Judge in Microsoft tax case to decide if IRS improperly hired Quinn Emanuel

June 18, 2015

Can the Treasury Department and the Internal Revenue Service hire private lawyers to advise the government on big-dollar corporate tax audits that may result in litigation? On Wednesday, U.S. District Judge Ricardo Martinez of Seattle agreed to take up that question, granting Microsoft’s motion for an evidentiary hearing into the government’s $2.2 million contract with Quinn Emanuel Urquhart & Sullivan, which is serving as a litigation consultant in the IRS’s audit of Microsoft’s cost-sharing arrangements with affiliates in Puerto Rico and Asia.

Quinn Emanuel’s engagement is apparently the first time the IRS has brought in a private firm to advise the government on a tax audit but it may not be the last. In June 2014, Treasury and the IRS issued a temporary regulation – without any notice and comment period – permitting private contractors to participate in interviews with witnesses responding to IRS summonses. The temporary regulation, which has also been proposed as a formal rule, does not expire until 2017.

Microsoft contends that Treasury and the IRS improperly issued the regulation to justify their deal with Quinn Emanuel – which, according to Microsoft, is itself “an impermissible delegation of an inherently governmental function.” The government, as I’ll explain, disputes both parts of Microsoft’s allegations of impropriety. But first, it’s helpful to understand a little bit about the history of the case.

Since 2007, the IRS has been investigating Microsoft’s tax returns from 2004, 2005 and 2006. The specifics of Microsoft’s tax strategy aren’t really important for this story, but there’s a lot of money at stake in the audit. According to a government brief describing its hiring of Quinn Emanuel, the Microsoft case potentially involves tens of billions of dollars of taxable income.

Microsoft cooperated with the tax audit as it expanded, turning over more than a million pages of documents to the IRS, providing more than 50 employees for interviews and extending the statute of limitations eight times. According to a declaration from Microsoft tax counsel Michael Bernard, the company was eager for the IRS to wrap up its evaluation so the case could move to the tax appeals division and Microsoft and the government could discuss a settlement.

In early 2014, the IRS asked for settlement concessions Microsoft refused to accept and substantive settlement talks tapered off. Microsoft asked for a “30-day letter,” basically a tax bill that the company could appeal. Instead, in July 2014, the IRS issued 11 new demands for information, requesting both documents and witnesses for formal interviews. Additional document demands followed in August and October 2014.

Unbeknownst to Microsoft, the IRS had entered a contract with Quinn Emanuel in May 2014, after concluding, in the words of the government’s brief “the IRS would also benefit from having an independent analysis from, and examination support by, seasoned commercial litigators who had experience presenting, defending and critiquing fact-intensive and expert-dependent positions.” (The IRS, according to a Freedom of Information Act suit filed by Microsoft in May, first engaged David Boies of Boies Schiller & Flexner, but that agreement apparently fell through and Quinn Emanuel was hired instead.)

The IRS informed Microsoft in August that it had hired Quinn “to assist  in its evaluation and examination,” and that Quinn lawyers would attend upcoming interviews with Microsoft witnesses. By then, of course, Treasury and the IRS had issued the June 2014 temporary rule permitting exactly that practice. At the interviews, Quinn Emanuel lawyers advised IRS employees during the initial round of questioning and asked their own follow-up questions of Microsoft witnesses.

Microsoft pressed the IRS and Treasury for information about Quinn’s role, filing a series of FOIA suits. The company eventually obtained part of the IRS contract with Quinn, though the government declined to turn over documents responding to most of Microsoft’s FOIA demands. In October, in turn, Microsoft refused to provide all of the documents the IRS demanded in a summons. The company also refused to allow sworn, recorded testimony from some witnesses summoned to appear.

Quinn Emanuel, meanwhile, was conducting an independent assessment of the evidence the IRS had amassed on Microsoft’s cost-sharing arrangements, including a review of documents Microsoft turned over and transcripts of witness interviews Quinn lawyers hadn’t attended. In November 2014, Quinn presented government officials with its evaluation of the relative strengths and weaknesses of their case and Microsoft’s defense. In December, the government sued Microsoft to enforce compliance with its summons.

The government’s suit in federal district court in Seattle set up Microsoft’s motion for an evidentiary hearing on Quinn Emanuel’s involvement in the case. According to Microsoft, the case’s timeline suggested that Quinn was directing the IRS’s newly aggressive tactics – an impermissible “outsourcing,” according to Microsoft, of the IRS’s audit power. “The Internal Revenue Code prohibits the IRS from outsourcing an audit to private lawyers, as the power to audit (like the power to take testimony pursuant to summons) is an inherently governmental function expressly reserved to IRS officers and employees,” Microsoft said.

Nor could the government seek cover from the June 2014 temporary regulation, Microsoft said, because the regulation was invalidly enacted and moreover contradicts statutory language.

The Justice Department’s opposition brief argued that Quinn Emanuel stayed strictly within the lines of the temporary regulation’s mandate and laws permitting the Treasury Secretary to prosecute the tax code. The firm didn’t actually begin working on the case until July 2014, after the IRS launched the latest round of summonses. The firm didn’t draft the initial demands for information, the government said, and didn’t take the lead in questioning Microsoft witnesses.

“Microsoft fails to acknowledge that inherently governmental functions do not normally include ‘gathering information for or providing advice, opinions recommendations, or ideas to federal government officials,'” the government said, quoting from the U.S. code. “That is precisely the role Quinn Emanuel is playing with respect to the IRS’s examination of Microsoft: Quinn Emanuel is assisting in gathering facts and evidence, as well as providing advice, opinions, and recommendations to the IRS to assist the IRS in performing its examination.”

Judge Martinez, however, agreed with Microsoft and ordered an evidentiary hearing on both the issuance of the temporary rule permitting Quinn’s hiring and Quinn’s actual work for the IRS. “Among other circumstances to which Microsoft points, the issuance of the regulation shortly after the IRS’s contracting with Quinn Emanuel plausibly raises an inference of improper motive,” he wrote.

The judge also found a plausible “inference of impropriety in Quinn Emanuel’s role in the summons process,” he wrote. “While the United States contests that it has delegated any inherently governmental functions to the firm, the language of the contract itself suggests that the firm may be participating in components of the audit examination for which delegation is statutorily proscribed, such as inspecting books and taking testimony.”

It’s not clear from the order what evidence Judge Martinez plans to consider at the hearing, which hasn’t yet been scheduled. He said he’d consider Microsoft’s request for additional discovery from the government after the hearing.

At least two influential U.S. politicians have said they share Microsoft’s fears about the IRS contracting with private law firms on taxpayer audits. After Judge Martinez ordered an evidentiary hearing, the press secretary for Illinois Republican Peter Roskam, who heads the Oversight Subcommittee of the House Committee on Ways and Means, put out a statement: “Today’s district court ruling in favor of Microsoft supports what Chairman Roskam has been saying all along: It is inappropriate for the IRS to use private law firms to perform audits and administer tax law. Federal law does not allow for contracting out these inherently governmental activities, not least of all because it threatens taxpayer privacy and confidentiality.”

Previously, Microsoft entered in the court docket a three-page letter to the IRS Commissioner from Senator Orrin Hatch, the Utah Republican who chairs the Senate Finance Committee. “The IRS’s hiring of a private contractor to conduct an examination of a taxpayer raises concerns because the action: 1) appears to violate federal law and the express will of the Congress; 2) removes taxpayer protections by allowing the performance of inherently governmental functions by private contractors; and 3) calls into question the IRS’s use of its limited resources.”

Martinez said in a footnote in Wednesday’s decision that Microsoft can introduce the Hatch letter at the evidentiary hearing.

I left a phone message requesting comment from the Justice Department but didn’t hear back.

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