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.


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.


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.


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.


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.


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.

Treasury on the Right Side of the APA in Altera

We welcome back guest blogger Professor Susan C. Morse from University of Texas School of Law and first-time PT blogger Professor Stephen E. Shay from Harvard.  Professors Morse and Shay joined forces with other law professors with expertise in tax administration and international tax identified in the body of the blog to produce an amicus brief designed to persuade the 9th Circuit that the Tax Court went too far in striking down Treasury regulations requiring the sharing of stock-based compensation costs in Altera.  This post explains the arguments presented in their brief.  We have previously blogged about Altera here.  It is certainly no exaggeration to describe Altera as the most important decision of the Tax Court in 2015.  The outcome of the case at the Circuit Court level has significant importance and the amicus brief offers the Court valuable insight.  Keith

In 2013, one of us did a presentation at a Tax Executives’ Institute lunch panel in the heart of Silicon Valley.   In the presentation, she dismissed the idea that Treasury’s 2003 regulations requiring the sharing of stock-based compensation costs in cost-sharing agreements could be anything but valid.  There was an audience question, “What about Altera?”  She simply replied, “What about Mayo?”  It seemed the obvious response.  But, apparently, Mayo was not sufficient for the Tax Court.


Mayo confirmed that Treasury regulations promulgated under Administrative Procedure Act (APA) notice and comment procedures, like administrative regulations under non-tax law, receive full Chevron deference.  For several years around the time that Mayo was decided, the tax administrative law literature was largely absorbed with issues like the deference due to more informal guidance, such as notices and revenue rulings.  But the final, notice-and-comment regulations that required the inclusion of stock-based compensation in the cost base for cost-sharing agreements were outside that discussion.   Surely, deference would be due.

Yet the Tax Court in Altera invalidated Treas. Reg.  § 1.482-7(d)(2)(2003) under the APA.  The Tax Court’s decision was not based on APA § 553(c), which contemplates the notice-and-comment rulemaking process and supports deference under Mayo (as well as Chevron).  Rather, the decision was based on APA § 706(2)(A), which empowers a court to invalidate a rule that is “arbitrary” and “capricious.”  The Tax Court relied on case law including State Farm, a 1983 Supreme Court case that found an administrative action reversing prior action to be arbitrary because it was unexplained and contrary to evidence in the regulatory record.   In Encino Motorcars, a June 2016 case, the Supreme Court said the arbitrary and capricious standard required of an agency “adequate reasons for its decisions.”

The Altera Tax Court focused its arbitrary and capricious analysis on Treasury’s decision to require the sharing of stock-based compensation expense for controlled party cost-sharing agreements in the presence of evidence (submitted in the notice-and-comment process) that uncontrolled parties did not share costs in joint development agreements.  There are now three briefs that support the government’s appeal and request to the Ninth Circuit that it reverse the Tax Court decision, including the Department of Justice’s brief and two amicus briefs.

The government’s brief, filed on June 27, argues that the uncontrolled joint development agreements were not relevant because clear reflection of income for high-profit intangibles is not supposed to rely on uncontrolled party data.  The government points to “coordinating amendments” promulgated with 1.482-7(d)(2) to show coordination between the “commensurate with the income” language of § 482, and its 1986 legislative history, and the general arm’s length standard thereby supporting exclusive reference to facts internal to the transaction.  As we say in our brief, we agree with the government.  A brief principally drafted by NYU’s Clint Wallace and joined by 18 law professors argues that the “commensurate with the income” portion of the statute provides an independent basis for the validity of the regulation (whether or not the general rule is satisfied).  Our brief agrees with that position as well.

The brief that we wrote with the help and advice of our fellow amici (Dick Harvey, Leandra Lederman, Ruth Mason and Bret Wells) makes a complementary, alternative argument under the “traditional” view of the arm’s length standard.  We argue that uncontrolled joint development agreements that do not take account of stock option expense do not provide good evidence of the prices that will “clearly reflect income” in controlled transactions.  This is because they are not sufficiently comparable to be reliable evidence under the standards of I.R.C. §482.

A key example in the brief is “Example 2”, which assumes unrelated parties in a joint development agreement have stock-based compensation costs disproportionate to expected benefits:

Company C and Company D are not commonly controlled and want to share the R&D costs for a new innovation on a 50/50 sharing ratio (based on expected future benefits from the innovation).   Company C and Company D will jointly own the resulting intellectual property on a 50/50 basis. Company C pays cash compensation of 80 and grants stock options with a cost of 20 for its R&D employees. Company D pays cash compensation of 20 and grants stock options with a cost of 80 for its R&D employees.

If stock option expenses are included, the pool of expenses is 200, and each company pays 100, so no cost-sharing payment is necessary. This is the correct answer. If stock option expenses are disregarded, however, the pool of expenses appears to be 100, and Company D appears to contribute only 20 to the pool of expenses. Under this (incorrect) analysis, Company D would be required to make a net payment of 30 to Company C as its share of costs. In other words, Company D and its shareholders will suffer an additional compensation burden of 30 if the stock-based compensation costs are not shared. This burden would be in addition to the 20 of cash compensation expense and the 80 of stock-based compensation expense that Company D already incurs.

In this litigation and in litigation over the sharing of stock-based compensation before such sharing was explicitly required by the cost-sharing arrangement regulations, taxpayers argued that stock-based compensation was disregarded because they were not real economic costs.  Yet the economics and accounting disciplines, in addition to the tax law, have recognized stock compensation, including stock options, as economic costs for some time.  A 1995 FASB release, for example, stated that financials would be more “representationally faithful if the estimated fair value of employee stock options was included in determining an entity’s net income, just as all other forms of compensation are included.”

Within the bounds of “traditional” arm’s length analysis, we think the most reasonable conclusion is that the uncontrolled party agreements cannot further the objective of clearly reflecting income, because they are not reliable comparables. The brief highlights that controlled parties generally have a common issuer of stock underlying stock-based compensation whereas uncontrolled parties do not, which presents incentives and risks in the uncontrolled transaction not found in the controlled transaction.

Altera is a case about administrative procedure. The issue presented is not whether the Treasury’s decision to disregard uncontrolled party joint development agreements was the only permitted interpretation, but rather whether Treasury’s decision was arbitrary and capricious under the APA § 706(2)(A) (not the IRC § 482) standard. Under the APA § 706(2)(A) arbitrary and capricious standard, the government need only show that it provided a sufficient explanation for its conclusion that these agreements could not form a basis for clearly reflecting income. This the government did, we argue, in the regulatory Preamble. For instance, it explained that “[t]he uncontrolled transactions cited by commentators do not share enough characteristics of QCSAs involving the development of high-profit intangibles to establish that parties at arm’s length would not take stock options into account in the context of an arrangement similar to a QCSA.” It also stated that “at arm’s length the parties to an arrangement … would ensure through bargaining that the arrangement reflected all relevant costs, including all costs of compensating employees.”

As tax law encounters administrative law more regularly in litigation, it turns out that things can be made more complicated than a straightforward application of Mayo.   The Ninth Circuit faces the challenge of translating the APA arbitrary and capricious legal standard to the tax setting in this case. Depending on how the case plays out, it may also have an opportunity to consider whether the Treasury’s interpretation of its own regulations deserves Auer deference.

If the Ninth Circuit were to disagree with us and also with the other arguments in favor of the government’s position, the question of remedy would arise.   Perhaps the regulations should be remanded to Treasury, as the NYU brief argues; as we say in our brief, we concur with that argument. Or, if the reg is invalid and the remand remedy is not pursued, the Ninth Circuit may have a chance to say what should happen to an elaborate statutory safe harbor – here, the -7 regulations that authorize cost sharing agreements – when one piece of the regime is invalidated. There appears to be the assumption that the rest of the taxpayer-favorable safe harbor stands even if one of the building blocks falls. Yet the safe harbor falls far short of achieving clear reflection of income in many cases without the stock-based compensation regulation. If the stock-based compensation reg is invalid, our brief observes that Treasury might reasonably conclude that the whole safe harbor ought to be withdrawn.


Private Carriers, APA Impact on Notices and New Blog

Les and I each wrote short, essentially follow up posts which we are combing into one.  We anticipate we will be writing more on mailing deadlines and on the APA impact on notices.  Keith

Using Private Carriers to Meet a Filing Deadline

In Notice 2016-30, IRS published a new list of designated private delivery services  (“designated PDSs”) for purposes of the timely mailing treated as timely filing/paying rule of section 7502. The Notice provides rules for determining the postmark date for these services. The Notice updates Notice 2015-38, which had updated Notice 2004-83. This marks the second time IRS has updated the rules in under a year after an eleven or so year run for the original notice.

The main change is that the notice, effective April 11, 2016, adds to the acceptable list a number of DHL-provided services. IRS dropped DHL in last year’s following DHL’s cutback in services.

The Notice reminds people that not all services offered by the anointed carriers qualify as PDS’s. We have discussed numerous times issues taxpayers and practitioners have had meeting petition deadlines. Failing to track which services qualify can have major consequences. Keith has discussed the sad case of Guralnik v Commissioner when the taxpayer used FedEx First Overnight to mail his petition, a service not found within the 2004 notice but one IRS added in 2015. In addition, a summary opinion from a couple of years ago, Sanders v Commissioner, involved a pro se taxpayer who sent in his petition on day 89 using UPS Ground. UPS Ground was then and is still not one of the many UPS services that the IRS treats as a PDS.

In Sanders, the petition arrived at Tax Court after the 90-day period elapsed. IRS moved to dismiss, and the Tax Court held that the petition was untimely “because UPS Ground has not been designated by the Commissioner as a private delivery service.”

Addressing the consequences the Tax Court added:

In so holding we acknowledge that the result may appear harsh, notwithstanding the fact that petitioner had nearly 90 days to file his petition but waited until the last moment to do so However, the Court cannot rely on general equitable principles to expand the statutorily prescribed time for filing a petition.

The Tax Court concluded that Sanders was not without recourse; he could pay the tax and file a refund claim and suit. Given that he deficiency was for two years and totaled over $40,000, with the Flora rule requiring full payment, that option may not have given Sanders much comfort.

Follow up on Statutory Notice and the Administrative Procedure Act Post

One commenter on the post suggested additional links.  After the post was written, QuinetiQ filed its reply to the Government’s brief.  So, this brief post will provide a quick update of documents available for those interested in this case.

In the post I provided a link to the Tax Court opinion; however, the commenter pointed out that the most pertinent document from the Tax Court case was an order, linked here, setting out the Court’s views on the motion to dismiss based on lack of jurisdiction due to the (allegedly) improper notice of deficiency.  The order provides details about the Tax Court’s reasoning in denying the motion that I did not include in the original post.

In the 4th Circuit, QuinetiQ filed the opening brief as the appellant.  For some reason we could not access that brief and did not include it as a link in the post.  It is linked here.  Now that QuinetiQ has filed a reply brief, it is also available and is linked here.  The briefs filed by QuinetiQ make clear that it thinks the notice of deficiency in this case really provided no meaningful notice.  Not having seen that notice I can only imagine from other notices I have seen that the possibility certainly exists that the notice itself was bad.  Then the question is so what?  Must the taxpayer move forward on the substance of the matter gleaning what it can from the notice, from what it knew of the audit and from the information that comes out during the Tax Court case or can it get a court to strike the notice of deficiency as inadequate under provision s of the Administrative Procedure Act.  Do those provisions apply to an informal agency action such as a notice and, if they do, in applying them to this notice, should it be stricken?  Is this just another example of tax exceptionalism that needs to fall or is the notice of deficiency something totally covered by the IRC, outside of the APA, and subject to very relaxed standards for what provides adequate notice.


New Tax Blog

A group of tax professors, some of whom publish great material on tax procedure, have just started a new blog for those who might be interested.  Check it out at



A Few More Words on Ax and the Future of Tax Court Exceptionalism

Today’s post is a follow up post discussing Ax v Commissioner. The original post has generated some thoughtful comments, and today Professors Stephanie Hoffer  & Christopher J. Walker from the Michael E. Moritz College of Law at Ohio State discuss Chenery and why perhaps Ax opens the door for a differing take on the APA in other types of cases.

Note we apologize if subscribers also received this post earlier today; our site has been having some technical issues. Les

As Les notes in his great write-up, the Tax Court reached the right outcome in this week’s Ax decision. We write here to add just a few words about Chenery and the Court’s use of § 703 (but not § 706) of the Administrative Procedure Act (“APA”).


In The Death of Tax Court Exceptionalism, 99 Minn. L. Rev. 221 (2014), we don’t tackle the part of Chenery raised by the petitioners in Ax—that agency reasons must have been raised at the agency decision-making level and not for the first time in court. But we do tackle another core principle from the Chenery decisions: the ordinary remand rule. That is, when a court concludes that an agency’s decision is erroneous, the ordinary rule is to remand to the agency to consider the issue anew (as opposed to the court deciding the issue itself).

These two Chenery principles are intertwined, and the analysis used to determine whether one applies in a given situation is arguably the same for either. Here’s what we had to say about the remand rule and deficiency actions (at 266-67, footnotes omitted):

This [ordinary remand rule] does not mean, however, that the Tax Court must remand every erroneous IRS determination to the IRS for reconsideration. As the ordinary remand rule suggests, it is the “ordinary” rule subject to exceptions for “rare circumstances.” These rare circumstances include when there are minor errors as to subsidiary issues that do not affect the agency’s ultimate decision or when the agency lacks authority to decide the issue. And there is another exception of particular relevance here: when APA § 706(2)(F) applies and “the facts are subject to trial de novo by the reviewing court.” In particular, in explicating the ordinary remand rule and how it is “the proper course, except in rare circumstances,” the Supreme Court has noted that “[t]he reviewing court is not generally empowered to conduct a de novo inquiry into the matter being reviewed and to reach its own conclusions based on such an inquiry.” Logically, then, if the reviewing court is empowered to conduct a trial de novo, the court is not required to remand (though it retains discretion to do so) because de novo review allows the court to take the unusual step of substituting its judgment for that of the agency.

In light of these principles, it becomes clear that the Tax Court need not remand when it conducts a trial de novo. As explained in Part II.A, the Tax Court conducts a trial de novo of an IRS tax deficiency determination in any proceeding in which the underlying deficiency determination is challenged. (That said, as discussed in Part III, in some circumstances policy considerations may weigh in favor of the Tax Court exercising its discretion to remand even some de novo redeterminations to the IRS.) But when the trial de novo provisions of APA § 706(2)(F) do not apply, the Tax Court should adhere to the ordinary remand rule.

In other words, as Les notes in his post, the Tax Court seems to have gotten the outcome right (that Chenery does not apply in deficiency actions in Tax Court), but that’s not because the APA does not apply. That’s the result you get after applying the APA.

In fact, the Tax Court actually did apply the APA in Ax, although it stopped short of acknowledging that it is a reviewing court for purposes of the APA. In particular, the Court relied on APA § 703, which describes the form and venue of judicial review of an agency action, to support the position that it is not bound by APA § 706 in deficiency actions. Section 703 provides that the appropriate form of judicial review of an agency action is “the special statutory review proceeding relevant to the subject matter in a court specified by statute,” or, if none, “any applicable form of legal action.” The Court reasoned that because IRC § 6213 and other sections mentioned by Les describe a “special statutory review proceeding,” APA § 706, which provides procedural defaults, does not apply to redeterminations of deficiency. (As discussed above and as we flesh out more fully in our paper, our position is that APA § 706 does apply to deficiency actions, but that deficiency actions are “trial de novo” proceedings under APA § 706(2)(F), and thus Chenery’s limitations do not apply.)

Notably, although the Court mentions ODwyer’soverly broad holding that the Tax Court is not subject to the APA, its reference to the greying case is almost a throwaway in light of the Court’s APA analysis. The Court takes pains to note (at 18) that its decision to look beyond the IRS’s notice of deficiency “does not violate administrative law principles or conventional standards of judicial review.” It is not clear what the court means by “conventional standards of judicial review,” but its later discussion of Mayo indicates that it is working within the framework provided by the APA (albeit within an APA-provided exception to the default provisions on judicial review). There, the Court notes (at 19) that Mayo did not consign judicial review of IRS actions to a “single one-size-fits-all paradigm for standard and scope of review,” but rather preserved (indeed, in our view, mandated) the application of APA § 703 (the Court cites § 704 here, but it is clearly a typographical error).

In its conclusion, the Court carefully notes (at 20) that its decision “in a deficiency case” is not at odds with either Chenery or APA § 706. The Court’s limitation of its reasoning to deficiency cases suggests that the Court may be rethinking the role of the APA in its review of IRS decision-making. Although the Court’s position on the issue of deficiency is entrenched, there is plenty in the law to suggest that its stance is not in error, and while Ax reads like an anti-APA decision at first blush, the Court’s careful use of APA § 703 in relation to § 706 perhaps foreshadows a different result for petitions related to matters other than deficiency. In short, nothing in Ax precludes the Court from moving away from exceptionalism and toward normalization with its sister courts though full-fledged adoption of the APA provisions on judicial review.