Focus on Tax Controversy


Supreme Court to Hear Tax Injunction Act Case

Arthur R. Rosen

On August 20, 2013, in Direct Marketing Association v. Brohl, the U.S. Court of Appeals for the Tenth Circuit held that the federal Tax Injunction Act (TIA) prohibited the U.S. District Court for the District of Colorado from ruling on the Direct Marketing Association’s (DMA) challenge to Colorado’s use tax notice and reporting requirements. 735 F.3d 904 (10th Cir. 2013). The Supreme Court of the United States has granted certiorari and will hear the case during its October 2014 term.

State Court Bias and the Tax Injunction Act

Among state and local tax practitioners there exists the perception that state court judges, despite their sincere efforts, have difficulty remaining unbiased when hearing state tax cases. The concern is that the judges may be unconsciously biased against the claims of taxpayers because the judges themselves are inextricably entwined with state government. Every decision in favor of a taxpayer results in a reduction of revenue for the state—the ultimate payor of the judge’s salary—and perhaps a slap in the face of the judge’s colleagues in state government. As a result, they may improperly take the loss of state government revenue and power into consideration when determining case outcomes.

Taxpayers can point to numerous examples of state courts considering the loss of state government revenue when issuing a ruling. For example, in Exelon Corp. v. Illinois Department of Revenue, the taxpayer successfully convinced the Illinois Supreme Court that electricity was tangible personal property, and thus the taxpayer was entitled to the investment credits for taxpayers engaged in retailing tangible personal property. 917 N.E.2d 899 (Ill. 2009). However, following a motion for rehearing, the court limited its holding to prospective application only. In Miller v. Johnson Controls, Inc., the Kentucky Supreme Court upheld legislation retroactively prohibiting refunds resulting from the change from separate unitary filing to unitary combined filing. 296 S.W.3d 392 (Ky. 2009). The court held that the retroactive application did not violate the taxpayer’s due process and equal protection rights because the legislation was rationally related to the legitimate governmental purpose of preventing the loss of revenue. See Arthur R. Rosen & Julie M. Skelton, “Desperately Seeking State Tax Fairness: The Need for Federal Adjudication,” 61 State Tax Notes 357 (Aug. 8, 2011). Based on these decisions, taxpayers’ worries about state court bias may be for good reason.

Taxpayers have long desired a way to engage in federal court adjudication to receive impartial treatment. Despite concerns about state court bias, the TIA and its common law basis, comity, prohibit taxpayers from petitioning federal courts for the adjudication of most state tax controversies. The TIA prohibits federal district courts from “enjoin[ing], suspend[ing] or restrain[ing] the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.” 28 U.S.C. § 1341. Such actions may be pursued only in state courts.

The Supreme Court of the United States has previously commented on the scope of the TIA in Hibbs v. Winn and Levin v. Commerce Energy, Inc. In Hibbs v. Winn, the Supreme Court determined that the TIA does not apply to a third party challenging a state tax credit’s constitutionality under the Establishment Clause. 542 U.S. 88 (2004). The TIA only prohibits federal courts from hearing cases that interfere with the state’s collection of revenue. The Supreme Court also noted that “in enacting the TIA, Congress trained its attention on taxpayers who sought to avoid paying their tax bill by pursuing a challenge route other than the one specified by the taxing authority. Nowhere does the legislative history announce a sweeping congressional direction to prevent ‘federal-court interference with all aspects of state tax administration.’” Id. at 104 – 05.

In Levin v. Commerce Energy, Inc., the Supreme Court distinguished Hibbs v. Winn, holding that the comity doctrine, separate and apart from the more narrow TIA, barred the “taxpayer’s complaint about allegedly discriminatory state taxation framed as a request to increase a competitor’s tax burden.” 560 U.S. 413, 425 – 26 (2010). The Supreme Court indicated three factors that gave rise to the application of comity: (1) the respondent sought “federal-court review of commercial matters over which Ohio enjoys wide regulatory latitude; [the] suit [did] not involve any fundamental right or classification that attract[ed] heightened judicial scrutiny,” (2) respondents sought “federal-court aid in an endeavor to improve their competitive position,” and (3) the state courts were better positioned to correct any violation because of a greater familiarity with “state legislative preference and because the TIA does not constrain their remedial options.” Id. at 431 – 32.

One could argue that the TIA evidences Congress’ desire to narrow the common law comity principle. Justice Ruth Bader Ginsburg has stated that “the [TIA] may be best understood as but a partial codification of the federal reluctance to interfere with state taxation.” Id. at 414 (quoting Nat’l Private Truck Council v. Okla. Tax Comm’n, 515 U.S. 582, 590 (1995)). Treating the TIA as having a narrower jurisdictional bar than the pre-existing common law comity principle renders the TIA superfluous. Therefore, it may be more sensible to see the TIA as Congress narrowing comity.

Direct Marketing Association v. Brohl

As noted below, in Direct Marketing Association v. Brohl, the Tenth Circuit held that the TIA prohibited a federal district court from ruling on the constitutionality of Colorado’s remote seller use tax reporting laws despite the provisions neither imposing nor requiring the collection of a tax. 735 F.3d 904 (10th Cir. 2013).

Colorado’s use tax requires Colorado purchasers that have not paid sales tax on the purchase of tangible goods to pay a 2.9 percent use tax on the “storage or acquisition charges or costs for the privilege of storing, using, or consuming in [Colorado] any articles of tangible personal property purchased at retail.” Colo. Rev. Stat. § 39-26-202(1)(b). The use tax compensates for the loss of sales tax revenue resulting from residents purchasing property from other states with lower sales tax rates (or no sales tax at all) and bringing the property back into Colorado for its use. Colorado requires individuals to self-report their use tax liabilities. See Colorado DR 0252, Consumer Use Tax Return and Instructions. However, the extremely low compliance rate has resulted in the loss of state tax revenue.

In 2010, Colorado attempted to capture this revenue by adopting Colorado Revised Statutes sections 39-21-112(3.5)(c) and (d) and Colorado Code of Regulations section 39-21-112.3.5, requiring certain retailers that have not collected sales tax from Colorado purchasers, such as remote sellers, to: (1) provide transactional notices to Colorado customers stating that the retailer does not collect Colorado tax and that the purchase is not exempt solely because it is made over the internet or by other means, (2) send annual purchase summaries to Colorado customers, and (3) annually report Colorado customer information to the Colorado Department of Revenue (Department). See also Direct Marketing Assoc., 735 F.3d at 907; Brief Amicus Curiae of Council on State Taxation in Support of Petitioner, Direct Marketing Assoc. v. Brohl, 2014 WL 1285844 (U.S. 2014) (No. 13-1032). Many observers believe that the Colorado legislature hoped that these onerous requirements, which would require sellers to invent and implement totally new systems, would economically coerce sellers into collecting and remitting the tax.

In June 2010, the DMA sued the Colorado Department of Revenue’s executive director in the U.S. District Court for the District of Colorado, arguing that the notice and reporting requirements were unconstitutional under the Commerce Clause. The district court granted the DMA’s motion for summary judgment, holding that the notice and reporting requirements facially discriminated against interstate commerce and placed burdens on out-of-state retailers that would unconstitutionally interfere with interstate commerce. The court reached this conclusion because it placed an obligation only on sellers with no physical presence in Colorado (since those with Colorado presence would be collecting the tax and thus not subject to the reporting requirements). Direct Marketing Assoc. v. Huber, 2012 WL 1079175, No. 10-cv-01546-REB-CBS (D. Colo. Mar. 2012).

The Department appealed to the Tenth Circuit, arguing that the TIA barred the federal court from hearing the case. First, the DMA argued that the TIA did not apply because the DMA is not a taxpayer seeking to avoid a tax. In rejecting this argument, the Tenth Circuit took an expansive view of the TIA, stating that it “applies to federal court relief that ‘would … operate[ ] to reduce the flow of state tax revenue.’” Direct Marketing Ass’n, 735 F.3d at 911 (quoting Hibbs v. Winn, 542 U.S. at 106). The court limited Hibbs v. Winn to the holding that the TIA does not apply to a petitioner contesting a tax benefit provided to a third party because the suit did not attempt to reduce the flow of state tax revenue. Citing to Tenth Circuit case law and Congress’ “state-revenue-protective objectives,” including prohibiting “taxpayers, with the aid of a federal injunction, from withholding large sums, thereby disrupting state government finances,” the Court of Appeals held that the TIA does not apply only to taxpayers challenging their own state tax liabilities, but also to plaintiffs seeking to prevent “the State from exercising its sovereign power to collect … revenues.” Hill v. Kemp, 478 F.3d 1236, 1249 (10th Cir. 2007).

The DMA also argued that the TIA did not apply because it sought to avoid notice and reporting obligations, not a tax, and thus did not seek to restrain the assessment, levy or collection of any tax. Direct Marketing Assoc., 735 F.3d at 912. The court read “restrain” broadly to apply to not just the direct challenge of a tax, but to a lawsuit concerning a procedure that operates to enforce and increase tax collection. For instance, the court found that “the annual customer information reports sent to the Department would aid the Department’s auditing of taxpayers” and be a significant tax collection mechanism. Id. at 914.

Under the Tenth Circuit’s interpretation of the TIA, taxpayers would not be able to challenge any aspect of taxation that would operate to hamper, even indirectly, a state’s ability to raise revenue. The Tenth Circuit’s opinion has resulted in a circuit court split with the First, Second and Sixth Circuits. These courts have each viewed the TIA as not applying to a tax agency’s administration functions that serve to indirectly aid in the collection of tax. See United Parcel Serv., Inc. v. Flores-Galarza, 318 F.3d 323 (1st Cir. 2003); Wells v. Malloy, 510 F.2d 74 (2nd Cir. 1975); BellSouth Telecommunications, Inc. v. Farris, 542 F.3d 499 (6th Cir. 2008).

Supreme Court of the United States

On July 1, 2014, the Supreme Court granted certiorari in Direct Marketing Association v. Brohl. The court will determine “whether the TIA bars federal court jurisdiction over a suit brought by non-taxpayers to enjoin the informational notice and reporting requirements of a state law that neither imposes a tax, nor requires the collection of a tax, but serves only as a secondary aspect of state tax administration.” See Direct Marketing Assoc. v. Brohl Question Presented.

The Supreme Court will have the chance to revisit Hibbs and Levin, clarify the limits of the TIA and the common law comity principle, and remedy the federal circuit court split regarding whether the TIA applies to secondary elements of state tax administration that only indirectly affect the collection of tax. The Tenth Circuit has broadly interpreted the TIA’s purpose, prohibiting taxpayers from challenging practically any aspect of tax administration in federal court if the challenge would hamper the state’s ability to raise revenue, even indirectly. A ruling against the DMA would expand the reach of the TIA to encompass nearly all state tax-related lawsuits and extinguish state taxpayers’ hopes of receiving unbiased treatment from the judiciary.

Tax Court Approves Use of Predictive Coding During ESI Discovery

Andrew R. Roberson | Joshua David Rogaczewski | Kevin Spencer

On September 17, 2014, the U.S. Tax Court issued its first opinion regarding the discovery of electronically stored information (ESI). InDynamo Holdings, Ltd. vs. Commissioner, 143 T.C. No. 9 (Sept. 17, 2014), the Tax Court permitted a taxpayer to use “predictive coding” as a first-level review of a large pool of documents. The court’s opinion is important for taxpayers faced with requests for a substantial amount of ESI, and has the potential to reduce the burden and cost of complying with such requests.


Most documents today originate in electronic form, and taxpayers may have a duty to preserve ESI. ESI has traditionally been subject to discovery requests, but it was only recently that the judicial system amended its rules to specifically address ESI. The case law and procedural laws emphasize that e-discovery should be a cooperative and reciprocal process, and that parties should not be subject to undue burden or cost. Failure to comply with e-discovery obligations can result in sanctions, which vary depending on the type and severity of the violation.

To respond to requests for ESI, taxpayers and their advisors have several tools to assist in extracting and analyzing responsive information. One such tool is predictive coding.

What Is Predictive Coding?

Predictive coding is a type of computer-assisted review software technology that leverages human expertise and sophisticated computer algorithms to iteratively train a computer to apply coding decisions on a sample set of documents across a universe of documents. Typically, in a predictive coding workflow, senior team members with a strong understanding of the substantive legal issues in the case review a small set of “seed” documents in order to identify documents that are responsive to a particular request or issue. These initial decisions are then captured, analyzed and used to teach the computer to apply similar logic-based decisions to conceptually similar documents within the database. This process is then repeated several times with the human decisions in each seed set informing and refining the computer’s identification of responsive documents.

Dynamo Establishes that Predictive Coding Is an Acceptable Document Review Technique

In Dynamo, the Internal Revenue Service (IRS) determined that certain cash transfers to a related party were actually disguised gifts to the taxpayer’s owners. The taxpayer argued that the transfers were loans. During litigation, the IRS sought the production of ESI that was contained on two backup storage tapes. The taxpayer asked the court to deny the IRS’ request because it was merely a “fishing expedition.” Alternatively, the taxpayer asked the court to permit it to use predictive coding to reduce the number of documents to be reviewed to determine the relevant and not privileged documents that would be produced to the IRS. Allegedly, there were up to seven million documents to review to determine the relevant and not privileged documents.

The IRS argued that the taxpayer should be required to produce the entire universe of potentially relevant information (including any privileged documents) because it wanted to review not only the documents themselves but also all of the metadata associated with each document. The IRS also argued that the court should deny the taxpayer’s request to use predictive coding because it is an “unproven technology.” However, the IRS assured the court that, to the extent that the set of documents produced contains privileged documents, the IRS would agree that the disclosure of those privileged documents would not constitute waiver of any privilege claims that the taxpayer may assert.

First, the court reviewed its discovery rules and determined that ESI is discoverable in Tax Court. Second, the court weighed the parties’ competing interests. One the one hand, the IRS is entitled to a complete response to its discovery request. On the other hand, the taxpayer has the right to protect its privileged information and avoid the substantial costs associated with a so-called “linear review,” a review of each putatively responsive document by a human reviewer.

The court determined that predictive coding is a “potential happy medium” that addresses each side’s concerns. In making its decision, the court recited articles and studies that indicated that, in general, predictive coding is more accurate than a traditional, linear review because humans tend to make more mistakes than computers. The court also found support for the use of computer-assisted review by other courts facing similar issues.

The court’s opinion is a welcome development for taxpayers in the current electronic age, particularly given the limited number of tax cases addressing e-discovery. The IRS has broad authority to request documents from taxpayers, and the time and cost associated with such requests can skyrocket when large amounts of ESI are involved. Tools such as predictive coding can make the discovery process more efficient for all involved.

Predictive Coding Makes Large Document Review Projects More Efficient

The advent of email and electronic media has made discovery during litigation an exponentially complicated and expensive ordeal for litigants. Predictive coding may answer the question of how to be efficient and reasonable when you have large amounts of electronic data. Predictive coding offers several benefits. First, it offers a proven, viable method to assist courts with their duty to limit discovery within reasonable bounds. The Federal Rules of Civil Procedure state that a “court must limit the frequency or extent of discovery” if the discovery proposed is “unreasonably cumulative or duplicative” or if the information can be obtained from “a more convenient, less burdensome, or less expensive” alternative source. Fed. R. Civ. P. 26(b)(2)(C). Tax Court Rule 70(c)(2) contains a similar “undue burden or cost” exception. Also, predictive coding can substantially improve rates of precision and accuracy. The computer’s concept identification, multi-dimensional “thinking” and continuous fine-tuning can be better than simply using key words to find similar documents and identify true responsiveness. Finally, leveraging an advanced review technology, such as predictive coding, is a smart way to proactively manage the often massive scope and cost of discovery, resulting in substantial savings to clients.

Computer-assisted Document Review Is Here to Stay

Being facile with predictive coding and other ESI review tools will become increasingly important as more courts sanction their use. Cases in which one side has significant ESI and the other does not will continue to present hurdles for the use of sophisticated ESI review tools. But in complex cases, where both sides are sophisticated litigants and have large amounts of ESI, we expect more and more cases to involve party-negotiated and court-approved ESI-review terms. Indeed, ESI discovery in complex cases will become increasingly impractical in the absence of the advantages created by recently developed ESI review tools. In that sense, the trend in favor of using those tools is inevitable.

How Best to Prepare for ESI Discovery

There are several things that clients can do to take advantage of the trend. First, clients should take stock of their ESI. The more that a client knows about its data (e.g., the quantity of data, how the data are stored and backed up, retention policies), the easier it is to identify the tools that can efficiently analyze the data. Part of this process may require updating document retention policies—given that individuals are more likely to retain electronic data than paper documents—to ensure that unnecessary ESI can be disposed of prior to time any duty to preserve may apply. Second, clients should delegate internal controls for ESI to a single, responsible individual who can interface with outside counsel. In the authors’ experience, clients that have a designated ESI officer understand the ESI issues and options more deeply than those that do not. Finally, clients should consider investing in a system that would make iterative ESI collection easier, faster and more efficient. This may be especially important with clients that are routinely involved in litigation. ESI collections can be very expensive and time consuming, but developing a system in which subsequent collections can build off earlier ones may reduce per-collection costs and improve efficiencies.

Illinois Appellate Court Finds Chicago Bears Ticket Holder Amenities Taxable

The First District of the Illinois Appellate Court, in Chicago Bears Football Club v. Cook County Department of Revenue, 2014 IL App (1st) 122892 (Aug. 6, 2014), affirmed an administrative determination finding that the Chicago Bears owe Cook County more than $4.1 million in amusement tax and related interest, on the basis that the amenities and privileges enjoyed by Bears premium ticket holders are taxable admission charges. The ordinance at issue imposes tax on “admission fees or other charges paid for the privilege to enter, to witness or to view such amusement” but excludes “any separately stated charges for non-amusement services or for sales of tangible personal property.” Cook County, Ill. Code of Ordinances, part I, ch. 74, art. X, § 74-392(a), (e).

The charges at issue include those for club-level seats, luxury suites and the Skyline Suite. For club-level seats, the assigned seat location varies from the 50-yard line to the end zone. On the face of the ticket, the charge for the seat and for the amenity license is separately stated. The price of the seat is constant regardless of location, while the price of the license varies depending on the seat location. Amenities provided to a club seat ticket holder include access to a “club lounge” for use before, during and after the game. The lounge has buffet and bar areas (food and beverage not included in ticket price), better food selection than that available in the regular seating area, and high-definition televisions for viewing the Bears game in progress and other National Football League games. A club-level ticket holder cannot view the entire field from the lounge. Other amenities include rights to early ticket purchases for playoff games and non-Bears-game events at Soldier Field, special parking privileges, invitations to autograph sessions and merchandise giveaways, free game day programs and invitations to appreciation events year-round.

The luxury suites provide a private enclosed area for up to 20 guests. Seating is not assigned. Tickets list a single price. Suite amenities include individual temperature controls, private bathrooms and high-definition televisions. Food and beverage generally are not included in the ticket price. Other available amenities include first option to use the suite for most non-Bears events at Soldier Field, travel arranged by the Bears for certain away games, invitations to non-football game day events, participation in game day drawings for special prizes, parking passes, special recognition in Bears publications and invitations to appreciation events year-round.

The Skyline Suite is an open area shared by multiple licensees and has non-assigned seating. Food and beverage are included in the price. Like luxury suite tickets, Skyline Suite tickets list a single price. The same amenities available to luxury suite ticket holders are available to Skyline Suite ticket holders.

The appellate court affirmed the county’s assessment, concluding tax is owed on 100 percent of the club seat ticket price and on 60 percent of the luxury suite and Skyline Suite licenses. For club-level seats, the court reasoned that a person who wants to watch a game from a club seat cannot get to a seat without paying the privilege license fee, relying on its decision in Stasko v. City of Chicago, 2013 IL App (1st) 120265 (Sept. 30, 2013). In Stasko, the court found taxable under the City of Chicago amusement tax (substantively similar to the county tax) permanent seat license fees that had to be paid before purchase of a season ticket for a specific seat location.

The court’s analysis with respect to club-level seats is erroneous. First, the Stasko decision does not apply, because the only benefit provided to a purchaser of a permanent seat license is the seat location. In contrast, the purchaser of a club seat ticket gets the seat location plus the amenities. If a person did not want the amenities, he or she would buy a regular seat ticket. Second, the Bears met the “separately stated” requirement for non-amusement services. As the dissenting opinion observed, even the county’s auditor recognized that the Bears separately stated the price of the admission and the price of the amenities. See 2014 IL App (1st) 122892, ¶¶ 48-49. Third, the amenities enjoyed by club seat ticket holders are significant, and some are available even during the off season. The fact that live play cannot be seen from the “club lounge” highlights the difference between the amenity privileges and the simple right to view the game. Tactically speaking, the Bears could have improved their position by increasing the separately stated ticket price, rather than the license fee, based on quality of seat location. But the court ignored this fact.

The court’s analysis of luxury suites and the Skyline Suite withstands scrutiny. The Bears did not come within the terms of the ordinance because they did not separately state the value of the seat from the value of the amenities. The Bears introduced internal books and records showing the value of a seat, but the court found no basis to exclude any part of the luxury suite charge because the ordinance does not refer to internal records as evidence of the value of a seat. Additionally, the county’s auditing mistake allowed the Bears to reduce the tax base of luxury suites by 40 percent because the county believed that all luxury suites included food and beverage (not subject to amusement tax) when that was the case with the Skyline Suite only. The county did not contest this mistake. Even for the Skyline Suite license, a 40 percent discount is arbitrary, as argued by the dissent. The auditor provided no explanation for this determination, suggesting, as the Bears pointed out, that the amount of the discount is based on a City of Chicago ordinance that bases the Chicago tax on 60 percent of the value of a skybox. The Bears’ appeal of the luxury suites and the Skyline Suite ruling is strategically suspect because a remand would have resulted in tax being owed on the full price of the luxury suites.

The county’s administration of the tax is deplorable. Given the amounts at stake, the ordinance should have been drafted with the club seat/luxury suite issue in mind. That is how the City of Chicago drafted its ordinance. Instead, the Bears were left to guess at how the county would impose the tax. The auditor’s suggestion that the club seat license could have been excluded had the Bears sought an agreement with the county—when the ordinance says nothing about requiring a taxpayer and the county to negotiate the tax base—shows that the administration was irrational. The appellate court compounded the problem by effectively reading the exclusion for non-amusement services out of the tax for the club seats. The Bears could not come within the separately stated requirement for the luxury suites and the Skyline suite without trying to state a separate price for the value of the seats and the food and beverage. Such a separate statement could be a practical or business impossibility. As the dissent found, the county made no effort to clarify how it would impose the tax. The issue is entirely straightforward. The county’s position, leading to years of litigation, is unconscionable. As with the recent debacle over its illegal Use Tax (Reed Smith LLP v. Ali, 2014 IL App (1st) 132646-U (Aug. 4, 2014)), Cook County’s capricious use of its tax power tarnishes the Chicago area’s attractiveness to business.