KPMG report: Federal district court vacates Notice 2016-66 (microcaptive insurance transactions)

The U.S. District Court for the Eastern District of Tennessee this week held that Notice 2016-66 was invalid because the IRS did not comply with the notice-and-comment requirements set forth in the Administrative Procedure Act (APA) and because the IRS acted arbitrarily and capriciously in issuing the notice.

The federal district court vacated Notice 2016-66 and ordered the IRS to return all documents and information produced as a result of the notice.

The decision comes following a long procedural journey from the district court through appeals to the Sixth Circuit and the U.S. Supreme Court and back to the district court on remand.

The case is: CIC Services, LLC v. IRS, No. 3:17-cv-110 (E.D. Tenn. March 21, 2022). Read the district court’s decision [PDF 257 KB] 

Microcaptive insurance transactions involve companies that have made elections under section 831(b) to be treated as small insurance companies that are taxed only on their investment income.

The IRS in November 2016 issued Notice 2016-66 that identifies certain “microcaptive transactions” as “transactions of interest”—a subset of reportable transactions. Notice 2016-66 explains that these transactions have “a potential for tax avoidance or evasion,” but that the IRS “lack[s] sufficient information” to distinguish between transactions that are lawful and those that are unlawful. By deeming these transactions to be reportable transactions, Notice 2016-66 imposed certain reporting requirements on taxpayers and material advisors, and also exposed taxpayers and their material advisors to penalties under sections 6707, 6707A, and 6708 if they failed to report information required by the notice.

The plaintiff (CIC) was a material advisor to taxpayers engaging in microcaptive transactions.

After the issuance of Notice 2016-66, CIC filed a complaint seeking to enjoin enforcement of the notice, alleging: (1) the IRS notice failed to comply with the notice-and-comment requirements of the APA; and (2) the notice was arbitrary and capricious. A key threshold issue was the proper application of the Anti-Injunction Act (AIA), which divests federal district courts of jurisdiction over suits “for the purpose of restraining the assessment or collection of any tax.” On CIC’s initial appeal from the dismissal of the lawsuit, the U.S. Supreme Court last year held that the AIA did not prohibit CIC’s challenge to Notice 2016-66, returning the case to the district court to consider the merits. Read TaxNewsFlash

With respect to CIC’s notice-and-comment argument on remand, the federal district court relied on a recent Sixth Circuit decision in Mann Construction v. United States to find that Notice 2016-66 did not comply with the APA. In Mann Construction, the taxpayer challenged the validity of a different IRS notice (Notice 2007-83) that triggered the same reportable transaction rules, arguing among other things, that the notice failed to comply with the notice-and-comment requirements set forth in the APA. On appeal, the government did not dispute that it did not follow notice-and-comment procedures when it issued Notice 2007-83 but argued that the notice was merely an interpretive rule which did not require notice and comment. The government further argued that even if the notice were a legislative rule, Congress exempted IRS notices from the APA's notice-and-comment requirements. 

The Sixth Circuit expressly rejected the government’s arguments in the Mann Construction case, holding that the IRS's notice regarding disclosure obligations for listed transactions constituted a legislative rule and that Congress did not exempt the IRS from complying with the notice-and-comment requirements set forth in the APA. Read TaxNewsFlash

In the present case, the government made similar claims—e.g., that notice-and-comment was not required for Notice 2016-66 or that the notice is not a legislative rule—which the federal district court rejected for the same reasons that the Sixth Circuit rejected in Mann Construction.

With respect to CIC’s arbitrary and capricious argument, the federal district court found that there were no facts in the administrative or litigation record to demonstrate that microcaptive insurance arrangements had the potential for tax avoidance or evasion. The court noted that even though the IRS was “aware of microcaptive transactions and believes that the transactions had the potential for tax avoidance or evasion,” Notice 2016-66 did not identify any facts or data supporting its belief, nor did the IRS present and facts or data during the court proceedings. According to the district court’s findings, the administrative record primarily consisted of prior IRS notices regarding certain reinsurance arrangements as well as legislative history and case law regarding insurance and captive insurance in which the IRS noted some disapproval of captive insurance transactions. No detailed information was provided as to IRS awareness of the potential of microcaptives to be used for tax avoidance or evasion when it issued Notice 2016-66.

Because Notice 2016-66 did not follow the requirements of the APA and was found to be arbitrary and capricious, the court ordered its vacatur under the APA. The court noted the IRS may be able to promugulate a new notice to address microcaptives after proper notice-and-comment procedures.

As far as the information gathered under Notice 2016-66, the court ordered the IRS to return all information and documents it collected pursuant to the notice to all taxpayers and material advisors—not just the plaintiff—reasoning that the IRS received documents it was not entitled to because of its failure to comply with the APA. The court, however, declined to enter an injunction barring agencies from offering documents produced by any individual or entity in response to the notice in judicial or administrative proceedings, noting that Notice 2016-66 was just one source of information and that the IRS may be able to lawfully acquire the same information from other sources.

Tax professionals have observed that with the vacatur of Notice 2016-66, the reporting requirements of the notice and any associated penalties for failure to comply with the reporting requirements should no longer apply—at least for taxpayers and material advisors resident in the Sixth Circuit (Tennessee, Kentucky, Ohio, and Michigan are the states in the Sixth Circuit).  To the extent that any penalties have been imposed or proposed by the IRS, it appears such penalties would be abated if the judgment goes final. Observers believe that the government is likely to appeal and that, outside the Sixth Circuit, the IRS would be expected to maintain its position that Notice 2016-66 was properly issued.

On the merits, tax professionals believe that the CIC decision is unlikely to meaningfully affect the IRS’s current microcaptive campaign. With multiple victories in the U.S. Tax Court against microcaptives since the issuance of Notice 2016-66—e.g, Avrahami v. Commissioner and Syzygy v. Commissioner—and the increased audit activity following from the notice, the IRS remains in a strong position to place significant pressure on taxpayers to discontinue microcaptive arrangements. The potential amounts at issue for microcaptives are modest compared to the cost of litigating against the government.

This week’s decision by the federal district court is unlikely to halt current IRS audit activity because some information may have been gathered by the IRS improperly under Notice 2016-66—as the court indicated, there are other lawful ways the IRS could acquire similar information, such as through a general examination of a taxpayer’s return.
 

For more information contact a KPMG tax professional:

Sheryl Flum | +1 (202) 533-3394 | sflum@kpmg.com

Lori Robbins | +1 (212) 533-3491 | lorirobbins@kpmg.com

Tom Greenaway | +1 (617) 988-1221 | tgreenaway@kpmg.com

William Olver | +1 (617) 988-1642 | wolver@kpmg.com