R.H. Donnelley Corporation v. U.S., (CA 4 3/31/2011) 107 AFTR 2d ¶2011-625
The Court of Appeals for the Fourth Circuit, affirming a district court, has concluded that IRS could deny a corporation a refund based on its carrybacks of unused research and foreign tax credits from a closed year where IRS's review of that closed year showed that a deficit exceeded the value of the tax credits sought to be carried back.
Background. In Lewis v. Reynolds (S Ct 1932), 10 AFTR 773, the Supreme Court concluded that the ultimate question in a refund case is whether the taxpayer has overpaid his tax, and that this involves a redetermination of the entire tax liability. While no new assessment can be made after the statute of limitations has run, the taxpayer isn't entitled to a refund unless he has overpaid his tax. Thus, even when IRS may not collect a deficiency, it may retain payments already received when they do not exceed the amount which might have been properly assessed and demanded.
In Estate of Michael v. Lullo (CA 4 1999), 83 AFTR 2d 99-1759, the Fourth Circuit concluded that while Lewis allows IRS to refuse certain refunds, it doesn't allow IRS to collect any additional tax after the limitations period has expired. The Court stated that “the statute of limitations not only prevents the IRS from assessing these taxes in the future, it extinguishes potential liability for all such time barred taxes.”
Facts. R.H. Donnelley Corporation (Donnelley) timely filed a consolidated federal tax return for the tax year ending Dec. 31,’94. IRS examined this return and didn't determine any additional tax deficiencies before the expiration of the statute of limitations. Donnelley filed a refund claim for its’91 tax year based on the carryback of $3,080,395 in unused research credits from the’94 tax year. It also filed a refund claim for its’92 tax year based on the carryback of $8,048,374 in unused foreign tax credits from the’94 tax year.
In response to the refund request, IRS sent Donnelley a Statement of Income Tax Change that determined “an increase of tax” for the’94 tax year based on a “total corrected income tax liability” for’94 of $43,727,655. The letter stated that this increase of more than $43 million would not be assessed due to the expiration of the statute of limitations for the’94 tax year. The uncharged tax liability for’94 thus increased the limitations for research and foreign tax credits in’94, causing all the’94 research and foreign tax credits to be used, and leaving no credits to be carried back to the’91 or’92 tax year.
Donnelley filed suit. Depending on whether Donnelley was entitled to carry back the research and foreign tax credits claimed from the’94 tax year, the parties stipulated that it would either get $11,128,769 or nothing.
Taxpayer's position. Donnelley conceded that when a taxpayer sues for a refund of taxes paid, IRS is allowed to conduct an audit to ensure that a refund is in fact owed. But because this occurred after the statute of limitations had expired for the’94 tax year, Donnelley argued that IRS was only allowed to review its’91 and’92 returns, and had to accept any carryback amounts from other years as they were stated when the statute of limitations expired.
District court's decision. The district court, finding in IRS's favor, concluded that because Donnelley was found to have a deficit in taxes paid for’94 that exceeded the value of the research and foreign tax credits at issue, it couldn't carry back these tax credits to’91 and’92. Accordingly, it wasn't entitled to a refund. The court reasoned that there was a significant difference between IRS seeking to collect additional taxes and protecting itself from refund claims after the statute of limitations had expired.
In this case, if the statute of limitations hadn't expired, Donnelley would owe more than $30 million in additional taxes for’94, even after the tax credit deductions. While it was undisputed that these taxes couldn't be collected, Donnelley was seeking a refund for carrybacks that would not exist had its tax burden been properly calculated for the’94 tax year.
The court found that a deficiency determination in which IRS seeks to establish a taxpayer's additional tax liability was patently different from a refund determination in which the taxpayer sought repayment or credit from IRS. While IRS had no authority to collect additional taxes for’94, it was allowed to look at that tax year to determine whether carrybacks were proper for’91 and’92. Any other result would allow a taxpayer to benefit twice from underpayments.
Appellate decision. The Fourth Circuit, affirming the district court, concluded that under Lewis no one who had not actually overpaid his taxes was entitled a refund. Since Donnelley hadn't overpaid its taxes, it wasn't entitled to a refund claim.
The Court rejected Donnelley's reading of the language in Estate of Michael to support its conclusion that all it potential liability for additional taxes it might have owed in’94 was “extinguished.” The expiration of the statute of limitations did “extinguish potential liability” in the sense that the taxpayer had no obligation to pay any additional taxes that IRS might try to collect. The Fourth Circuit clarified that Estate of Michael didn't stand for the proposition that IRS could not re-examine tax years intertwined with a claim for a refund. Such a reading was strained and would do violence to the Supreme Court's clear holding in Lewis.
The Fourth Circuit also rejected Donnelley's argument that Lewis only allowed IRS to raise issues arising in that same tax year as an offset to the refund claimed. Under this theory, IRS could challenge a deduction from’91 or’92, the years for which Donnelley claims a refund, but couldn't reexamine whether there were excess credits in’94 to be carried back to’91 and’92. The Court reasoned that tax years were not insular units, and the Code often allows taxpayers to shift tax items to other years (for example, in the carryback and carryover of unused business credits under Code Sec. 39, and the carryback and carryover of excess foreign tax credits under Code Sec. 904(c)).
In this case, whether there were overpayments in’91 and’92 depended on whether Donnelley had excess foreign tax and business credits to carry back from’94. The Court noted that IRS properly acknowledged that Lewis doesn't allow it to defend against a refund claim for one year with an unassessable (i.e. time-barred) understatement of tax from a different year. But the Court concluded that Lewis must allow IRS to recalculate tax items from other years when those items are necessary to determine the correct tax in the year of the claimed refund. Any other result would allow a taxpayer to benefit twice from its underpayment.
Donnelley's refund claim depended on credits that could be carried back only because Donnelley had misreported its taxes in the first place. While it was true that the statute of limitations may protect Donnelley from additional collection, that didn't give Donnelley a license to claim a second windfall in the form of a refund. To claim otherwise, the Court said, was almost beyond belief.
The Court also rejected as wishful thinking Donnelley's claim that Code Sec. 901(a) prevented IRS from recalculating the foreign tax and business credit limitations for’94.
References: For the effect of an unassessable deficiency on a refund, see FTC 2d/FIN ¶T-5206; United States Tax Reporter ¶64,014.01.