions and that persons who fail to make required disclosures may be subject to penalty under Code Sec. 6707(a), Code Sec. 6707A, and Code Sec. 6708(a), which are contained in Subchapter 68B of the Code.

Background—Anti-Injunction Act. The Code strictly limits the circumstances under which a suit to enjoin the assessment or collection of any tax is permitted. Under Code Sec. 7421(a) (also known as the Anti-Injunction Act, or AIA), no suit for the purpose of restraining the assessment or collection of any tax can be maintained in any court by any person, whether or not that person is the one against whom the tax is assessed, except as otherwise provided. While the AIA does not bar all legal claims pertaining to taxation, it does bar those suits seeking to restrain the assessment or collection of taxes.

Taxpayers have, however, a number of other ways to challenge the assessment and collection of taxes, including, for example, paying and then suing for a refund under Code Sec. 7422.

Background—Declaratory Judgment Act. The Declaratory Judgment Act (DJA) provides that a court may “declare the rights and legal relations of any interested party seeking such declaration,” except “with respect to Federal taxes…” (28 U.S.C. § 2201(a))

Facts. The taxpayers were CIC, a manager of captive insurance companies, and Ryan, a tax services corporation which also manages captive insurance companies. The taxpayers asserted that they were subject to the Notice’s disclosure requirements for material advisors and that complying with the Notice’s disclosure requirements would force them to incur significant costs. The taxpayers further asserted that the Notice: (1) constitutes a “legislative-type rule” that fails to comply with mandatory notice-and-comment requirements under the Administrative Procedures Act (APA), 5 U.S.C. § 533, et seq.; (2) is “arbitrary and capricious and ultra vires in nature”; and (3) fails to comply with the requirements of the Congressional Review of Agency Rule-Making Act, 5 U.S.C. § 801, because IRS failed to submit it to Congress and the Comptroller General. Based on these allegations, the taxpayers sought a declaration under the DJA that the Notice is invalid and an injunction prohibiting IRS from enforcing the disclosure requirements set forth in the Notice based on IRS’s failure to comply with the APA’s notice-and-comment requirements.

IRS primarily argued that the court should dismiss the taxpayers’ claims because it lacks subject-matter jurisdiction due to the AIA and the tax exemption to the DJA. IRS contended that the taxpayers’ claims and their requested injunction violated the AIA and the tax exemption to the DJA, because any ruling in the taxpayers’ favor would necessarily operate to restrain tax assessment and collection.

Court agrees with IRS. The court dismissed the taxpayers’ action because the court lacked subject-matter jurisdiction.

First, the court said that, although the Notice provides that persons who fail to comply with it will be subject to “penalty” under Code Sec. 6707(a), Code Sec. 6707A, and Code Sec. 6708(a), the plain language of the governing statutes establishes that such a “penalty” is a “tax” within the AIA’s prohibition against injunctive relief. Specifically, Code Sec. 6671(a) provides: “The penalties and liabilities provided by [Subchapter 68B] shall be paid upon notice and demand by the Secretary, and shall be assessed and collected in the same manner as taxes. Except as otherwise provided, any reference in this title to “tax” imposed by this title shall be deemed also to refer to the penalties and liabilities provided by [Subchapter 68B].”

The Supreme Court has agreed that penalties assessed under Subchapter 68B are properly considered taxes for the purpose of determining whether the AIA divests a court of jurisdiction. In National Federation of Independent Business v. Sebelius (S Ct 2012), 109 AFTR 2d 2012-2563, the Supreme Court said that Congress can describe something as a penalty but direct that it nonetheless be treated as a tax for the purposes of the AIA. Describing such a legislative choice, the Supreme Court specifically pointed to Code Sec. 6671(a) and explained that “[p]enalties in Subchapter 68B are…treated as taxes under Title 26.”

Further, in Florida Bankers Association, (CA Dist Col 2015) 116 AFTR 2d 2015-5623, the D.C. Circuit reaffirmed that taxpayers cannot sidestep the AIA by ostensibly challenging only a reporting requirement and not the penalties imposed for violating that reporting requirement. The D.C. Circuit explained that a challenge to such a requirement is “necessarily also a challenge to the tax imposed for failure to comply with that reporting requirement” because “[I]f the taxpayers’ challenge were successful, IRS would be unable to assess or collect that tax for failure to comply with the reporting requirement.”

Relying on the Supreme Court’s decision in South Carolina v. Regan, (S Ct 1984) 53 AFTR 2d 84-732, the taxpayers also argued that the AIA does not bar a lawsuit when doing so would deprive a plaintiff of an adequate remedy at law. The taxpayers asserted that, in the absence of a preliminary injunction, they would never recover costs of compliance with the Notice or for harm to their businesses.

But the court here said that Regan does not support the taxpayers’ argument. Regan creates an exception to the AIA only where Congress has not provided an alternate avenue for an aggrieved party to litigate its claims. That was not the case here. The ability to initiate a refund suit after paying an assessed penalty provides an adequate alternate avenue to challenge IRS action.

In this case, the taxpayers’ claims and their requested injunction necessarily operated as a challenge to both the reporting requirement and the penalty or tax imposed for failure to comply with the reporting requirement. Because the Notice contemplates assessing penalties for non-compliance pursuant to Code Sec. 6707(a), Code Sec. 6707A, and Code Sec. 6708(a), all found within Subchapter 68B, the taxpayers sought, at least in part, to restrain IRS’s assessment or collection of a tax.

Accordingly, the Court lacked subject-matter jurisdiction over the taxpayers’ claims because they were barred by the AIA and the tax exception to the DJA.

References: For micro-captive transactions as transactions of interest, see FTC 2d/FIN ¶  S-4445.6. For the Anti-Injunction Act, see FTC 2d/FIN ¶  V-5701; United States Tax Reporter ¶  74,214.

CIC Services LLC, (DC TN 11/2/2017) 120FTR 2d ¶ 2017-5463