United States: District Court Grants Evidentiary Hearing In Dispute Over IRS Use Of Private Firm In Microsoft Audit

On June 17, 2015, the United States District Court for the Western District of Washington granted Microsoft Corporation an evidentiary hearing on whether the IRS' use of lawyers from Quinn Emanuel Urquhart & Sullivan LLP in the summons process was lawful.³⁸ The IRS has been auditing Microsoft's transfer pricing arrangements from the company's 2004 to 2006 tax returns, and seeking to enforce the related summonses in United States v. Microsoft Corp. et al.³⁹

What began as a routine IRS audit of Microsoft's cost-sharing arrangements with affiliates soon became a case full of rare happenings: the first time the IRS has hired a  private law firm to aid in the audit process, and one of the rare instances where a District Court has granted an evidentiary hearing in a summons enforcement proceeding. The IRS contracted for Quinn Emanuel Urquhart & Sullivan LLP to help in its Microsoft  audit, relying on the temporary regulations it issued in June 2014. Microsoft challenged both that contract and the validity of the regulation that permitted it. US District Judge  Ricardo S. Martinez found that Microsoft had carried its burden for an evidentiary  hearing, distinguishing this case from prior ones where hearings had been denied. On  July 17, 2015, Judge Martinez also denied the Government's motion to exclude witnesses, allowing Microsoft's attorneys to testify at the hearing and agreeing with the company that an evidentiary hearing is not a trial.

Timeline of Events

The saga started in 2007, when the IRS began investigating Microsoft's activities from 2004 to 2006. The IRS audit focused on two of the company's cost-sharing  arrangements, one with Microsoft affiliates in Puerto Rico and another with affiliates in Asia, a process that continued over the next seven years. The fact gathering had been  done by just the agency thus far, but on June 9, 2014, the Treasury and the IRS issued a "temporary regulation" without notice and comment that would allow third-party contractors like private law firms to "receive books, papers, records or other data  summoned by the IRS and take testimony of a person who the IRS has summoned as a witness to provide testimony under oath."⁴⁰

Based on this temporary regulation, the IRS entered into a $2,185,500 contract with Quinn Emanuel for help on the audit of the Puerto Rico arrangement, which included  services such as analysis of issues, identification of any further documents needed and participation in interviews. Quinn Emanuel's involvement allegedly did not begin until  July 15, 2014, however, the IRS did not inform Microsoft it had retained private civil  litigators for the audit until August 28, 2014. Quinn Emanuel attorneys were present at  interviews, reviewed documents and independently assessed the Puerto Rico  arrangement from September to October 2014.

On October 30, 2014, the IRS issued a summons to Microsoft pursuant to 26 U.S.C. §§ 7602 and 6503(j), followed by filed petitions in the District Court for the  Western District of Washington to enforce those summonses beginning in  December 2014. After finding that the IRS had made the requisite initial showing for  enforcement, the Court issued an Order to Show Cause to Microsoft. Microsoft responded  by filing motions seeking an evidentiary hearing, alleging IRS abuse of process in  contracting the audit out to a private law firm, and that discovery is therefore warranted  prior to the Court's decision on summonses enforcement. Microsoft also filed Freedom of  Information Act ("FOIA") requests in the meantime for documents relating to the IRS's  retention of Quinn Emanuel.

Legal Background and Issues

The crux of this case is whether the IRS can retain outside private attorneys in an audit,  and whether the temporary regulation it relied upon to do so was valid. The IRS acted  well within the law when it brought an enforcement action. See 26 U.S.C. § 7604(b). Once  the court has found that the IRS has made a prima facie case, the burden shifts to the  taxpayer to show that enforcement of the summons would result in an abuse of the  court's process. United States v. Powell, 379 U.S. 48, 58 (1964). However, in such  enforcement proceedings, the court is limited to deciding only whether the IRS issued the  summons in good faith and without improper purpose.⁴¹  Taxpayers are also entitled to a  pre-enforcement evidentiary hearing if they can point to "specific facts or circumstances  plausibly raising an inference of bad faith" or of another "appropriate ground" to defeat  the summons, a threshold showing that can be satisfied via circumstantial evidence.⁴²

Microsoft made two arguments in support of an evidentiary hearing: first, that the IRS, in  hiring a private law firm to conduct audit interviews, improperly outsourced an  inherently governmental function and thus abuses court process; and second, the facts  and circumstances of how Quinn Emanuel was retained raised a "plausible inference"  that the IRS may have also improperly delegated other aspects of the tax audit to the firm.  The company also asserts that this is the first time that the IRS has retained private civil  litigators in a US income tax audit, and that while the contract covers four non-severable  phases for the firm's services, only the first phase is detailed.

The IRS countered that whether the outsourcing was improper or not is a legal question,  and not one requiring factual discovery. The hiring of Quinn Emanuel was also one fully  supported by law, and challenges the idea that the circumstances raised any inference of  impropriety.

Circumstantial Evidence Deemed Sufficient

In ruling for Microsoft, Judge Martinez distinguished the present case from past denials  for hearings because Microsoft had carried its burden to trigger an evidentiary hearing:  Microsoft was able to point to specific circumstances from which the court could infer  that the temporary regulation was invalid; and the company was also able to point to facts  and circumstances raising an "inference of impropriety."⁴³

According to the court, while the IRS was correct in saying that the challenge to the  validity of the temporary regulation was a question of law, the challenge itself raises  questions of fact that may warrant discovery.⁴⁴ Whether the temporary regulation  expanding the parties able to assist in tax audits is valid could then turn on the facts: the  regulation might be one that the IRS could issue without notice and comment  procedures, as listed in 5 U.S.C. § 553(b)(3); the regulation might be found arbitrary and capricious—and therefore invalid—because it could not be reconciled with the plain language of the IRC.

In addition, the court found that Microsoft was able to point to sufficient facts and circumstances "plausibly raising an inference of impropriety." In support of its allegation  that the IRS was improperly delegating government functions in the audit, Microsoft showed language in the contract that could suggest the firm was inspecting books and taking testimony, activities that are statutorily limited to the Government alone. Microsoft also alleged that the IRS retained Quinn Emanuel before the temporary regulations were issued, raising an inference that the firm played a larger role in the  issuance of summonses and information documents requests and had access to confidential taxpayer information in violation of the Code.⁴⁵

Evidentiary Hearing is Not a Trial

Exactly one month after his order granting an evidentiary hearing, Judge Martinez also allowed Microsoft's attorneys to participate as witnesses in the same trial in which they were also advocates, denying the IRS's motion to exclude. Microsoft had sought to allow their attorneys to testify about IRS' contract, a move the IRS said was barred by Washington's rules of professional conduct—rules that forbade attorneys from being both witnesses and advocates at the same trial.

Judge Martinez once again sided with Microsoft, saying that while the state rules of professional conduct did apply in District Court, the attorneys' testimonies would not  violate them because an evidentiary hearing was not a trial. After the court's decision, Microsoft said that the attorneys would be acting only as witnesses for the hearing, with other attorneys taking on their former roles as advocates.

The IRS retaining outside counsel for a tax audit is an unprecedented move, and while grants for evidentiary hearings are rare, the unique circumstances of this case may have  affected the decision. The evidentiary hearing is scheduled for August 25, 2015.

Footnotes

^{38 United States v. Microsoft Corp. et al, No. 2:15-cv-00102 (W.D. Wa., June 17, 2015).}

^{39 See United States v. Microsoft Corp. et al No. 2:15-cv-00102 (W.D. Wa. filed Dec. 11, 2014); No. 2:15-cv-00103 (W.D. Wa. filed Dec. 19, 2014).}

^{40 See 79 Fed. Reg. 34,625 (June 18, 2014); 26 C.F.R. § 301.7602-1T(b)(3).}

^{41 See United States v. Clarke, __ U.S. __, 134 S.Ct. 2361, 2367 (2014) (quoting United States v. Stuart, 489 U.S. 353, 369 (1989)).}

^42 Id.

^{43 Microsoft filed a supplemental brief regarding the recent Tax Court decision in Altera Corp. v. Commissioner, 145 T.C. No. 3 (2015). According to Microsoft, the Altera decision is relevant to its claim that enforcing the IRS summonses would be an abuse of the court's process.}

^{44 Prior to the temporary regulation, the Internal Revenue Code allows only the Secretary or any duly authorized "officer, employee or agency of the Treasury Department" to examine documents, issue summons or take testimony under oath to investigate tax liability. See 26 U.S.C. § 7602(a)(1)-(3); § 7701(a)(11)(B), (a)(12)(A)(i).}

^{45 See 26 U.S.C. § 6103.}

Written with the help of Eva Yung, a summer associate at Shearman and Sterling LLP.

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