Refund Claims: The Substantial Variance Rule and Legal Theories.

To obtain a tax refund, a taxpayer must submit an administrative claim to the IRS. There are regulations that address the content of the claim, and they require that a refund claim “set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.” Proc. & Admin. Regs. § 301.6402-2(b).

Based upon the requirement that taxpayers exhaust administrative remedies, along with the regulations imposing requirements on the content of refund claims, courts have developed a “substantial variance rule,” which limits the extent to which a taxpayer can vary the legal theories and factual basis that support a refund claim. The point of this rule is to give the IRS fair notice of the legal and factual basis for the claim and an opportunity to address it.

In terms of legal theories, the substantial variance rule will typically bar a court from considering a ground for a refund that is “neither specifically raised by, nor comprised within the general language of, a timely formal or informal application for refund to the Internal Revenue Service.” Union Pacific R.R. v. United States, 182 Ct. Cl. 103, 108 (Ct. Cl. 1968)(citations omitted). While there are some situations in which the substantial variance rule may be relaxed, particularly where a new theory was actually considered by the IRS or where it is very closely related to the theory on which the refund claim was based, generally, all legal theories supporting relief must be presented in the administrative claim.

A recent Court of Federal Claims decision highlights this principle; in the course of addressing a fairly complex refund action, the court applied the substantial variance rule to bar what it considered an alternative legal theory. Yamagata v. United States, 2014 U.S. Claims LEXIS 7, slip op. at *56-*61 (Fed. Cl. Jan. 6, 2014).

Yamagata involved a dispute over whether an entity formed under Japanese law was properly taxed as a corporation or a partnership under prior Treasury Regulations that focused on factors such as centralized management, limited liability, and free transferability of interests. Id., slip op. at *3.

On the issue of limited liability, the taxpayers had presented an argument that the entity did not provide limited liability due to provisions of Japanese law that deny corporate shareholders limited liability in the context of tax obligations under a “denial of transaction rule.” The taxpayers also sought to argue that they did not have limited liability under Japanese law because a shareholder who contributes “essential assets” to a company could be held liable for delinquent taxes up to the value of the “essential asset” contributed or the amount of profits earned by the “essential asset.” Id., slip op. at *55-*56. This theory was not presented to the IRS.

The court concluded that the substantial variance rule precluded it from considering the “essential assets” theory. It rejected the taxpayers’ argument that the “essential assets” theory was sufficiently related to their contention that they had personal liability under local law, reasoning that the taxpayers were obligated to provide the IRS with “adequate notice of the specific local law theories on which their refund claims are based.” Id., slip op. at *60. Moreover, the factual predicate for the “essential assets” theory had never been presented to the IRS. Id.

Yamagata is a useful reminder of the need to plan carefully in framing a refund claim to assure that all potential theories have been identified.

Jim Malone is a tax lawyer in Philadelphia. © 2014, Malone LLC.

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