Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.

Foreign Income & Taxpayers

Engineer cannot escape closing agreement

A closing agreement, in which a taxpayer living and working in Australia waived his right under Sec. 911(a) to elect to exclude foreign earned income, was validly executed and could not be set aside due to malfeasance or misrepresentation of material fact by the IRS.

Background

During the years at issue, Cory Smith was a U.S. nonresident citizen who worked at the U.S.-Australian Joint Defense Facility at Pine Gap, Alice Springs, Northern Territory, Australia (Pine Gap), a military surveillance facility. Generally, the United States taxes the worldwide income of its nonresident citizens, which creates the potential for their double taxation--in Smith's case, the taxation of his income by both the United States and Australia.

U.S. law provides some relief from double taxation for U.S. citizens working abroad. Relevant to Smith is the relief provided by Sec. 911(a), which allows qualified individuals to elect to exclude foreign earned income from their gross incomes and treats that income as exempt from U.S. federal income taxation.

In addition to providing relief through U.S. law, to avoid double taxation for U.S. citizens working at Pine Gap, the United States and Australia entered into two agreements in 1966 and 1969 (the Pine Gap agreements) that generally provide that the income U.S. citizens earn at Pine Gap will be deemed not earned in Australia, so long as it is actually taxed by the United States. The United States and Australia signed a new income tax treaty in 1982. To the extent the Pine Gap agreements are read as giving U.S. citizens working at Pine Gap more favorable treatment, the 1982 treaty would seem to have left those arrangements intact.

For the United States and Australia, the relief provided under Sec. 911 presented a particular problem in resolving issues of potential double taxation for U.S. citizens working at Pine Gap. Sec. 911 provides that certain qualified individuals may elect to exclude from gross income and exempt from U.S. federal income taxation certain foreign earned income. However, the Pine Gap agreements provided that U.S. citizens could avoid Australian taxation on their Pine Gap income only if that income "is not exempt, and is brought to tax, under the taxation laws of the United States." Australian domestic law similarly required that the relevant income not be "exempt from income tax imposed" in the United States for its sourcing recharacterization rule to apply. Moreover, the 1982 treaty preserved the benefits of the Pine Gap agreements only if those benefits are viewed as "any exclusion, exemption, deduction, rebate, credit or other allowance."

To resolve these potential problems, the United States and Australia determined that U.S. citizens working at Pine Gap would need to forgo making a Sec. 911 election to avoid Australian taxation. The countries also determined Pine Gap employees could forgo the election by entering into a closing agreement with the IRS.

For decades, both U.S. citizen employees at Pine Gap and the U.S. and Australian tax authorities abided by this framework. As far as the interested parties were concerned, the closing agreements waiving U.S. taxpayers' right to elect under Sec. 911(a) were sufficient to preempt potential issues of double taxation for U.S. citizens working at Pine Gap. But a few years ago, some U.S. citizens who worked at Pine Gap and had entered into closing agreements, including Smith, decided to ignore the agreements and made the Sec. 911(a) election on their original tax returns or on amended returns for earlier tax years.

Smith, a former Air Force engineer, received an offer in 2009 from Raytheon Corp. to work at Pine Gap. The onboarding process for the job was extensive, and it was approximately a year before Smith went to Pine Gap and began work.

During the onboarding process, Smith was given a copy of Raytheon's Australian Operations Overseas Handbook. The handbook included a general discussion of US.-Australian taxation of employees working at the facility, including the effect of signing or not signing a closing agreement waiving their right to elect the Sec. 911(a) foreign earned income exclusion. The handbook indicated that signing this waiver was optional.

On his first day of work at Pine Gap, Raytheon gave Smith a blank form closing agreement. According to Smith, despite what was stated in the company handbook, Raytheon staff informed him that signing the agreement was not optional and that his employment was contingent on his signing the agreement. Smith claimed that he signed the agreement, which covered the years 2010 through 2012, because he was afraid of losing the job that he had prepared for over a year to take. No one from the IRS was present during Smith's discussions with Raytheon staff about the agreement, and Smith did not communicate with the IRS before executing the agreement. During the following years while Smith was employed at Pine Gap, he signed an identical closing agreement (except for the tax years covered by the initial agreement) at least two more times. This included signing the agreement at issue in the case, which covered the years 2016, 2017, and 2018.

For all the agreements, after he executed them, Smith gave them back to Raytheon staff and Raytheon sent them to the IRS. Deborah Palacheck, director, Treaty Administration, in the IRS Large Business and International Division (LB&I), executed the 2016-2018 closing agreement in her official capacity. The IRS sent a fully executed copy of the agreement to Raytheon, which gave a copy to Smith.

Smith timely filed income tax returns for 2016 and 2017, on which, consistent with the terms of the 2016-2018 closing agreement, he did not make the Sec. 911(a) election. Later, he filed amended returns for both years on which he...