Is it Possible to Quash an IRS Summons Issued to Build a Civil or Criminal Tax Case in a Foreign Country?

The rapid rise of globalism has made the world feel smaller. Americans are more connected to people on the other side of the world than ever before. Not only are Americans more connected to people on the other side of the world than ever, more and more of Americans are earning income in one or more foreign countries. Americans that earn income and are physically present in a foreign country may not only find themselves not being subject to worldwide income taxation in the United States, but also subject to foreign income taxes and foreign wealth taxes on his or her worldwide income and assets. If a foreign tax agency believes an American owes additional foreign taxes, the tax agency may conduct a civil or criminal audit of the American. If the foreign country conducting the audit has entered into a tax treaty with the United States, the foreign tax agency may make a treaty request to the Internal Revenue Service (“IRS”) for assistance to gather information.

Many tax treaties with U.S. treaty partners contain an article that authorizes the exchange of information and administrative cooperation between the tax authorities of the two States. For example, Article 27 of the U.S.-Spain Tax Treaty requires the United States to “use its information gathering measures to obtain” tax information requested by Spain, even if the United States “may not need such information for its own purposes.” See S.Treaty Doc. No. 113-4, art 27(4), 1990 WL 10696296. This includes having the IRS issue summonses to obtain information requested by Spanish tax authorities. See Lidas, Inc. v. United States, 238 F.3d 1076, 1081 (9th Cir. 2001); I.R.M. 11.3.25.3(9). Let’s assume that Tom filed his Spanish tax returns for the 2021 tax year and that the Spanish tax authorities believed that Tom owed additional tax on his worldwide income and assets. If the Spanish taxing authorities believe they need information regarding Tom’s U.S. income and assets, the Spanish tax authorities may send a request to the IRS for information regarding his U.S. income and assets. If the IRS does not have the information requested by the Spanish tax authorities in its possession, the IRS may issue a summons to obtain the information requested by the Spanish taxing authorities. Any information obtained by the summons will not only be turned over to the Spanish tax authorities by the IRS, but the IRS is also free to use the information it obtained from the summons to build a civil or criminal case against Tom.

This article will discuss if it is possible to challenge an IRS summons issued on behalf of a foreign tax agency in court.

IRS’ Investigatory Powers and Territorial Limits of Its Summons Authority

Internal Revenue Code Section 7602 has been used to gather, determine, or collect liability for not only an internal revenue tax of the United States but also a tax imposed by a foreign country having a treaty with the United States. A summons served to obtain information concerning liability for a foreign country’s tax has been enforced, at least where the United States has a tax treaty in effect with the foreign country that requested the information under a “competent authority” provision in that treaty. See United States v. Burbank Co., 525 F.2d 9 (2d Cir.), cert. denied, 426 U.S. 934 (1975). In United States v. Stuart, 489 U.S. 353 (1989), Canada’s Department of National Revenue had requested the IRS for assistance under the U.S.-Canada Income Tax Treaty in obtaining records of bank accounts maintained in the United States by Canadian citizens and residents. The IRS used its summons authority to obtain information for the Canadian Department of National Revenue. The Supreme Court held that the IRS was entitled to enforcement of its summons, whether or not the Canadian investigation was directed toward criminal prosecution under Canadian law. However, the investigation of the foreign country must meet the four part-test enunciated in United States v. Powell, 379 U.S. 48 (1964).

In Powell, the Supreme Court established a four-part test to evaluate whether the issuance of an IRS summons meets the good-faith standard. Under the Powell test, the IRS “must establish that (1) the investigation will be conducted for a legitimate purpose; (2) the material being sought is relevant to that purpose; (3) the information sought is not already in the IRS’s possession; and 4) the IRS complied with all the administrative steps required by the Internal Revenue Code. See Crystal v. United States, 172 F.3d 1141, 1143 (9th Cir. 1999). This test applies where the IRS issues a summons pursuant to a request from a treaty partner. See Stuart, 489 U.S. at 370. But even in this context, it is only the IRS’s good faith that matters; the good faith of the requesting treaty partner is irrelevant. See Lidas, 238 F.3d at 1082. The IRS’s burden in satisfying the Powell test “is a slight one and typically is satisfied by the introduction of a sworn declaration of the revenue agent who issued the summons that the Powell requirement has been met.” See Stewart, 511 F.3d at 1254.

If the IRS satisfies the Powell test, it has made a prima facie case for the enforcement of the summons. See Crystal, 172 F.3d at 1144. The burden then shifts to the individual contesting the summons “to show an abuse of process, e.g., that the summons was issued in bad faith for an improper purpose.” See Liberty Fin. Servs. V. United States, 778 F.2d 1390, 1392 (9th Cir. 1985). This is a “heavy” burden that requires the individuals challenging a summons to “allege specific facts and evidence to support allegations of bad faith or improper purpose.” See Crystal, 172 F.3d at 1144.

In any litigation involving the enforcement of an IRS summons made on behalf of a foreign tax agency, the IRS will typically claim that its employees reviewed a foreign tax agency’s request for information and issued a summons in response, demonstrating the summons was issued in good faith under Powell. In addition, any Fifth or Fourth amendment based arguments that a summons is issued to gather evidence for a foreign criminal tax prosecution will be irrelevant for purposes of quashing the summons. The only potential argument to quash an IRS summons made on behalf of a foreign tax agency is that the summons was issued for an improper purpose and/or bad faith.

Definition of Improper Purpose and Bad Faith Use of a Summons

When the IRS uses its summons power for an unauthorized purpose or if the IRS uses its summons power not in good faith, the Supreme Court has stated that the summons will not be enforced. See Reisman v. Caplin, 375 U.S. 440 (1964). Generally, the IRS must issue a summons before it has referred a taxpayer’s case to the Justice Department with a recommendation of criminal prosecution and the IRS must have issued the summons in good faith pursuant to the statutorily authorized purpose of Section 7602. On the other hand, this good faith use is not present where (1) the summons was issued to harass the taxpayer or put pressure on him to settle a collateral dispute or for some other similar purpose or (2) at a time when the IRS had an institutional commitment to make a referral to the Justice Department and the summons was issued to gather additional evidence for the prosecution rather than to pursue civil tax determination or collection.

Since its decision in Reisman, the Supreme Court has recognized an improper criminal-purpose limitation. However, the Supreme Court has had difficulty describing when a summons is issued for an improper criminal purpose. The Supreme Court attempted to define the improper criminal-purpose limitation in Donaldson v. United States, 400 U.S. 517 (1971). In Donaldson, an IRS special agent’s summons was challenged on the ground that it was served for an improper purpose because it was in aid of an investigation that could potentially result in a recommendation that criminal prosecution be instituted against the taxpayer. The Supreme Court rejected the challenge, finding that when criminal prosecution is only a potentiality, a summons served by a special agent may not be challenged as seeking material for the improper purpose of obtaining evidence for a criminal prosecution. The Court stated that the improper purpose referred to in Reisman exists only where there is a “pending criminal charge.”

As a result of conflict between the circuits regarding the meaning of the Donaldson opinion, the Supreme Court decided United States v. LaSalle National Bank, 437 U.S. 298 (1978). In LaSalle, a special agent of the IRS was conducting an investigation alone. The trial court found that the investigation was solely for criminal purposes. The special agent issued summons to a number of financial institutions. The summons the special agent had served on the financial institutions were issued before any recommendations of criminal prosecution had been made by the IRS to the United States Attorney. The Supreme Court determined in LaSalle that the improper-purpose limitation applies to summons issued before, as well as after, a referral for criminal prosecution. Thus, the IRS must at all times use its summons authority in good-faith. The Supreme Court made it clear that resolution of the question of whether an investigation has solely criminal purpose did not depend on the “agent’s personal intent.” It was “answered only by an examination of the institutional posture of the IRS” and determining whether such posture lacked “a valid civil tax determination or collection purpose” in serving the summons. In LaSalle, the Court held that the party claiming an impermissible use of a summons for criminal purposes “bear[s] the burden to disprove the actual existence of a valid civil tax determination or collection purpose by the [IRS].” See LaSalle 437 U.S. at 316.

Does an IRS Criminal Referral to the Justice Department for Criminal Prosecution Provide a Basis to Quash a Summons Issued in Response to a Treaty Request?

As indicated above, to secure enforcement of a summons, the IRS need only demonstrate that the IRS issued them in good faith under the Powell test. The Powell test has four prongs: (1) the investigation will be conducted for a legitimate purpose; (2) the material sought is relevant to that purpose; (3) the information sought is not already in the IRS’s possession, and (4) the IRS complied with all the administrative steps required by the Internal Revenue Code. To satisfy this burden, the IRS need only demonstrate its own good faith, not that of the requesting sovereign. In most cases involving an IRS summons issued on behalf of a foreign government, the IRS this prima facie case for the enforcement of the summons. This prima facie case may only be defeated by specific facts or evidence of the IRS’s bad faith.

One potential way of defeating a prima facie case for the enforcement of a summons is to present evidence that the IRS is attempting to use a summons issued on behalf of a foreign government to obtain evidence for a domestic criminal investigation. Congress has barred the IRS from issuing summons to collect information on persons whom the IRS has referred to the Justice Department for criminal prosecution. See IRC Section 7602(d). This “prophylactic restraint on the use of the summons” prevents the IRS from abusing Section 7602 to broaden “the Justice Department’s right of criminal litigation discovery or to infringe on the role of the grand jury as a principal of criminal accusation.” See LaSalle, 437 U.S. 298, 312-13 (1978). While the Supreme Court in LaSalle held that an IRS summons may not be issued for “solely criminal purposes,” this holding “is now dubious.” See Moering v. United States, 893 F.2d 1338, 1990 WL 3132 (9th Cir. 1990). In 1982, Congress amended Internal Revenue Code Section 7602…to eliminate the requirement that the investigation given rise to the summons have a civil component.” See United States v. Patel, 996 F.2d 1229, 1993 WL 170947 (9th Cir. May 1993). Internal Revenue Code Section 7602 permits the IRS to “inquire into any offense connected with the administration or enforcement of the internal revenue laws, the IRS may issue summons in a wholly criminal investigation before it refers a case to the Justice Department for investigation.” See Weiss v. Commissioner, 919 F.2d 115, 118 (9th Cir. 1990).

Applying the Supreme Court’s reasoning in LaSalle, if an individual that is subject to an IRS summons on behalf of a foreign government, can establish there is a Justice Department referral in his or her case, a district court may grant a motion to quash the summons. However, it remains an open question whether a court would grant a motion to quash an IRS summons issued on behalf of a foreign government even if there is a Justice Department referral. This is because LaSalle’s rule against using IRS summonses for purely criminal purposes does not address whether the IRS can issue a summons in response to a treaty request even if there is a Justice Department referral. But in Stuart, the Supreme Court held that an IRS summons in response to a treaty request is enforceable- even if the treaty partner is gathering evidence for a criminal investigation.

Conclusion

An IRS summons issued in response to a treaty request can have significant civil and criminal tax consequences in the United States and in a foreign country. If you have received notice of an IRS summons, you should immediately consult with a qualified tax attorney. Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony advises clients on tax compliance issues, including criminal tax investigations, sensitive civil audits, and voluntary disclosures. He has represented numerous clients worldwide in matters arising from the IRS and Justice Department’s crackdown on unreported assets and income.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or [email protected]. This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.