Court Sustains Competent Authority Decision to Not Grant Treaty Relief

The other day I discussed Starr International v US, and the lead up to an opinion earlier this month concerning the application of the US –Swiss income tax treaty. Before the court was able to resolve the matter on the merits, the district court addressed its jurisdiction to hear a challenge to the US Competent Authority’s decision to not grant discretionary relief under the treaty. While concluding that it could not order monetary relief, its prior opinion opened the door to Starr challenging the Competent Authority’s decision not to grant a lower withholding rate under the APA.

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The amount at issue was substantial. Starr was one of the largest shareholders in AIG. It received about $190 million in dividends. The US has treaties with many countries; those treaties generally provide exceptions or reduction to the default 30% withholding on some US sources of income, including dividends. The US Swiss treaty reduced withholding to either 5% or 15 %, depending on the Swiss entity’s ownership of the US corporation.

Most treaties have some form of anti-treaty shopping provisions that are meant to ensure that only bona fide residents of contracting states can take advantage of the treaty. The Swiss treaty has such a provision, Article 22, which, according to the treaty’s technical explanation (sort of treaty analogue to legislative history, which Treasury staffers draft and present to the Senate during the Senate’s treaty ratification process), denies treaty benefits to those who establish “legal entities . . . in a Contracting State with a principal purpose to obtain [treaty] benefits.”

Article 22 has a number of objective tests; an entity can establish that it is a bona fide resident if it meets any of the objective tests. The treaty recognized, however, that a party might be entitled to treaty relief even if it were unable to satisfy any of the objective tests. To effectuate that policy, the treaty provides:

A person that is not entitled to the benefits of this Convention pursuant to the provisions of the preceding paragraphs may, nevertheless, be granted the benefits of the Convention if the competent authority of the State in which the income arises so determines after consultation with the competent authority of the other Contracting State.

It was this discretionary benefit position that was at issue in Starr International. For international tax folks, the opinion has an important discussion of the precise contours of the anti-treaty shopping provision; Starr wanted a more mechanical approach to the issue but the opinion agreed with the government that the test is one that pivots off of a finding that the party seeking the benefits “has or had as one of its principal purposes the obtaining of [treaty] benefits.”

After agreeing that the treaty rule revolves around a principal purpose analysis, the court turned to the APA. Under the APA a reviewing court must “hold unlawful and set aside agency action, findings, and conclusions found to be . . . arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 USC 706(2). As we have discussed, this is generally a deferential standard; the opinion, citing the Supreme Court State Farm decision, notes that by way of example that “[a]gency action is arbitrary and capricious…if the agency ‘entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.’”

In arguing that the Competent Authority decision was arbitrary and capricious, Starr essentially made two main points: the Competent Authority considered irrelevant information and failed to consider the relevant information.

In finding that the Competent Authority did not consider irrelevant information, the opinion squarely addresses how much it should consider Starr’s prior moves. One of the main points Starr made was that its move to Switzerland was from Ireland, which had an automatic treaty reduction; in other words, it could not have had a principal purpose to get treaty benefits if it moved from a jurisdiction where it already was entitled to benefits. The government noted that Starr had moved previously, and wanted to consider the entity’s history of moving as to show that tax was often a if not the main reason for location.

The court agreed with the government, looking mainly to the treaty’s explanation:

[Starr’s] argument, however, assumes a much narrower inquiry than is called for by the Technical Explanation, which directs the Competent Authority to determine “whether the establishment, acquisition, or maintenance” of a company in the relevant jurisdiction had a principal purpose of obtaining treaty benefits. Technical Explanation 72. Notably, the Explanation does not direct the Competent Authority to ask merely what made a company’s current jurisdiction more favorable than its previous one—although that might be part of the analysis—but rather why a company chose to “establish” or “maintain” itself where it did. In other words, here the question was not simply why Starr chose Switzerland over Ireland, but rather why Starr chose Switzerland over any other jurisdiction where it might have moved.

This broader inquiry required not just a look at Starr’s recent move, but also its overall history of moves.

Starr also argued that the Competent Authority failed to consider the implications of how other bilateral treaties automatically allow treaty benefits to similarly structured entities (a for profit company owned by a charitable entity). Starr argued that there was strong evidence that the US and the Swiss did not consciously exclude that structure from benefits. The opinion gives short shrift to this point:

This argument is a nonstarter. Starr essentially asks the Court to find that the Competent Authority acted arbitrarily and capriciously because it failed to definitively conclude that the text of the U.S.-Swiss Treaty should be overwritten by text in other bilateral tax treaties, and because there is no legislative history to the contrary. But “[t]he interpretation of a treaty, like the interpretation of a statute, begins with its text.” Starr I, 139 F. Supp. at 226 (quoting Abbott v. Abbott, 560 U.S. 1, 10 (2010)). So at the very least, it was not unreasonable for the Competent Authority to decline to read into the treaty a provision that was not there. Moreover, it bears emphasizing that the Competent Authority reached no conclusion one way or the other on the matter, and therefore the analysis appears not to have grounded its final determination. It is therefore misleading for Starr to characterize it as a “justification,” although perhaps accurate to call it “irrelevant.”

Conclusion

On the merits, the opinion is a major victory for the government. Yet it is  an important procedural victory for taxpayers. It is another defeat of the reflexive government argument that some of its decisions are completely insulated from court review. It also is a roadmap for showing how parties can use the APA to challenge the somewhat murky world of Competent Authority decisions under treaties.

Starr v US and The Power to Confer Discretionary Treaty Benefits: Part 1

It is not often that the courts wrestle with the application of discretionary treaty provisions. Earlier this month, in Starr International v US , a DC federal district court found that the Competent Authority did not act arbitrarily or capriciously in denying discretionary relief under the U.S.-Swiss Treaty. In today’s post, I will  discuss the jurisdictional battle that led to last week’s opinion. I will follow up in Part 2 with a discussion as to the court’s application of the APA to the treaty claims.

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In 2015, in District Court Hands IRS Loss in its Bid to Exclude Discretionary Treaty Benefits From Judicial Review I discussed the fight between The Starr International Group and the IRS over Starr’s efforts to get the benefits of discretionary treaty relief that would have reduced US withholding on AIG dividends. Much of the post discussed the government’s unsuccessful efforts to convince the court that the decision was not subject to court review. That opinion, and my post, discusses why there is a strong presumption against unfettered agency discretion.

Following that setback, the government asked the court to reconsider. In a 2016 opinion, the government did get a victory, of sorts. Despite reaffirming its earlier conclusion about the court’s power to review the IRS’s decision to not grant discretionary treaty relief, the District Court held that separation of powers principles meant that it could not order a monetary refund for Starr even if it felt that the US competent authority improperly applied that the anti-treaty shopping provisions of the US –Swiss tax treaty.

The 2016 opinion explored the  limits of the court’s powers. In so doing, it discusses how in treaties there is a consultation process between the contracting states following one state’s Competent Authority determination that a party is entitled to discretionary treaty relief.  That consultation is an executive branch function. As such, the 2016 opinion concludes that the courts are unable  to mandate that a party is entitled to receive a refund based on a claim that there was an improper application of a discretionary tax treaty provision. On that point, the opinion was clear:

To determine that Starr is entitled to a certain sum of benefits, the Court would be forced to step into the shoes of the IRS and its Swiss counterparts and effectively preordain the outcome of any consultation between the two. This a court may not do.

Yet in that 2016 development the district court concluded that Starr could bring a claim under the APA seeking to set aside the U.S Competent Authority’s determination and that if Starr “prevailed on that claim, [it] would be entitled … to have the matter remanded to the U.S. Competent Authority for further action” consistent with the Court’s opinion.

The 2016 opinion nicely summarizes how the APA provided jurisdiction over Starr’s dispute:

The APA makes “final agency action for which there is no other adequate remedy in a court … subject to judicial review.” 5 U.S.C. § 704. The government concedes that the Competent Authority’s decision constitutes final agency action. And if the Court were to hold that Starr could not challenge the decision through a claim brought under the tax-refund statute, then no other adequate remedy would exist, and review under the APA would be proper. Cf. Cohen v. United States, 650 F.3d 717, 736 [108 AFTR 2d 2011-5046] (D.C. Cir. 2011) (en banc) (directing the district court to consider the merits of an APA claim against the IRS when plaintiffs had “no other adequate remedy at law”).

In allowing Starr to bring a claim under the APA, the 2016 opinion acknowledged that Starr’s ultimate goal was a refund, not just an academic finding that the Competent Authority acted improperly. Yet, the opinion paved the way for the Starr Company to amend its complaint to bring the APA claims and suggested that such a finding might in fact lead to a refund (or at least a consultation about a refund):

As the Court has explained, however, monetary relief of any sort is unavailable to Starr without improper judicial intervention into the consultation process….

The Court declines to assume, however, that Starr would forgo an opportunity simply to have the Competent Authority’s decision set aside as arbitrary, capricious, or an abuse of discretion. Indeed, as the government recognizes, remanding to the agency for further consideration is the norm when a court sets aside an agency’s action. And this relief is not illusory. Regardless of whether the Court possesses the authority to order the IRS to engage in consultation, counsel for the IRS has represented—and the Court would fully expect—that the IRS would not decline to consult with the Swiss in the event that the Court found that the IRS abused its discretion and remanded to the IRS, and the IRS otherwise preliminarily determined that Starr qualified for treaty benefits. Hr’g Tr., ECF No. 34, 42:8-18. The Court thus will not deprive Starr of the opportunity to seek this form of relief under the APA. It will grant Starr leave to amend its complaint to bring such a claim.

Starr dutifully amended its complaint to include APA claims. This led the district court in an opinion earlier this month to apply the APA to the Competent Authority’s decision to deny treat benefits. In Part 2 of this post, I will discuss the court’s analysis as to why under the APA the Competent Authority did not act improperly in finding that the discretionary treaty benefits did not apply to reduce withholding on the AIG dividends.

 

 

Tax Exceptionalism Lives? QinetiQ v. CIR

We welcome back guest blogger Bryan Camp who is the George H. Mahon Professor of Law at Texas Tech.  Professor Camp teaches both tax and administrative law which is why I sought him out for this guest post.  The decision here is important.  The lead attorney for the taxpayer, Jerry Kafka, is one of the best if not the best tax litigators in the country.  Though his client lost this case the arguments made here were not frivolous.  What could have been a game changer had the taxpayer won leaves us in the same posture we were in before the case was brought but with more light shone into the corners of tax and the APA.  Keith

Keith emailed me last week and asked if I would care to blog about a recent 4th Cir. opinion affirming a Tax Court decision that upheld a proposed deficiency in the taxes of QinetiQ US Holdings (Q).  (for previous PT posts on QinetiQ see here, here and here).It seems that Q took a big §83(h) deduction.  On audit, the Service disallowed the deduction and sent Q a Notice of Deficiency (NOD).  In court, Q argued that the NOD violated the Administrative Procedure Act (APA) because the NOD gave no explanation for the disallowance and, oh, by the way, the §83 deduction was proper.  The Tax Court rejected both arguments.  The 4th Cir. affirmed.

Maybe the §83 issue is interesting.  If so, I’m sure the Surly Subgroup will blog it.  To me, however, what makes this 4th Cir. opinion worthy of a shout out is its discussion about the relationship of the Administrative Procedure Act (APA) to tax procedure.  Ever since the Supremes decided Mayo Foundation in 2011, it seems everybody and their little dogs have been declaring that something called “tax exceptionalism” is dead.  The Fourth Circuit’s opinion gives a more nuanced take, one that is worth blogging about for three reasons.  First, it represents a new front on the “tax exceptionalism” debate.  Second, the Circuit’s opinion makes a critically important point about the relationship of the APA to tax procedure.  Third the opinion could affect court review of other types of IRS determinations, such as CDP determinations.

I will consider each of these points in turn.

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  1. A New Front on Tax Exceptionalism Debate

QinectiQ represents a new front in the ongoing debate over the proper relationship of the APA to tax practice and procedure.  Up to now, the debate has been chiefly about tax regulations and tax guidance.  That’s the Mayo case and other cases where taxpayers have sought to challenge the procedure by which Treasury and the IRS have issued regulatory and similar guidance.  This case involves the proper application of the APA to a very different type of agency action: an agency determination.  The APA has some general standards that courts are supposed to use in reviewing agency determinations in particular cases, also known as “agency adjudications.”

Professor Steve Johnson at Florida State has written extensively and lucidly about the tax exceptionalism debate.  In this short Florida Bar Review article from 2014 he encouraged tax practitioners to consider challenging NOD’s under an APA standard.  Apparently the lawyers for Q read his article!

The APA is found at 5 U.S.C. Subchapter II.   Section 706 says that courts should review agency adjudications to be sure they were not made arbitrarily.  To do that, the court needs to see what the agency’s rationale was for its decision.  So over time the Supreme Court has developed the requirement that “an agency provide reasoned explanation for its action.” FCC v. Fox Television, 556 U.S. 502, 515 (2009).

In QinectiQ, the taxpayer argued that the NOD failed the APA §706 standard.  The NOD said only that Q had additional taxable income of “$177,777,501” because Q had “not established that [it was] entitled” to a deduction “under the provisions of [26 U.S.C. §83].” The NOD gave zero explanation for why the Service was disallowing the deduction.  The failure to articulate a rational explanation for its disallowance decision meant that a review court had no way to police the NOD for arbitrariness.

In a short unpublished order, the Tax Court refused to apply the APA standard and held that the NOD was instead subject to the standard provided for in §7522(a). The taxpayer’s argument to the Fourth Circuit was essentially that §7522 and the APA standards were cumulative, not exclusive.

The Fourth Circuit affirmed the Tax Court.  It believed the taxpayer’s attempt to apply the APA standard “fails to consider the unique system of judicial review provided by the Internal Revenue Code for adjudication of the merits of a Notice of Deficiency.” (p. 9 of slip opinion).

The Fourth Circuit thought two features of tax administration made the APA standard inapplicable.  First, “because the Code’s provisions for de novo review in the tax court permit consideration of new evidence and new issues not presented at the agency level, those provisions are incompatible with the limited judicial review of final agency actions allowed under the APA.” (p. 10-11 of slip opinion).  Second, the Tax Code’s provisions for judicial review of NOD’s pre-dated the APA.  “Congress did not intend for the APA ‘to duplicate the previously established special statutory procedures relating to specific agencies.’” (p. 12 of slip opinion, quoting Bowen v. Massachusetts, 487 U.S. 879, 903 (1988)).

The Fourth Circuit’s consideration of these two features of tax administration is the more nuanced understanding that I think is worth commenting on.

  1. The Proper Relationship of the APA to Tax Administration

The nuance is this: the APA is not sui generis.  That is, the APA was enacted on top of existing agency practices and procedures.  One simply cannot pretend that the APA was enacted in a vacuum!  That’s the point I try to make about tax regulations in my article “A History of Tax Regulation Prior the Administrative Procedure Act,” 63 Duke L. J. 1673 (2014)

The APA was enacted on the basis of a massive, massive, study of federal agencies and their operations undertaken by the Attorney General’s Committee on Administrative Law (“the Committee”).  The Committee’s Final Report is generally believed to be the most important influence on the text and application of the APA.

The Final Report grew out of a detailed study of then-existing agencies, a study contained in 27 Monographs written by staff, each running hundreds of pages.  (Monograph 22 focused on the tax administration).  At its inception, the Committee “had initially hoped to be able to suggest uniform rules for agency practice” (quote from Grisinger Law in Action: The Attorney General’s Committee on Administrative Procedure, 20 J. of Policy History 379 (2008)).  In light of the information produced in the 27 monographs, however, the Final Report backed away considerably from that aspiration and instead prescribed a general framework for balancing the goals of agency efficiency and autonomy with the goals of agency transparency and protection of individuals from arbitrary agency actions. That is why the resulting APA was widely understood as standing for the proposition that “procedural uniformity was not well suited to the administrative process.” (Grisinger at 402; one sees the same theme in almost all the contemporary commentaries and reviews of the Final Report).  That is, the APA provided generalized standards for controlling administrative actions rather than detailed prescriptions. This conventional view is elegantly summed up by Professors Hickman and Pierce: “the Administrative Procedure Act is to administrative law what the Constitution is to constitutional law.” Kristin E. Hickman, Richard J. Pierce, Jr., Federal Administrative Law:  Cases and Materials, (Foundation Press, 2010) at 19.

What this means is that while the APA does apply to all agencies, including the IRS, it does not apply in the exact same way to all agencies.  Every agency is “exceptional” in that every agency faces a different set of operational demands and requirements and organic statutory provisions.  All of those variables must be reconciled to the general language of the APA and it should not surprise anyone that different reconciliations lead to different applications of the APA principles to different agencies.   That is why the Supreme Court, in Bowen, said “When Congress enacted the APA to provide a general authorization for review of agency action in the district courts, it did not intend that general grant of jurisdiction to duplicate the previously established special statutory procedures relating to specific agencies.” 847 U.S. 879 at 903.

Put another way, the debate is not “whether” the APA applies, it’s “how” the APA applies.  It is not so much whether the NOD review procedure “comply with” the APA as it is whether the procedures are “consistent with” the APA.  Does the APA displace or otherwise affect otherwise applicable rules that govern what goes into the NOD and how the Tax Court reviews it?

That is what the Fourth Circuit recognizes in QinetiQ.  The Tax Code’s specific statutory review structure makes the APA review standard inapplicable, for both historical and operational reasons.  The historical reason is what I said above: the specific statutory structure for court review of NOD’s pre-dates the APA and the APA was not written to displace prior law.  The operational reason is that taxpayers have the burden to prove entitlement for deductions and have every opportunity to do so in a de novo Tax Court review.  That de novo nature of review is what makes the current practice acceptable.  For example, if the IRS rejects a claimed deduction, tax law does not put the burden on the IRS to prove up the rejection.  The burden remains on the taxpayer to prove up the entitlement, only now in front of the Tax Court (or district court if the taxpayer chooses to pay the deficiency and then go for a refund).  It is the Tax Court’s job to determine or re-determine the taxpayer’s proper tax liability.  That’s why it can either increase the proposed deficiency (§6214(a)) or actually order a refund (§6512(b)).

The Tax Court has recognized these points as well.  It has a nice discussion of this kind of “tax exceptionalism” in Ax v. CIR, 146 T.C. No. 10 (2016) (which Les has previously blogged here and which Professors Stephanie Hoffer and Chris Walker give some very thoughtful comments here). In Ax, the taxpayer objected to the Service raising a new issue before the Tax Court, even though the Service acknowledged it bore the burden of proof.  Like the taxpayer in QinetiQ, the taxpayer in Ax argued that because “the Supreme Court rejected the concept of ‘tax exceptionalism,’ the Administrative Procedure Act and [case law] bar Respondent from raising new grounds to support his final agency action beyond those grounds originally stated in the notice of final agency action” (e.g. the NOD).  The Tax Court’s rejection of that position is worth reading.

III.  The Door Is Still Open: Implications of QinetiQ on Other IRS “NODs”

Have you ever noticed how you need an NOD to get Tax Court review?  I don’t just mean the “Notice of Deficiency.”  I also mean the “Notice of Determination” from a CDP hearing.  That’s a ticket to the Tax Court, too.  But, sorry, a “Determination Letter” is not a ticket.  Likewise, if a taxpayer petitions for “stand alone” spousal relief per §6105(f), the eventual “Notice of Determination” issued by IRS or Appeals is the ticket for Tax Court review (of course, §6105(e) also permits a taxpayer to seek judicial review in cases where the Service has not acted within 6 months of the initial request for spousal relief).

The point is that the Tax Court reviews agency decisions other than deficiency determinations.   QinectiQ deals with only ONE kind of IRS determination (although by far the most frequent).  The inimitable Steve Johnson gives an excellent and in-depth treatment of the variety of ways that the APA §706 might be applicable to a variety of IRS determinations in his Duke L. Rev. article “Reasoned Explanation and IRS Adjudication,” 63 Duke L. J. 1771.

The Fourth Circuit’s rationale for not applying the ABA §706 standard of review in QinectiQ actually suggests the ABA standard may be applicable to court review of some of these other IRS determinations.  One sees this in the opinion’s discussion of Fisher v. Commissioner, 45 F.3d 396 (10th Cir. 1995).  In Fisher, the 10th Circuit held an NOD invalid because the NOD implicitly denied, without explanation, a taxpayer’s request for penalty abatement.  Since the Service has the discretion to grant or deny such requests, the 10th Circuit thought that the failure to explain why the Service was exercising its discretion to deny the relief violated “an elementary principal of administrative law that an administrative agency must provide reasons for its decisions.”  45 F.3d at 397.  Unexplained exercise of discretion is per se arbitrary, says Fisher.

The Fourth Circuit could have just disagreed with Fisher.  The IRS issued a well-reasoned AOD that explained why Fisher was wrong.  AOD-1996-08, 1996 WL 390087.  But the Fourth Circuit instead chose to distinguish Fisher, saying in footnote 6: “we do not read Fisher…as requiring a reasoned explanation in all Notices of Deficiency.”  Hmmmm.  Does that suggest that in situations where the Service is exercising discretion—like refusing to grant a request for spousal relief, or refusing to accept a collection alternative offered in a CDP hearing—that one of those decisions would be subject to the APA §706 standard, even when the Tax Code has very detailed special statutory procedures?  After all, both the CDP provisions and spousal relief provisions were added by Congress after the APA.

Let’s look at CDP procedures.  Currently the Tax Court’s approach to CDP review is both (a) abuse of discretion and (b) de novo.  That’s not quite square with how the APA contemplates the relationship of a reviewing court to agency decisions.  Here’s how the Court explained it in a recent CDP case, Drilling v. Commissioner, T.C. Memo 2016-103:

the standard of review employed by the Tax Court is abuse of discretion, except with respect to the existence or amount of the underlying tax liability, for which the standard of review is de novo. Goza v. Commissioner, 114 T.C. 176, 181-182 (2000). The evidentiary scope of review employed by the Tax Court is de novo. Robinette v. Commissioner, 123 T.C. 85, 101 (2004), rev’d, 439 F.3d 455, 459-462 (8th Cir. 2006). That means that the Court’s review is not confined to evidence in the administrative record. See Speltz v. Commissioner, 124 T.C. 165, 177 (2005) (citing Robinette v. Commissioner, 123 T.C. at 94-104), aff’d, 454 F.3d 782 (8th Cir. 2006). If the Court remands a case to the Appeals Office, the further hearing is a supplement to the original hearing, not a new hearing, Kelby v. Commissioner, 130 T.C. 79, 86 (2008), but the position of the Appeals Office that the Court reviews is the position taken in the supplemental determination, id.

Notice that this means if the taxpayer wants to present new information, the Tax Court has the option of hearing that new evidence itself or sending the case to the Appeals Office for a “supplemental” hearing.  See e.g. Drake v. Commissioner, T.C. Memo 2006–151, aff’d 511 F.3d 65 (1st Cir. 2007) (“The resulting section 6330 hearing on remand provides the parties with the opportunity to complete the initial section 6330 hearing while preserving the taxpayer’s right to receive judicial review of the ultimate administrative determination.”)

The Tax Court’s practice of allowing new information is IMHO a perfectly reasonable procedure and it reflects the ongoing nature of both CDP and 6015(f) determinations.  Each of those determinations can be affected by facts that change at any time.  But it is arguably NOT the procedure contemplated by the APA.  Notably, the APA contemplates that the record, once made, is unalterable.  And the danger of allowing an open record is that the Tax Court becomes mired “with tax enforcement details that Congress intended to leave with the IRS.” Robinette v. Commissioner, 439 F.3d 455, 459 (8th Cir. 2006) aff’ing in part 123 TC 85.

Both the CDP and the spousal relief review provisions were added by Congress long after the APA’s enactment.  Perhaps the flip side of pre-existing administrative schemes not being displaced by the APA is that post-APA statutory provisions do not exclude application of APA §706 but incorporate that standard (unless of course Congress says the provisions are to be exclusive).  Of course, the operational reasons for concluding that the §706 standard has been trumped by the specific CDP provisions may remain.

Those of us who study this stuff are not in agreement.  For Les’ take, see here; for Stephanie Hoffer and Chris Walker’s take, see here.  As Keith points out, the CDP procedures have astonishingly large gaps in them.  But IMHO the APA does not mandate a uniform set of rules for the Tax Court to deal with those gaps.  Like the U.S. Constitution, the APA simply provides the touchstone by which to measure any rules or procedures that the Tax Court or IRS come up with in implementing CDP.   Claiming that a procedure violates §706 is like claiming one process or another violates “due process.”  You first have to figure out what process is “due” before you can find a violation.

In sum, I believe the Fourth Circuit’s opinion in QinetiQ leaves open the door to argue that for non-deficiency determinations, APA §706 has greater applicability than for standard Tax Court review of deficiency notices.  Personally, I think that (1) the specificity of the both the CDP and innocent spouse provisions, and (2) the specific relationship that the Tax Court has in supervising so many aspects of tax administration still trump the general provisions in the APA.  But those two reasons for treating current procedure as may not be as applicable to other types of determinations, such as §6672 decisions, or penalty abatement decisions, or other “discretionary” decisions that are not clearly covered by specific Tax Code provisions.

 

Tax Court Again Holds APA Does Not Impact Validity of Statutory Notice of Deficiency

One of the main issues in tax procedure over the next few years will be the  relationship of IRS actions with the Administrative Procedure Act. Last week in Taking a Hard Look at Court Review of Treasury Regulations I discussed an article that considered rulemaking in light of 5 USC § 706(2)(A), which empowers a court to invalidate a rule that is “arbitrary” and “capricious.” That issue is front and center in the Altera case involving the validity of regulations under Section 482. That case is currently on appeal in the Ninth Circuit.

A close cousin of the Altera issue is teed up in the context of IRS adjudications in QinetiQ v Commissioner, a case on appeal in the Fourth Circuit. In QinetiQ, well-represented taxpayers are arguing that the IRS’s poorly explained notice of deficiency  should be set aside for its arbitrariness. (for previous PT posts on QinetiQ see here and here).

In QinetiQ the taxpayer is arguing that by violating the APA the notice should lose its validity and IRS would have to issue a properly detailed notice to generate a possible deficiency. A side issue would be whether the SOL on assessment would be tolled while the parties fought over the validity of the original notice, an issue I am certain that IRS and taxpayers would disagree over.

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In Ax v Commissioner, the Tax Court has not embraced the position that the APA imposes additional obligations on the IRS’s issuance of stat notices, as we explained in Tax Court Rules that APA and Administrative Law Principles Do Not Bar IRS From Amending Answer and Asserting New Grounds for Deficiency. Professors Stephanie Hoffer and Chris Walker followed up and gave additional context on this issue in A Few More Words on Ax and the Future of Tax Exceptionalism.

Circuit courts will soon be weighing in on this issue. Oral argument in the Fourth Circuit in QinetiQ occurred in late October; for an audio of that interesting argument see here. The argument is rich, with taxpayer counsel framing the issue as one of basic fairness in terms of dealing with the government and DOJ counsel describing the impact of a taxpayer win as potentially “catastrophic.”

Other cases are in the pipeline where taxpayers are making similar arguments. In Soechting v Commissioner taxpayers argued in a summary judgment motion that a shoddy notice of deficiency invalidated the notice under the APA. In an October order, the Tax Court disagreed, relying on Ax. The taxpayers then requested that the Tax Court certify the issue for immediate appeal to a circuit court (presumably the Fifth Circuit, as taxpayers reside in Texas). Under IRC § 7482(a)(2)(A), the Tax Court has the authority to certify an issue in a case for immediate appeal if there “is a substantial ground for a difference of opinion…”

In an order from earlier this week the Tax Court denied that request:

Petitioners’ submissions make it abundantly clear that they disagree with the Court’s position that the issuance of a notice of deficiency is not subject to the Administrative Procedures Act (APA). But this Court has repeatedly adhered to that position in the past, and most recently in Ax v.Commissioner, 146 T.C.__ (April 11, 2016). Petitioners have presented no authority to the contrary. Their reliance upon Altera Corp. v. Commissioner, 145 T.C. 91 (2015) is misplaced as that case addresses the applicability of the APA to the Commissioner’s regulation promulgation authority.

As I have explained previously, taxpayers are swimming upstream on this issue though there is an atmospheric problem with IRS issuing notices that may be wrong on their face or at best failing to explain much about why IRS is proposing a deficiency. Yet taxpayers generally have the right to de novo review of a stat notice. There are other remedies and specific provisions addressing inadequate stat notices, and taxpayers enjoy the right to meaningful prepayment review of IRS actions. While the courts are pushing IRS toward the mainstream of administrative law in some areas I suspect that this is one issue where tax procedure may stay somewhat outside APA norms.

Taking a Hard Look at Court Review of Treasury Regulations

As the holiday season is upon us, we are also in the season of lists: best movies, books, songs, to name a few. We have not taken the plunge with a post discussing our top posts of the year though my suggestion is just search Keith Fogg and pick up the last ten posts for a good place to start.

No doubt one of the most important tax procedure cases of 2015 and beyond is Altera, which Susan Morse and Stephen Shay discussed most recently in Treasury on the Right Side of the APA in Altera and in one of our most read posts of 2015 in Pat Smith’s A Massive Loss and a Huge Rebuke for the IRS from the Tax Court in Altera Decision. As our readers likely recall, in Altera, the Tax Court unanimously rejected parts of regulations under Section 482 requiring related parties to share stock based compensation costs. The case has major significance beyond the substance because it marked the first time that the Tax Court specifically held that Treasury regulations, whether issued under a grant of general authority or under a specific statutory mandate, were subject to the APA’s notice and comment requirements. After opening that door, the Tax Court applied a “traditional” administrative law arbitrary analysis under APA § 706(2)(A), which empowers a court to invalidate a rule that is “arbitrary” and “capricious.”  In invalidating the regulation, the Tax Court relied on case law including the 1983 Supreme Court State Farm decision which essentially imposed on agencies rulemaking principles embedded in the 1943 Supreme Court Chenery decision. Chenery stands for the general proposition that courts should evaluate agency action based on the reasons that motivated the agency at the time of the agency’s original action, rather than allow agencies to come up with after the fact explanations to justify earlier agency conduct.

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IRS has appealed Altera and the case is teed up in the 9th Circuit. No matter how the case is resolved, the battle over the validity of Treasury regulations and other IRS guidance is one that is likely to place the courts in the difficult position of applying administrative law principles to test the procedural soundness of the agency’s conduct in issuing guidance.

With that in mind, I noted with interest Arbitrariness Review Made Reasonable: Structural and Conceptual Reform of the Hard Look, an article in the current Notre Dame Law Review by administrative law scholars Sidney Shapiro and Richard Murphy. In the article, Professor Shapiro and Professor Murphy provide a comprehensive history of how under the arbitrary standard in APA § 706(2)(A) court review of agency rulemaking morphed from a relatively light touch to a more thorough hard-look requiring that “an agency must establish that, at the time it took its action, it had a contemporaneous rationale sufficient to satisfy the requirements of ‘reasoned decisionmaking.’”

After detailing the ways that courts have shifted from a light touch, the authors make the policy argument and argue against the modern hard-look review that the Tax Court appears to be employing in Altera:

In the abstract, nothing could sound more reasonable than for courts to insist that agencies actually base their actions on good reasons. As implemented, however, modern arbitrariness review has made the rulemaking process unduly onerous and time-consuming, with important rules often taking many years to complete. Once completed, these rules are then subject to judicial review that can be political and unpredictable, making it difficult for agencies to guess whether an explanation for a rule will be upheld under hard look review. This state of affairs is all the more problematic given agencies’ notorious lack of sufficient resources to carry out their assigned statutory missions.

The authors propose allowing the agencies the opportunity to defend the substance of rulemaking on reasons that were not necessarily the ones the agency relied on in proposing the rules in the first instance:

[T]his Article proposes a simple reform that may, on first hearing, sound heretical but that proves to have surprisingly strong roots in both the history of administrative law and current judicial practice. Specifically, courts should relax their bar on post hoc rationales, allowing agencies to rely upon them so long as they are based on information exposed to outside scrutiny during the notice-and-comment process.

There is lots in this article, and I have not fully digested it nor the many proposals that administrative law scholars have offered over the years to cut back on the excesses of court review of agency rulemaking. As the authors make clear, the APA is riddled with at times competing values, and with hard-look review, “the courts advanced legitimate administrative law values, including accountability, accuracy, and fairness, but with a loss of agency effectiveness and efficiency, which are also administrative law values of the first rank.”

Finding the balance between these at times competing values is now what courts will be doing when evaluating Treasury regulations and perhaps subregulatory guidance as well. In IRS’s Budget Likely ‘Miserable’ for 2017 and Beyond [free link not available] earlier this week BNA’s Daily Tax Report reported how the prospects for IRS budgets in the near and mid-term look pretty bleak. To be sure, some fear a more efficient IRS and Treasury, and would be happy to tie the agency up in knots to ensure that the agency cannot promulgate rules that some view as overreaching. No doubt that the inclination to impose onerous process requirements on Treasury is at least atmospherically related to how far Treasury deviates from a clear statutory mandate to issue guidance. Yet as courts wrestle with some of these principles in cases of first impression we should be worried about hamstringing an agency that has a vast and complex statutory regime to administer, and often not enough resources to do all that Congress and taxpayers expect.

 

 

 

 

A Fresh Look at Tax Exceptionalism: Tax Is A Little Different

Today we welcome first-time guest poster Professor James Puckett from Penn State Law School.  Past posts have wrestled with tax procedure’s place in the world of broader administrative law principles. James’ thoughtful recent Georgia Law Review article Structural Tax Exceptionalism takes on these issues. Situating tax adjudications and the mix of IRS guidance into broader administrative law norms, James suggests that some of the unique aspects of the IRS’s guidance and review process serve as a check on the wholesale adoption of those norms.

This issue is closely related to the discussion surrounding Treasury and IRS’s longstanding practice of exempting tax regulations from normal agency review procedures, an issue discussed in this month’s GAO report on IRS guidance practice and the subject of a recently released memorandum of understanding between IRS and OMB that dates from 1983. How tax fits in with broader and nontax specific agency practice will be an important issue in tax administration and tax procedure for the foreseeable future. Les

Amid a scholarly near-consensus that tax exceptionalism is dead or dying, my recent article, Structural Tax Exceptionalism examines some of the distinctive features of tax administration that remain viable. “Tax exceptionalism,” as it relates to tax procedure, holds that tax is so different, special, complicated, or important that otherwise applicable administrative law principles do not apply. This kind of tax exceptionalism was probably fatally undermined by the Supreme Court’s 2011 decision in Mayo Foundation v. United States. Perhaps leaving a crack in the door for future litigants to bring an adequate “justification,” the Court declared that it was “not inclined to carve out an approach to administrative review good for tax law only.”

In Structural Tax Exceptionalism, I argue that the peculiarities of tax rulemaking and adjudication severely constrain the potential for effectively mapping general administrative law principles onto tax. To be clear, the intent of the article is not to revive tax exceptionalism as an analytical guide. The APA is essentially a template, and Congress has customized tax rulemaking and adjudication. I argue that these modifications are important and should not be unraveled as a result of looking to the APA to start. In this post, I sketch the atypical features of tax rulemaking and adjudication, as well as their interplay.

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A prototypical agency may find rulemaking relatively burdensome and accordingly prefer to fall back on adjudication. Outside of tax, pre-enforcement challenges to rules promulgated by administrative agencies are commonplace. Whereas the Supreme Court has interpreted the Anti-Injunction Act (26 U.S.C. § 7421) broadly to bar pre-enforcement challenges to tax regulations, no such limitation applies under the APA. Moreover, in the event of a successful procedural challenge, assuming the agency tries again, it cannot backdate a newly issued replacement rule. With exceptions for interpretative rules, statements of policy, and “good cause,” APA § 553(d) generally requires publication of a final rule to precede its effective date by at least 30 days. Thus, low-risk pre-enforcement challenges may succeed in pushing back effective dates of legislative rules even if the agency ultimately prevails and the contents of the eventual valid rule come as no surprise to the public.

Even with the risk of post-enforcement litigation, APA challenges to tax rules have multiplied post-Mayo. Sometimes, of course, there will be a more fundamental flaw with the guidance, e.g., that it is unreasonable or contrary to the Code. However, my article argues that in cases involving procedural technicalities, the IRS and Treasury Department may be able to solve some enforcement problems by backdating a replacement rule. Final tax regulations, under the authority of I.R.C. § 7805(b)(1)(B), are routinely backdated to the date of the notice of proposed rulemaking (NPRM). Perhaps in the case of replacement regulations it would be more appropriate to label the NPRM relating to the invalidated regulation a “notice substantially describing the expected contents” of the replacement regulation (I.R.C. § 7805(b)(1)(C)).

Part III.A of the article expands on this and other potential arguments relating to the backdating of tax rules. Beyond the basic § 7805(b) argument outlined above, there are other potential arguments under the Code (e.g., prevention of abuse, as well as the more flexible predecessor to Section 7805(b), which arguably still applies in some cases). Moreover, no examination of rulemaking procedures would be complete without an examination of the vexing legislative-interpretative rule distinction. Although I would not go so far as some in classifying tax rules as legislative, the IRS and Treasury have probably been too quick to claim exemption from the APA for “interpretative rules.”

Outside of tax, a recurring complaint about agencies is that they fail to engage in sufficient rulemaking, instead opting to make policy through case-by-case adjudication. The IRS clearly has to undertake a great deal of adjudicative activity in reviewing tax returns. However, courts review deficiency determinations as well as typical refund claims de novo. Part III.B. of my article expands on how this differs from the deferential judicial review ordinarily afforded to agency formal adjudication.

Stephanie Hoffer and Chris Walker argue in their excellent article on The Death of Tax Court Exceptionalism and in their posts on Procedurally Taxing discussing that article that the Tax Court’s review should be deferential where the APA has not been overridden (e.g., innocent spouse relief and collection due process). Like Hoffer and Walker, I am intrigued by the potential benefits of deferential review and remands in appropriate cases. Moreover, I agree that there may be more room for courts to explore discretionary remands to the IRS.

In any event, for the time being, adjudication does not present the same attraction to the IRS as it would to the prototypical agency. To substantially improve the odds of a court following the IRS’s position on an issue, rulemaking offers more promise. The prospect of de novo review of IRS adjudication, along with the potential flexibility of backdating rules under § 7805(b), represent sticks and carrots that may push the IRS and Treasury toward rulemaking—at least relative to a prototypical agency’s incentives. This may be a good thing, if we are hoping for more published tax guidance.

IRS Wins Latest Battle on Voluntary Return Preparer Testing and Education Though Other Battles Likely Remain

Last week in AICPA v IRS the DC District Court ruled in favor of the IRS in the latest round of the AICPA’s fight to dismantle the IRS’s Annual Filing Season Program. As some of you may recall, the Annual Filing Season Program (AFSP) was the IRS’s reaction to losing in its efforts to impose on unlicensed preparers a mandatory testing and education regime in Loving v IRS. Rather than force unlicensed preparers to take an entrance test and take continuing education, the IRS now allows preparers to opt in, with the benefit that those who sign on appear in an online searchable database of preparers. The AFSP also imposes a cost to those who do not opt in; they are not permitted to engage in limited representation of the clients whose returns the IRS audits.

Last year the DC Court of Appeals, reversing the District Court, held that the AICPA had standing to bring the suit challenging the AFSP. After the case was remanded to the District Court and prior to that court getting to the heart of the merits argument, IRS filed another motion to dismiss, this time not on constitutional standing grounds (where it lost on appeal). Instead, IRS argued that the case should be dismissed because AICPA was not within a zone of interests that Congress sought to protect. In last week’s opinion, the District Court held that while AICPA had standing to bring the suit the suit should be dismissed because AICPA was not within the zone of interests protected by 31 U.S.C. § 330(a) (dealing with regulating practice before Treasury and conditioning practice upon qualifications) and 31 U.S.C. § 330 (b) (comprising of penalties and rules for the disbarment of practitioners).

In this post I will briefly discuss the zone of interests issue and also address some of the procedural implications of the opinion, including how the opinion foreshadows other challenges to the AFSP.

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The AICPA is Not in the Zone of Interests

As last week’s opinion discusses, the zone of interests question is not a constitutional standing question (though it is similar); instead, “it is a ‘statutory question’ that asks ‘whether ‘a legislatively conferred cause of action encompasses a particular plaintiff’s claim.’ Mendoza v. Perez, 754 F.3d 1002, 1016 (D.C. Cir. 2014). Likely for this reason, satisfaction of the zone-of-interests test is no longer a “jurisdictional requirement” and is instead “a merits issue.” Crossroads Grassroots, 788 F.3d at 319 (citations omitted).

Was AICPA within the class of persons Congress sought to protect with 31 U.S.C. § 330(a) and (b)? The court said no. The upshot of the opinion is that AICPA brought this suit because it felt that the Annual Program would threaten its members’ market share; worried that the public would view the Annual Filing Season as a credential that would draw consumers from CPAs during tax season, the AICPA sought to stop the program:

AICPA’s objective here, as it relates to its competitive injury, is to “remov[e] the AFS Rule’s spurious credential from the marketplace.” Opp. at 2; see id. at 3 (“[A]s competitors of unenrolled preparers, AICPA members’ interests” consist of, inter alia, “ensuring that their hard- won qualifications are not diluted by the Rule’s unlawful credential.”). Digging deeper, however, its interest relates to “maximizing . . . profits, apparently by avoiding competition with” unenrolled preparers in the market for tax services. See Liquid Carbonic Indus. Corp. v. F.E.R.C., 29 F.3d 697, 705 (D.C. Cir. 1994).

That, according to the District Court ran counter to the protective purpose of 31 USC § 330, which Congress enacted in the mid-19th Century as a means to protect Civil War veterans against unscrupulous agents:

On the surface, it seems difficult to square AICPA’s interest in dismantling the IRS’s program with Congress’s goal of safeguarding consumers. In creating the AFS Program, the IRS aimed to improve unenrolled preparers’ knowledge of federal tax law, thereby “protecting taxpayers from preparer errors.” Rev. Proc. 2014-42, § 2. This objective appears closely aligned with Congress’s goal of ensuring taxpayers are provided “valuable service.” 31 U.S.C.
§ 330(a)(2)(C). AICPA does not impugn the IRS’s motive in creating the program or otherwise argue that, apart from the risk of “consumer confusion” – i.e., that consumers might confuse a more-qualified but higher-priced CPA with a less-qualified but cheaper unenrolled preparer – the AFS program does not flow logically from Congress’s objective of protecting consumers. Rather, it seeks to eliminate the Program notwithstanding its potential benefit to consumers precisely because the program’s “‘government-backed credential[]’” renders “unenrolled preparers . . . ‘better able to compete against other credentialed preparers,’ ‘uncredentialed employees of [AICPA] members,’ and ‘CPAs and their firms.’” Opp. at 10 (quoting AICPA II, 804 F.3d at 1197-98).

The zone of interests test is more nuanced than this snapshot provides, and I leave to those who wish to dig deeper to read the opinion itself as well as Ed Zollar’s excellent write up of the case and that issue in Federal Tax Developments.

Not the Final Word on Challenges to the IRS Program

In addition to providing a roadmap on the zone of interests test, the opinion itself is worth a careful read for its suggestion that other parties may in fact have a beef with IRS even if the AICPA does not. To that end, while Judge Boasberg, the judge who wrote the district court Loving opinions, carefully recounts the history of IRS efforts to regulate preparers, he also offers a not so subtle critique of the IRS’s decision to use a Revenue Procedure to promulgate the AFSP. He does so by reminding that he issued a clarifying opinion after IRS lost in Loving.  There he rejected IRS’s request for a stay of the injunction pending appeal, though he noted that IRS might choose to keep in place some of the apparatus of its licensing regime as “it is possible that some preparers may wish to take the exam or continuing education even if not required to. Such voluntarily obtained credentials might distinguish them from other preparers.” He notes that “[p]erhaps taking this clarification to heart, the IRS decided to retain much of the rule’s infrastructure, but did so by relying on tax preparers’ willingness to voluntarily participate.”

While referring to the IRS’s possibly taking his advice, this opinion also discusses that IRS put this process in place in a revenue procedure, “albeit without notice and comment.” The IRS use of revenue procedures to carry the hefty weight of meaningful rules is something we have discussed before; as is the IRS penchant for getting rules in place without formal notice and comment (see Dan Hemel’s post  earlier this week for the Chamber of Commerce challenge to Treasury’s inversion regs, for example).

More from the opinion and the hint to other challengers:

A final word. While AICPA does not have a cause of action under the APA to bring this suit, the Court has little reason to doubt that there may be other challengers who could satisfy the rather undemanding strictures of the zone-of-interests test. “The same claim may be viable in the hands of one challenger and not in those of another that, for example, has interests that make it less than a reliable private attorney general to litigate the issue of the public interest in the . . . case.” HWTC IV, 885 F.2d at 925-26 (citations and quotation marks omitted). Given the points raised in the merits briefing, which the Court now has no occasion to consider, Defendant may wish to ensure that its Program was properly promulgated before a suitable party mounts its own challenge.
 (emphasis added)

A few years ago I wrote an article explaining why I thought it was important for IRS to seek greater input especially on rules that have a significant impact on those whose interests are not typically represented through trade associations or lobbying groups. In writing the article, I drew upon a deep literature in administrative law that discusses the pros and cons of requiring agencies to more closely adhere to the requirements to use the notice and comment procedure to promulgate rules. I am no zealot on these issues, and while it has been a while since I deeply waded in those waters I am sympathetic to those who feel IRS should more meaningfully and systematically engage with those whose perspective would improve the quality of the rules the IRS issues. As an added benefit it would also likely engender greater acceptance of the rules from those who may not necessarily like the outcome but who feel that their voice was heard. (I do recognize that before IRS did come up with its ill-fated mandatory testing and education program that the courts invalidated IRS did seek input in the form of hearings and an informal comment period).

We likely have not seen the last of the challenges to the IRS Annual Filing Season Program; nor have we seen the last procedural challenge to the issuance of rules. While this round is a nice IRS victory, Judge Boasberg’s opinion is perhaps a reminder that IRS ignores strict adherence to some administrative law norms at its peril.

 

 

 

 

 

 

 

 

Administrative Law Grab Bag: Chevron and State Farm Developments

Last week’s post Treasury on the Right Side of the APA in Altera highlighted the importance of administrative law generally as well as some landmark cases such as Chevron and State Farm. In today’s post I offer some general developments on both Chevron and State Farm, one in the form of proposed legislation that if enacted would overrule Chevron and shift the power to interpret statutes from agencies to courts. The other is a Supreme Court decision from late June that elaborated on State Farm in a way that may have specific relevance for challenges to Treasury regulations when parties allege that Treasury has failed to adequately explain its reasons for promulgating regulations.

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First some background. As most tax people know in the post-Mayo world, Chevron provides a two-step inquiry for reviewing agency interpretations of statutes that is easy to state but challenging to apply. Under Chevron the court first (under Step 1) determines if Congress directly spoke to the question at issue. If a court finds that Congress did, then the court defers to the statute and the agency’s interpretation falls if it is inconsistent with the statutory language. If Congress did not address the issue in question in the statute itself or if the language is ambiguous then the inquiry (under Step 2) is whether the agency’s answer is based on a “permissible” construction of the statute. A permissible construction is one that is not “arbitrary, capricious, or manifestly contrary to the statute.” If it is permissible then the court defers to the agency.

In PT we have also discussed principles relating to State Farm, issues that are front and center in the Altera dispute. As Pat Smith discussed for us in his post discussing the IRS’s Altera defeat, “[u]nder the Supreme Court’s landmark 1983 State Farm decision, in order for agency action to satisfy the arbitrary and capricious standard, the agency action must be the product of “reasoned decision-making,” and the agency must, at the time it takes the action being reviewed, provide a reasoned explanation for why it made the particular decision it did.”

Proposed Legislation on Chevron

Last week the House passed the Separation of Powers Restoration Act, a bill that if enacted would overturn Chevron and amend the APA to provide that courts review “de novo all relevant questions of law, including the interpretation of constitutional and statutory provisions and rules.” The legislation is the product of efforts of the Article I Project, a network of House and Senate legislators that describes itself as working on a “new agenda of government reform and congressional rehabilitation.” The Article I Project Web Page states that its mission is to “develop, advance, and ultimately enact an agenda of structural reforms to strengthen Congress by reclaiming its constitutional legislative powers that today are being improperly exercised by the Executive Branch.”

Republican Congressman John Ratcliffe of Texas is the sponsor of the legislation in the House. He has a post in the Hill Separation of Powers Restoration Act Key to Rebalancing Government describing the legislation:

This critical measure reverses the 1984 Supreme Court decision that established the “Chevron doctrine,” placing the power to determine ambiguous laws back into the hands of the Judiciary. This would help stop future abuse of power by preventing administrative agencies from establishing regulations with the intent of leveraging the “Chevron doctrine” to implement them however they so choose, fully free from judicial review. Instead, agencies will be forced to adhere to the courts’ interpretation of the laws they implement – keeping them from “grading their own papers,” as they’re allowed under the “Chevron doctrine.”

There is also a Senate version of the bill (co-sponsored by Senators Hatch, Lee and Grassley) though that has yet to move out of committee. An article in the Dallas Morning News indicates that the President would veto this bill if it came to his desk.

Does Chevron Make a Difference?

Does Chevron deference make a difference in agency outcomes in court? In a working paper called Chevron Deference and the Courts Professor Kent Barnett of University of Georgia Law School and Professor (and former PT guest blogger) Christopher Walker from Ohio State Moritz College of Law suggest that it does. They looked at every published decision citing Chevron in a ten year period and “found that the circuit courts overall upheld 71% of interpretations and applied Chevron deference 75% of the time. But there was nearly a twenty-five percentage-point difference in agency-win rates when the circuit courts applied Chevron deference than when they did not.”

The study found differences across circuits and a difference between Supreme Court and circuit court outcomes, with the authors concluding that Chevron may not have as much of an effect on agency outcomes at the Supreme Court but that it may be “an effective tool to supervise lower courts’ review of agency statutory interpretations.”

Supreme Court Developments on State Farm

So while there are some rumblings in Congress to overturn Chevron, there are some preliminary questions that arise before one gets into the Chevron inquiry. For example, what has been called Chevron Step Zero asks whether Congress intended to defer to agencies in the first place. To that end if issues implicated are extraordinary and of great importance, as in King v Burwell last year (involving the IRS’s regulatory definition of exchanges for purposes of tax credits), the courts may conclude that the issue is one that Congress did not intend for agencies to play a role in filling statutory gaps. The upshot in those cases is that courts take a de novo crack at the statute in the manner that the Separation of Powers Act legislation proposes.

Another of those preliminary questions presents itself in the Supreme Court case Encino Motorcars v Navarro, decided this past June. Bloggers and law profs Michael Pollock and Daniel Hemel at the Notice & Comment blog discuss the Encino Motorcar case and its relationship to general administrative law principles in the post Chevron Step .5 Their post is terrific. I highly recommend that readers with an interest in the area read the whole post, though I hit some of the high points here.

The Encino case involved Labor Department rules that provided that service employees at car dealers were entitled to overtime pay. The service employees sued the car dealers asking for overtime; the dealers claimed that Department of Labor failed to adequately explain why it changed its mind and promulgated rules that said that service employees at car dealers were not exempt from overtime pay (a statute exempts overtime for “any salesman, partsman, or mechanic primarily engaged in selling or servicing automobiles, trucks, or farm implements, if he is employed by a nonmanufacturing establishment primarily engaged in the business of selling such vehicles or implements to ultimate purchasers.”). The Labor Department had gone back and forth on the issue for decades and in 2011 took the view that service employees were not exempt from overtime.

The 9th Circuit applied a traditional two step Chevron inquiry and found that the statute was ambiguous (Step 1) and the agency’s interpretation was reasonable (Step 2). In Encino Motorcars the Supreme Court stated that the Labor Department failed to explain its reasons in coming up with its 2011 rules, remanding the case back to the 9th Circuit to interpret the statute:

One of the basic procedural requirements of administrative rulemaking is that an agency must give adequate reasons for its decisions. The agency “must examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.” Motor Vehicle Mfrs. Assn. of United States, Inc. v. State Farm Mut. Automobile Ins. Co., 463 U. S. 29, 43 (1983) . . . .

Applying those principles here, the unavoidable conclusion is that the 2011 regulation was issued without the reasoned explanation that was required in light of the Department’s change in position and the significant reliance interests involved. In promulgating the 2011 regulation, the Department offered barely any explanation. . . . This lack of reasoned explication for a regulation that is inconsistent with the Department’s longstanding earlier position results in a rule that cannot carry the force of law. See 5 U.S.C. § 706(2)(A); State Farm, supra, at 42-43. It follows that this regulation does not receive Chevron deference in the interpretation of the relevant statute.

How does this relate to Chevron and State Farm? Using a helpful example, bloggers Pollock and Hemel suggest that there is a preliminary step that arises prior to the two-step Chevron test and after Step Zero, a Chevron “.5” step:

To put the point starkly, imagine an agency had been granted the authority to engage in notice-and-comment rulemaking and wrote a new regulation (on a matter within its jurisdiction and expertise) on the back of a napkin nailed to a signpost outside the White House. The regulation contains an interpretation of an ambiguous statutory provision, again within the agency’s jurisdiction. If that agency then claimed its interpretation written on that napkin was entitled to Chevron deference, it would (we think) be laughed out of court. But why? Congress intended for the agency to fill gaps in the statute (Chevron step zero) and the statute is indeed ambiguous (Chevron step one). Suppose, too, that the interpretation adopted by the agency on the napkin is entirely reasonable (indeed, maybe even the best reading of the statute), and that the agency actually explained its reasoning quite thoroughly despite the napkin’s surface-area limits. So the interpretation should pass muster at Chevron step two—and would even satisfy State Farm’s reason-giving requirement. But no one (we don’t think) believes that an agency can get Chevron deference for a position taken on a napkin. Why not? Because the agency failed to follow the proper procedure for exercising its gap-filling authority. The napkin rule flunks at Chevron step 0.5.

The post goes on to explain why it is likely that winning a Step .5 challenge does not automatically result in a victory, as agency interpretations will still be given heightened (though not quite Chevron) deference under Skidmore, where the weight of an agency interpretation “depend[s] upon the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade, if lacking power to control.” Skidmore, 323 U.S. 134, 140 (1944)).

Moreover, using some administrative law acrobatics, the post explains why in many other challenges involving a party bringing an action against an agency (except tax cases), courts generally resolve procedural defects such not under this type of Step .5 analysis but under the APA itself.

Some Parting Thoughts

A decade or so ago there were only a handful of tax cases that leaned on administrative law principles. Now, litigants look to administrative law and its complexities as a principal means of attacking IRS and Treasury actions. No doubt that Treasury and IRS are deeply aware of the administrative law sharks circling agency actions; the extensive discussion of comments in the preamble to Treasury’s recently promulgated regulations under Section 7602 addressing the use of private contractors to assist in interviewing summoned witnesses reflects that sensitivity (note Keith commented on those regs last week in Tax Notes; a free link is not available).

With Altera and other cases teeing up an application of some basic administrative law principles in the tax context, and many other cases in the pipeline where litigants are looking to administrative law principles to challenge IRS rulemaking and other practices we will likely see many more cases and posts in PT struggling to come to terms with how tax cases fit in with the many nuances of administrative law.

UPDATE 7.18 10:30 PM: Florida State’s Steve Johnson has written a taxprof blog Op-Ed on the proposed legislation. It raises some questions in the event of passage (unlikely at least for now as Steve acknowledges) and is full of good references to other works and Steve’s prolific writings on Chevron and related topics over the years. It does a nice job as well situating Steve’s support for dispensing with Chevron.