Ninth Circuit Hears Altera Tomorrow

We welcome back guest bloggers Professor Susan C. Morse from University of Texas School of Law and my colleague Senior Lecturer on Law Stephen E. Shay from Harvard.  Professors Morse and Shay, building on an earlier post as well as their amicus brief, explain that the Tax Court went too far in striking down Treasury regulations requiring the sharing of stock-based compensation costs in Altera.  The underlying issue as well as the procedural issue make this a case to watch. We have previously blogged about Altera here and here.   Keith

On Wednesday of this week, October 11, the Ninth Circuit will hear argument in Altera, a case about transfer pricing and administrative law. Politically, Altera is a case about big multinational technology companies and under-resourced government regulators. Technically, it is about the transfer of intellectual property rights from U.S. affiliates of a multinational firm (a “U.S. group”) to one or more non-U.S. offshore subsidiaries under a qualified cost sharing arrangement (QCSA).

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Firms from Google and Apple to Altera, a semiconductor company owned by Intel, use the QCSA “cost sharing” strategy to support the attribution of intellectual property for tax purposes to low-tax offshore subsidiaries and thereby justify allocation of substantial taxable income to those subsidiaries. The smaller the amount of U.S. group costs included in the pool, the more tax revenue the U.S. loses with respect to the cost-shared IP. Billions of dollars are at stake. Two amicus briefs prepared pro bono by academics and former tax practitioners support the government and multiple amicus briefs on behalf of interested business groups support the taxpayer in this important litigation.

Altera challenged a final Treasury regulation that requires multinationals who enter into QCSAs with offshore affiliates to include the cost of stock options granted to employees who develop the IP (among other expenses) in the pool of costs to be shared. Under cost sharing, if net costs are borne by the U.S. group the non-U.S. affiliates must reimburse the U.S. group for that amount. Prior regulations did not specifically address the issue of stock option cost allocation in a QCSA. In a prior case, Xilinx, the Tax Court and Ninth Circuit held that the government could not make offshore affiliates pay a share of stock option expense under these earlier regulations.

The revised final regulation requires taxpayers to include stock option costs in the pool of expenses for determining cost sharing payments. They provide that this is required under the arm’s length standard and, consistent with the directive of Section 482 of the Internal Revenue Code, is necessary clearly to reflect the income of the U.S. group.

Taxpayers challenged the final regulation and won in Tax Court in a reviewed decision that was unanimous among the judges that participated. The Court held that the regulations departed from the historic understanding of “arm’s length standard” which required the use of data about unrelated party transactions. The Tax Court proceeded to conclude, under a review based on State Farm (US 1983), that the regulatory change was arbitrary and capricious under § 706(2)(A) of the Administrative Procedure Act.

The misconception in the Tax Court’s decision is fundamental. One reason is that the historic understanding of “arm’s length standard” does not require the starting point of data about unrelated party transactions. Sometimes an application of the arm’s length standard uses unrelated party data. For example, if a taxpayer sells a commodity to related affiliates and unrelated firms, the unrelated firm price is the right starting point for the related affiliate price, because it is sufficiently comparable. But in other cases, unrelated party transactions are not comparable enough to serve as good starting points.

The arm’s length standard has always been a counterfactual inquiry. It has always asked how a related party transaction would be treated if, contrary to fact, the same transaction (including the actual relationships presented in fact) were conducted by unrelated parties (i..e, as though the relationship did not exist). This does not mean insisting that the reasoning begin with an unrelated party transaction if that transaction has sufficiently different facts and is not comparable.

Several transfer pricing methods, including the comparable and residual profit split methods, do not require use of unrelated party prices as starting points.   Moreover, large chunks of the 482 rules prove that the arm’s length standard is not a brittle instruction to use whatever unrelated party information is available. The 482 regs include many pages of comparability adjustments which at every turn show that a starting unrelated party price, even if available, often needs a lot of work before it can be considered a comparable.

Altera and other multinational tech companies want to avoid paying for the stock option cost component of technology by arguing that unrelated firms that share technology do not require payment for stock option costs. They say that the arm’s length standard requires a starting unrelated party data point, and further that any departure from the unrelated party data point requirement is a significant regulatory change.

One reason that Altera should lose in the Ninth Circuit is because the arm’s length standard does not, and never has, required a starting unrelated party data point in all cases. Government briefs include this argument. They show that uncontrolled joint development agreements were not relevant to the question of whether to include stock option costs in QCSAs because clear reflection of income for high-profit intangibles cannot succeed if it relies on uncontrolled party data.  One amicus brief points out that Section 482’s reference to pricing “commensurate with income” only makes sense if the arm’s length standard embraces transfer pricing that is not bound to unrelated party pricing.

Another amicus brief (ours, with coauthors) explains that unrelated party data points cannot be starting points for an arm’s length analysis if the unrelated information is wholly incomparable to the related party situation. This is the case for the evidence that Altera points to, which consists of technology sharing deals among unrelated parties that do not mention stock option costs. This evidence is not relevant for QCSAs because it is not comparable.

The facts of Example 2 in our brief illustrate the lack of comparability between unrelated party joint ventures and related party technology transfer agreements:

Assume that Company C and Company D are unrelated and want to share the R&D costs and benefits for a new innovation on a 50/50 basis.

Company C pays cash compensation of 80 and grants stock options with an expected cost of 20 for its R&D employees. Company D pays cash compensation of 20 and grants stock options with an expected cost of 80 for its R&D employees. There are two possible ways of looking at the R&D costs in this deal:

Option 1: If stock option expenses are included, the pool of expenses is 200, and each company pays 100. No transfer between C and D is required to achieve a 50/50 split of expenses.

Option 2: If stock option expenses are not included, the pool of expenses is 100: 80 contributed by Company C and 20 contributed by Company D. D would transfer 30 to C to achieve a 50/50 split of expenses.

The correct answer is Option 1. Any rational economic actor would estimate and incorporate the stock option expense cost. Note that Company C and Company D do not need to mention stock option costs in order to consider and incorporate them into their transaction. The lack of a specific mention of stock options in the unrelated party deal document does not mean that stock option costs are priced at zero or intentionally disregarded.

The arm’s length standard has always recognized the absence of comparable third-party transactions in some areas of transfer pricing, including the large-scale licensing of IP among related parties. Thus the revised regulation at issue in Altera does not revolutionize the meaning of arm’s length. Instead it stays true to the meaning of clear reflection of income.

Tune in again after October 11 to hear how the taxpayer, the government and the judges of the Ninth Circuit approached this case at oral argument.

 

More on the Successful Challenge to the Anti-inversion Regulations

Today Professor Bryan Camp shares with us some of his views on the government’s loss in Chamber of Commerce v IRS, the challenge to Treasury’s anti-inversion regs that I discussed here.The case has been generating significant comment. For example, Professor Andy Grewal on the Notice & Comment blog nicely summarized the outcome and gave some additional context.

Below Professor Camp discusses why the court’s approach may be out of sync with traditional views of the Anti-Injunction Act. As Bryan suggests, the AIA battle is likely to be one where the Treasury may be able to circle the wagons and fend off early challenges to its rulemaking procedures. Les

I know everyone is chomping at the bit to get to the cool APA stuff, but I think the Anti-Injunction Act is the big issue here.  Or at least should be.  If I read the decision correctly (a big if), this appears to be a suit by an Association and they get standing only because one of their members believed that the regulation under attack would deny them a tax benefit they believed they would get absent this section 7874 regulation on inversion.

The court took an extremely narrow view of the Anti-Injunction Act, seeming to say that it only applies when a particular taxpayer seeks to contest an already assessed tax.  The court believed that ANY attack on the procedural validity of ANY regulation is permissible under the anti-injunction act.   The court says “Here, Plaintiffs do not seek to restrain assessment or collection of a tax against or from them or one of their members.  Rather, Plaintiffs challenge the validity of the Rule so that a reasoned decision can be made about whether to engage in a potential future transaction that would subject them to taxation under the Rule.”

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That statement reflects a poor understanding of tax administration.  You could say that about ANY substantive tax reg.  Is the court really saying that ANY tax regulation can be attacked by any taxpayer whose taxes are potentially affected by the regulation???  That cuts against loads of precedent going at least as far back at Fleet Equipment Co. v. Simon, 76-2 U.S. Tax Cas. (CCH) P16,231 (D.D.C. 2976).  This is exactly the kind of suit that the Anti-Injunction Act is supposed to stop.

In contrast to substantive regs the courts have allowed suits to restrain implementation of regulations that go to tax administration, such as return preparer regulations or information reporting regulations.  Those cannot be attacked in a refund suit and they do not affect the self-reporting taxpayers of the taxpayers subject to them.  But the time and place to attack a substantive tax regulation is in a refund suit.  Gosh and golly.

If the TP here wanted to attack the regulation, it could do so in a refund suit if it takes a different position, gets audited, and wants to fight.  Sure, the regulation would be in place, but the TP would argue that the regulation gets zero deference because it was (allegedly) invalidly promulgated.  Without the regulation, the IRS would still take the same position on the return item but the court would be faced with the TP’s position and the IRS position, unsupported by the authority of a valid regulation.  Just like an assessment is not valid when not properly done.

 

District Court in Texas Strikes Down Treasury’s Anti-Inversion Regs

A district court in Texas has struck down Treasury’s anti-inversion regulations for violating the APA’s notice and comment requirements.  The opinion can be found here  and a brief Reuters story on the background and opinion can be found here

Given the subject, the opinion is major news. It is also a significant tax procedure case, addressing at least 6 issues, each which could take up a post or article.

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  • Standing-it concludes that the Chamber of Commerce and the Texas Association of Business had standing to bring the suit;
  • Anti-Injunction Act-it concludes that the APA claims (that the rules were arbitrary and capricious and issued without required notice and comment) were not barred by the AIA, finding that the suit was not for the purpose of restraining assessment and collection of tax;
  • Statutory Authority-it concludes that the issuance of rules on the subject was within Treasury’s statutory authority;
  • Arbitrary and Capricious- it concludes that the Treasury reg, as buttressed by the preamble’s explanation, demonstrated that the rule was not arbitrary and capricious;
  • Interpretive Rules-it concludes that the regulations are legislative and not interpretive, an important conclusion because interpretive rules are exempt from the APA notice and comment regime; and
  • No Notice and Comment Exception for Temporary Regulations-it concludes that Section 7805(e) does not authorize the issuance of binding temporary regulations without notice and comment in the absence of an explicit notice-and-comment exception found in the APA or the Code itself; given that the regs were issued in temporary form without notice and comment, the court concluded that the regs were invalid.

The last point is the main APA issue in the case. As a brief refresher, the APA generally provides that in the absence of an exception (like for good cause, not argued here, or if a rule is merely interpretive, argued here but a loser in this case and likely others involving Treasury regs), an agency must give the public notice and the right to comment as per 5 USC § 553.

Treasury has argued that Section 7805(e), which provides that temporary regulations must be accompanied by a notice of  proposed rule making and sunset after three years, is evidence of Congressional intent to exclude temporary regs from the main APA notice and comment regime. No controlling opinion had addressed that issue directly, though in Intermountain Insurance v Commissioner a concurring opinion by Tax Court Judges Holmes and Halpern makes the strong case that the 7805(e) was not sufficient to give Treasury a free pass on notice and comment.

Commentators, including persuasively Professor Kristin Hickman in her 2013 Vanderbilt law review article Unpacking the Force of Law, argue that Treasury’s practice of issuing temporary regulations without notice and comment likely violates the APA. (A 2012 National Tax Journal article by Professor Ellen Aprill also gives a careful look at APA and other procedural requirements accompanying Treasury rule making, including some great admin law context on Treasury temporary reg practice). Looking to other instances where Congress has exempted agencies from notice and comment, Professor Hickman notes that nontax legislation is more explicit in carving out the agency’s rule making from notice and comment, and that the Supreme Court has generally required there to be an explicit legislative pass on APA requirements. Moreover, Section 7805(e) is, in her (and my) view better seen as a provision that should be read in light of notice and comment requirements, rather than excepting the agency from it altogether.

I suspect that there will be an appeal here though this issue is a political hot potato. I believe the district court gave short shrift to the AIA issue (one that I have recently discussed in the updated IRS Practice and Procedure and an issue that Professor Daniel Hemel also discussed for us in a guest post on PT here) so there is a real possibility that an appellate court may not even reach the APA.  Yet this opinion should be a wake up call to the Treasury practice of issuing Temporary Regulations without a safer exemption from notice and comment. Where there is the demonstrated need to promulgate a rule without going through notice and comment, the APA provides a good cause exception. In this post-Mayo world, taxes, while vital, are not enough to justify an agency practice that seems out of sync with the rest of administrative law.

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.