Tax Court Rejects Taxpayer's Challenges to Validity of Closing Agreement

(Parker Tax Publishing September 2022)

The Tax Court held that a closing agreement a taxpayer entered into with the IRS under Code Sec. 7121 waiving his right to elect to exclude foreign earned income under Code Sec. 911(a) was valid and enforceable. Addressing issues of first impression, the court found that the IRS Director, Treaty Administration, had authority to execute the closing agreement on behalf of the Treasury Secretary; the court also held that the closing agreement should not be set aside under Code Sec. 7121(b) because the taxpayer failed to show malfeasance or misrepresentation of material fact. Smith v. Comm'r, 159 T.C. No. 3 (2022).

Background

Cory Smith is an Air Force veteran and engineer who, in 2009, received a job offer from Raytheon Company to work as an engineer at a joint U.S.-Australian defense facility in Australia called Pine Gap. After Smith accepted the job, Raytheon gave him a handbook which explained the tax implications of his new position. The handbook stated that the Australian government would not assess income tax on Pine Gap employees provided that they waived their ability to elect the foreign earned income credit under Code Sec. 911(a) in a closing agreement with the IRS under Code Sec. 7121. Although the handbook stated that employees could elect not to enter into a closing agreement, Smith said he was told by Raytheon staff once he was in Australia that his employment with Raytheon was contingent on his execution of a closing agreement.

The usual procedure for the execution of closing agreements by Raytheon employees was as follows. First, the IRS would send a blank closing agreement form via email to a Raytheon administrator at Pine Gap. Next, the administrator would provide the blank closing agreement form for completion and execution to the employee for each year the employee was working at Raytheon. After the employee completed and executed the agreement, the administrator would transmit it back to the IRS via email. Once received by the IRS, the agreements would be reviewed and signed by the IRS Director, Treaty Administration. Finally, after the closing agreements were fully executed, the IRS would send copies directly to Raytheon for its own recordkeeping and for distribution to the individual employees and the Australian Taxation Office.

Smith entered into a closing agreement with the IRS waiving his right to exclude foreign earned income under Code Sec. 911(a) for years 2016-2018 following the usual Raytheon procedure. After filing his 2016 and 2017 returns without making the Code Sec. 911(a) election, Smith filed amended returns making the election for those years, and the IRS issued refunds. Smith then made the election on his 2018 return. The IRS issued a notice of deficiency to Smith for tax years 2016-18 disallowing the elections. Smith petitioned the Tax Court for redetermination of the deficiencies. He argued that the closing agreement was invalid because the Director, Treaty Administration, Deborah Palachek, lacked the requisite signature authority. Smith also contended that in executing the closing agreement, the IRS committed malfeasance by disclosing his return information to Raytheon in violation of Code Sec. 6103 and that the closing agreement made misrepresentations of material facts.

Code Sec. 7121(a) authorizes the Treasury Secretary to enter into closing agreements. Under Reg. Sec. 301.7121-1(a) and Reg. Sec. 301.7701-9(b), the Treasury Secretary's authority to enter closing agreements is delegated to the Commissioner of the IRS. Delegation Order 4-12 (Rev. 3), Internal Revenue Manual 1.2.2.5.11 (Sept. 7, 2016), in turn delegates to the Director, Treaty Administration, the power to act as competent authority with respect to specific applications of tax treaties, "including signing mutual and other agreements" on behalf of the Commissioner of the IRS's Large Business and International Division. Under Code Sec. 7121(b), if a closing agreement is approved by the Treasury Secretary, it is considered "final and conclusive" and generally cannot be annulled, modified, set aside, or disregarded in any suit, action, or proceeding. In Hopkins v. Comm'r, 120 T.C. 451 (2003), the Tax Court held that closing agreements are meant to insure the finality of liability for both the taxpayer and the IRS, which is why courts have "strictly enforced" such agreements. Code Sec. 7121(b) provides that a closing agreement can be avoided only upon a showing of fraud or malfeasance, or misrepresentation of material fact.

Smith and the IRS filed competing motions for summary judgment. Smith argued that Palacheck lacked the requisite signature authority because Delegation Order 4-12 does not apply to closing agreements. According to Smith, the phrase "other agreements" in Delegation Order 4-12 refers only to certain types of mutual agreements. Smith further contended that under Delegation Order 4-12, the Director, Treaty Administration, has the authority to execute closing agreements only when a taxpayer makes a formal competent authority request. Alternatively, Smith argued that the IRS committed malfeasance by disclosing confidential tax information in violation of Code Sec. 6103 during each of the following three phases: (1) when providing the blank form closing agreement to Raytheon, (2) when receiving the half-executed closing agreement through Raytheon, and (3) when transmitting the fully executed closing agreement back to Smith through Raytheon. In addition, Smith asserted that he was induced to execute the closing agreement based on two false representations in the agreement. One was a statement that his wages from Raytheon were subject to Australian tax which did not mention that, regardless of whether he elected under Code Sec. 911(a), Australian tax law provides an independent exemption for income earned by U.S. citizens employed at Pine Gap. The other false representation stated that under the operating agreements governing the Pine Gap facility, his income would be deemed not to have been derived in Australia, provided it was subject to tax in the United States.

Analysis

The Tax Court held that the 2016-2018 closing agreement was valid and enforceable because (1) it was signed by an official with the requisite authority, (2) there was no malfeasance in the making of the agreement, and (3) there were no misrepresentations of material fact. The court noted that the issues before it were issues of first impression.

The Tax Court held that Palacheck acted within her delegated authority when she signed the closing agreement. The court found that under the tax treaty between the United States and Australia, the competent authorities of the two countries were not only authorized but directed to resolve by agreement "any difficulties or doubts" arising as to the treaty's application. The competent authorities did so, the court found, by establishing a process under which (1) the IRS would enter into closing agreements with U.S. citizens who worked at Pine Gap providing for the relinquishment of the right to make an election under Code Sec. 911, and (2) the Australian Taxation Office would in effect relinquish Australia's right to tax income earned in its territory once the closing agreements were in place. The court noted that one of the recitals in the closing agreement was that the waiver of Smith's rights under Code Sec. 911 was pursuant to an agreement with, and determination of, the competent authorities of the United States and Australia. In the court's view, it was therefore beyond question that implementing this arrangement required Palacheck to act as competent authority under Delegation Order 4-12. The court rejected Smith's argument that Delegation Order 4-12 does not apply to closing agreements. The court interpreted the phrase "other agreements" to mean agreements different from mutual agreements and, consistent with this interpretation, concluded that Delegation Order 4-12 is sufficiently broad to encompass the execution of an agreement - mutual or otherwise - that arises directly from the application of the tax treaty of the United States. In addition the court found no textual foundation in Delegation Order 4-12 for Smith's argument that Palacheck could only execute the closing agreement upon a formal competent authority request.

The Tax Court also held that Smith failed to show any malfeasance or misrepresentation of fact. The court found that there was either no unauthorized disclosure of return information in the closing agreement process or that any disclosure was immaterial to the execution of the agreement. First, the court found that the blank form agreement was not return information and was not "obtained by" any IRS official but rather was sent by the IRS to Raytheon. Second, the court found no violation of Code Sec. 6103 when Smith sent the half-executed form to Raytheon (which in turn provided it to the IRS) because the IRS did not disclose anything at this point; it merely received the document from Raytheon. Third, the court found that whether the IRS's disclosure of the fully executed agreement to Raytheon violated Code Sec. 6103 was immaterial because it occurred after the agreement became final and conclusive. Smith could not claim to have been induced into executing the agreement, the court reasoned, by an action taken after the agreement had become final and conclusive under Code Sec. 7121.

The court also found that there were no material misrepresentations of fact in the closing agreement. Rather, the court found that one of the recitals referred to by Smith was a legal conclusion regarding the application of U.S. treaty obligations and Australian domestic law to U.S. employees at Pine Grove, and the other was an entirely accurate statement of the express terms of the agreements governing the general operations of the Pine Gap facility.

For a discussion of closing agreements, see Parker Tax ¶263,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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