One of the most contested issues frustrating taxpayers is the use of contingent fee auditors by the states to conduct single or multi-state audits. Use of contingent fee auditors raises concerns by taxpayers for a number of reasons, most notably is that a contingent arrangement creates an incentive for the contract auditors to assess the highest amount of tax, and in doing so, to interpret the statutes and regulations in the most aggressive manner possible to favor the state(s). The second common criticism is that the contingent nature of the relationship can result in the contract auditor receiving fees that are disproportionate to the amount of time and expense expended on the audit.
The use of contract auditors is fairly commonplace with respect to sales/use, local property tax and transfer pricing audits. One area that has drawn the greatest criticism over the years is use of contingent fee auditors by the states in connection with unclaimed property audits, and most notably by the State of Delaware which has captured the ire of corporate America for years. These voices are finally getting heard.
On August 9, 2017, the Third Circuit Court of Appeals ("Third Circuit Court") reversed a 2016 ruling from the U.S. District Court ("District Court") dismissing the case (Plains All American Pipeline LLP v. Cook)1 against the District of Delaware for violating Plains All American Pipeline's ("Plains") due process. The District Court believed Plains did not have enough evidence at that time to file the suit because its grievances were based on potential threats instead of actual violations of due process. The State had yet to conduct the audit; therefore, Plains could not produce evidence of any violation. The District Court wanted Plains to go through the motions and "suffer an injury" before filing a suit. However, a year later, the Third Circuit Court reversed the dismissal allowing Plains to come forward with its claims.
The Federal Appeals Court has listened to numerous complaints regarding state escheat laws for what many businesses believe are a means to exploit money to raise state revenues rather than connecting owners with their rightful property. The Third Circuit Court agreed with the lower court that the majority of claims raised by Plains for dismissal of the unclaimed property audit were brought prematurely, hence were not "ripe", for intervention by the Federal Appeals Court to rule that the Plains constitutional rights had been violated. Nonetheless, the Federal Appeals Court did acknowledge one procedural due process challenge on Delaware's appointment of having the contingent fee auditor, Kelmar, as worthy of consideration by the District Court.
The Federal Appeals Court used the following three-part Step-Saver test to determine if the Plains case was justifiable and should be heard.
- Whether the parties' interests were adverse (i.e. will harm result if declaratory judgment is not entered?);
Whether judgment in the matter would be conclusive (i.e. is there a real controversy where specific relief could be provided by the Court?); and
- "Practical Utility" (i.e. will the parties plans/actions be affected by the judgment, and can the judgment affect others?).
Applying the above tests, the Federal Appeals Court held that all of the claims brought by Plains challenging Delaware's right to conduct the audit were not satisfied, at least not until the audit had been concluded. But, the Court did acknowledge that Plains requirement to submit a dispute to a self-interested party, Kelmar, was in violation of Plains Fourth Amendment constitutional right to due process and satisfied all of the prongs of the above three-part test. In so holding, the Court concluded that Plains rights had already been violated, hence were "ripe", because Kelmar, "a self-interested party", was authorized to conduct the audit and had already requested Plains to submit documents to a "biased adjudicator". The Court concluded that while it is possible that Delaware's arrangement with Kelmar is constitutional, it merits being heard by the District Court.
The Plains case addresses the perceived abuse of power by Delaware and its self-interested auditors in pursuing unreasonable unclaimed property claims against hundreds of corporations. Equally important, this case has the potential of upsetting the entire audit landscape well beyond Delaware unclaimed property audits where the states, at little cost, can engage the services of contingent fee auditors to pursue collections of all forms of taxes by auditors that are self-motivated to broadly interpret statutes and regulations in favor of the state.
Fortunately, for hundreds of companies that are currently under audit, the Third Circuit Court decision requiring the lower court to hear Plains arguments could ultimately prevent the states from continuing the use of contingent fee auditors. However, it may be a bit premature to pop open the champagne as the case is yet to be heard by the lower court, and if a decision is favorable, there is no telling what remedies may be available to companies that are currently under audit in Delaware or elsewhere. For now, we will continue to sit on the sideline and watch as the game continues to unfold.
Duff & Phelps will continue to monitor developments related to this case as well as the reaction by other states to the use of contingent fee auditors on future and pending unclaimed property as well as other state tax examinations.
Further information on the original dismissal is available here.
Further information on the entire Appeals Court Decision is available here.
1Case 1:15-cv-00468-RGA Document 49, filed 8/16/16.