Tax Pros Wary After IRS Hires Quinn Emanuel Litigators

Law360, New York (April 06, 2015, 4:47 PM ET) — Microsoft Corp. recently brought to light the IRS’ hiring of litigators from Quinn Emanuel Urquhart & Sullivan LLP to assist with examining the tech company’s transfer pricing activities, and some tax professionals say the agency’s unprecedented move is troubling.

In court filings last month, Microsoft revealed the terms of a $2.2 million contract between the IRS and Quinn Emanuel, in which the agency engaged partners John B. Quinn and John S. Gordon at rates of more than $1,000 per hour along with other firm attorneys to “assist with the evaluation, analysis, presentation and defense of claims or adjustments” related to an IRS audit of Microsoft’s transfer pricing practices. Since 2007, the IRS has been looking into two cost-sharing arrangements Microsoft made with offshore subsidiaries, according to court documents.

The IRS may have crossed a line by engaging a private firm to participate in a taxpayer dispute in such an unprecedented way, practitioners said. The agency published a set of temporary regulations in a seeming attempt to allow Quinn Emanuel’s participation in the examination without breaking the taxpayer privacy rules in Internal Revenue Code Section 6103 and other statutes, but it remains to be seen whether the rules would survive a court challenge, practitioners said.

Among tax professionals, there is “concern that this is something new and it potentially oversteps the bounds of the IRS’ obligations under 6103 as well as their going beyond the mandate of what the [IRS] and the [U.S. Department of Justice] are supposed to be doing,” Caplin & Drysdale Chtd.’s Charles M. Ruchelman said.

The IRS has routinely hired private contractors as experts in tax cases, but the participation by Quinn Emanuel in the examination of a taxpayer’s activities as contemplated by the agency’s contract with the firm is new territory, according to tax attorneys.

“Everybody was surprised,” said a D.C. tax practitioner who did not want to be identified. “It would be fair to say this is an unusual situation.”

And while IRS and U.S. Department of the Treasury employees are subject to extensive rules and policies governing their conduct in taxpayer audits, it is unclear how those rules would apply to an outside firm, practitioners said.

“We’re all familiar with those rules that lay out how the game is played,” Ruchelman said. “Is Quinn Emanuel or an outside law firm subject to these internal controls?”

The contract with Quinn Emanuel was executed on May 19, 2014, according to a declaration by Microsoft U.S. Tax Counsel Michael J. Bernard. Between May 19 and Dec. 31, the IRS sought 36 interviews with current and former Microsoft employees on the company’s transfer pricing practices and issued summons enforcement actions against former CEO Steve Ballmer and other current and former Microsoft employees.

Bernard said he received a letter from an IRS official saying the agency intended to have one or more contractors participating in the interviews possibly include outside counsel from Quinn Emanuel. Microsoft did not agree to have the contractors participate in the interviews, he said.

Last month, Microsoft told the court that if it enforced the summons enforcement action it would be an abuse of process because the Quinn Emanuel attorneys are not authorized by law to participate in the IRS interrogation of a taxpayer.

Shortly after engaging Quinn Emanuel, the IRS released temporary regulations to “clarify that contractors are permitted to participate fully in a summons interview. Full participation includes, but is not limited to, receipt, review, and use of summoned books, papers, records, or other data, being present during summons interviews, questioning the person providing testimony under oath, and asking a summoned person’s representative to clarify an objection or an assertion of privilege.”

Microsoft argued that the temporary regulations are invalid because they contradict the unambiguous language of the tax code, which says that only Treasury employees may take summoned testimony. Congress has enabled federal agencies to hire contractors as special government employees, but Quinn Emanuel attorneys do not fall under that rubric, the company alleged.

“The IRS-Quinn Emanuel contract seeks to effectively skirt these limits, by mischaracterizing Messrs. Quinn, Gordon and the other Quinn Emanuel lawyers as providing ‘expert’ services, all while drawing their hourly billing rates and expenses as contractors,” Microsoft said.

Furthermore, the temporary regulations were published without the required notification and opportunity for public comment, in violation of the Administrative Procedure Act, according to Microsoft.

Microsoft is not the only one to question the temporary regs’ legitimacy. In comments submitted in response to the rules, Richard L. Hunn of the State Bar of Texas’ Tax Section said the organization had concerns about allowing a private contractor to examine a witness.

If a private contractor is allowed to participate in an examination, it could cause the IRS officer conducting the interview to lose control of it, Hunn said in a letter to IRS and Treasury officials. Having multiple sources on the record could also be confusing, he said.

It is also unclear whether the IRS is authorized to delegate the authority to interrogate a witness to a private contractor without congressional approval, Hunn said.

“We are unaware of such regulations or orders previously being used to delegate authority to third-party contractors. This suggests that statutory authorization may be required for such delegation,” Hunn said. “Because the proposed regulations arguably exceed the statutory authority under Section 7602(a) by allowing a private contractor to examine a witness under oath, we respectfully request that this provision be removed.”

Including the provision in final regulations would result in costly litigation for the IRS that would waste taxpayer dollars and the courts’ time, Hunn said. Those costs would outweigh the benefit of having a private contractor examine a witness, he said.

Quinn Emanuel referred questions to the IRS. The IRS generally does not comment on ongoing litigation and did not respond to a request for comment.

Despite the legal implications, the IRS’ decision to hire Quinn Emanuel is simply baffling considering the agency is operating with limited resources, tax practitioners said. Why would the IRS spend money on outside counsel when it has its own crack team of litigators and the service is in the midst of a budget crisis?

“I don’t understand what they’re doing,” the Washington tax practitioner who did not want to be identified said. “Why do they need them?”

Ruchelman said, “Everyone’s wondering why the IRS is doing it. Why not get the DOJ tax involved if you’re short on staff?”

Tax professionals will be watching the outcome of the Microsoft trial to see if the Quinn Emanuel contract withstands scrutiny and if IRS collaboration with outside counsel on examinations will become a regular practice in the future, Ruchelman said.

“It’s troubling to those in the tax controversy legal field that the IRS is proceeding this way,” Ruchelman said. “[But] because the situation is so new and unique, there isn’t anything settled until a court rules on it.”

The case is U.S. v. Microsoft Corp. et al., case number 2:15-cv-00102, in the U.S. District Court for the Western District of Washington.