Good Fortune (for the IRS)

This week the Tax Court in Good Fortune Shipping v Commissioner,148 TC No. 10 upheld regulations relating to the exemption of income from the international operation of ships. Taxpayers are frequently teeing up issues relating to the validity of regulations, and this opinion is an important victory for the government. I will briefly describe the case and the way the Tax Court resolved the dispute.

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The statutory scheme under Section 883 (wildly simplified) is that gross income attributable to international shipping activities is exempt from US tax if the foreign country in which the corporation is organized grants an equivalent exemption to corporations organized in the United States. In Good Fortune the owners of the shipping company were in fact residents of a country that did grant a similar exemption, but the shareholders held the stock in bearer form rather than in registered form. The statutory scheme tied the exemption to shares “owned by individuals” of a reciprocating foreign country; the regulations additionally restricted the benefit to shares that were owned in a certain way, and in particular excluded from the possible statutory exclusion scheme shares that were owned in bearer rather than registered form.

Bearer ownership and transferability is generally evidenced by physical delivery; registered form ownership ties ownership to a name that is registered with the corporation or its agent. US tax law has generally frowned on conveying benefits that are dependent on residence of ownership when shares or securities are held in bearer form for the obvious reason that it is easy to circumvent rules that are meant to tie exclusions or reduced withholdings on beneficial ownership in a particular jurisdiction when ownership can be conveyed just by possessing the security. Bearer form ownership promotes privacy, which is a value that tax agencies weigh quite differently than taxpayers.

In Good Fortune, in upholding regulations that essentially stated that bearer shares of a foreign corporation may not be taken into account in establishing the ownership of the stock of the foreign corporation, the Tax Court, applying the two-step Chevron analysis, leaned heavily on Mayo in finding that Congress had not spoken directly on the issue (step 1) and ultimately concluded that the regulations in place for the year in question were a permissible construction of the statute (step 2).

In finding that the precision needed was lacking in Step 1 the opinion emphasized that there was a legislative gap in how to prove ownership:

The words “owned by individuals” in section 883(c)(1) do not, as petitioner appears to acknowledge, explain or otherwise address how to establish ownership by individuals for purposes of section 883(c)(1), let alone how to establish ownership where the shares of the foreign corporation are owned in bearer form. The dictionary definitions of the word “own” on which petitioner relies which petitioner claims are unambiguous definitions, do not address the problem under section 883(c) of determining how to establish ownership by individuals for purposes of section 883(c)(1) that the Internal Revenue Service (IRS) confronts when it examines a return of a foreign corporation seeking the benefits of section 883(a)(1) for a prior taxable year

Upon reaching Step 2, the opinion looked to legislative history to 1986 statutory changes that tied the reciprocal exemption to corporate ownership rather than just the location of where the ship was registered:

A foreign corporation’s entitlement under section 883(a)(1) to exclude certain income from gross income and exempt that income from U.S. tax no longer was based solely upon the country in which the foreign corporation’s vessel was registered or documented. Instead, Congress added in its amendment of section 883 in the 1986 Act a second hurdle to that favorable treatment by enacting section 883(c) in order to curb abuse by residents of certain foreign countries who owned stock in a foreign corporation that was seeking the benefits of section 883(a)(1) where those foreign countries did not provide an equivalent exemption to U.S. corporations.

With that context the opinion discussed how bearer shares, which tie ownership to physical delivery, “make it virtually impossible to know who the actual shareholders or owners of a corporation are because the only proof of ownership is physical possession at a particular point in time of the paper bearer share certificate.” The absence of a registry contributes to ownership anonymity. As such, it was a short step for the court to conclude that the regs passed muster under Step 2:

We conclude that the bearer share regulations do not contravene section 883(c)(1) but are a reasonable construction of that section which provides the IRS with the appropriate tools needed to enforce section 883. The bearer share regulations provide certainty and resolve the difficult problems of proof associated with establishing ownership of bearer shares, especially for prior taxable years. In not allowing bearer shares to be taken into account in establishing the ownership of the stock of a foreign corporation for purposes of determining whether the foreign corporation is described in section 883(c)(1) and thus whether it is entitled to the benefits of section 883(a)(1), the bearer share regulations set forth a sensible approach to effecting the intent of Congress in enacting section 883(c)(1) to ensure that abuse will not occur which will result in certain types of shipping transportation income described in section 883(a)(1) not being taxed.

Good Fortune shows how in the absence of statutory detail on implementation, agencies have considerable discretion in promulgating rules, especially true when the rules relate to exemptions, which as the Tax Court noted here, are to be interpreted narrowly.

Dean Zerbe Adds Insights to Whistleblower “Collected Proceeds” Tax Court Case

On August 4th, I wrote about the Tax Court’s second holding in Whistleblower 21276-13W v. Commissioner, and how the Court held that “collected proceeds” included criminal fines and civil forfeitures.   That post can be found here.  In the post, we noted that Dean Zerbe was the attorney on the prior case who successfully obtained the whistleblower award, and we assumed he was the lead attorney on this case, but the attorney of record was sealed.

Dean was one of the primary architects of the whistleblower statute, and one of the leading practitioners in this area, so it is not surprising to see him attached to these important cases.  Dean reached out to me last week and confirmed he was the lead attorney on this case also.  He also provided some feedback on the post and some of the issues we highlighted.  I’ve recreated some of Dean’s insightful comments below.  It probably goes without saying, any errors and coarse language are assuredly mine .

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I will not recreate my prior post, but will add a few excerpts to provide context to Dean’s comments.  The key issue was:

Under Section 7623(b), certain whistleblowers are entitled to mandatory awards if certain requirements are met.  That amount can be between 15% and 30% of the “collected proceeds” under (b)(1), which has a parenthetical indicating that is “(including penalties, interest, additions to tax, and additional amounts),” and the sentence further states these amounts can be “resulting from the action (including any related actions) or from any settlement in response to such action.”

As stated above, the Service took the position collected proceeds did not include criminal penalties and civil forfeitures.  The Service based this on the claim that Section 7623 should only apply to proceeds assessed and collected under the federal tax laws found in Title 26 of the United States Code.  As the fines and forfeitures here were imposed under Chapter 18, they could then not be “collected proceeds” subject to the statute; unlike the restitution, which as per 2010 law can be assessed and collected in the same manner as tax.

The Court held “internal revenue laws” were not simply those under Title 26, and included the fines and forfeitures.  This implicates FBAR penalties also, although not explicitly stated in the holding.  Dean’s thoughts on the holding generally were as follows:

I read  the case as the Court seeking to get rid of any shadows or dark corners about what is included in “collected proceeds” and not wanting to see this litigated again and again (there are a lot of these cases in the pipeline).  [My impression] is the Tax Court will not engage in hair splitting.  See page 26, “In sum, we herein hold that the phrase “collected proceeds” is sweeping in scope and is not limited to amounts assessed and collected under Title 26.”    And again on page 29, “We have already explained that ‘collected proceeds’ is a broadly defined term:  It encompasses ‘the total amount brought in’ by the Government.”   And then again, of course, the language in first paragraph of page 32.  There is nowhere to hide with those statements.

I think one of the more interesting points in this opinion (which deserves a lot of rereading) is on page 30, where the Court correctly states that the “forfeitures resulted from an administrative action with respect to the laundering of proceeds, which in turn, arose from a conspiracy to violate Section 7601 and 7206…”   Encompassing, properly, a broad linkage and again speaks to FBAR.

As to FBAR, Dean stated:

[I]t seems clear that FBAR [penalties are] encompassed by the Court’s sweeping ruling (particularly as [the holding]  fits with the discussion in the previous Section 7623(b)(5) case, as well as the reference in footnote 15 in this case to Hom – and citing that FBAR is “tax administration”).

Our readers and tax procedure enthusiasts are likely familiar with Mr. Hom.  His cases have graced our pages somewhat frequently, most recently in late July with the Ninth Circuit holding online gambling site accounts were not subject to FBAR disclosure (well done Joe DiRuzzo).  Les had a brief write up on that found here. The footnote Dean references cites to a different Hom case in the Ninth Circuit from this year, and the note states:

Ours is not the only court to note that tax laws and related laws may be found beyond those codified in title 26. The District Court for the Northern District of California in Hom v. United States, 2013 WL 5442960 … aff’d, … 2016 WL 1161577 (9th Cir. Mar. 24, 2016), stated: “[T]he issue here is whether [31 U.S.C.] Section 5314 is either an internal revenue law or related statute (either designation would make the disclosure [of taxpayer information under sec. 6103] permissible). The United States argues that [31 U.S.C.] Section 5314 is a ‘related statute’ under Section 6103 (Dkt. No. 13 at 6). This is correct. Congress intended for [31 U.S.C.] Section 5314 to fall under ‘tax administration.’”

Hammering home that FBAR penalties are likely included in “collected proceeds”.

Dean also addressed the Chevron comment from my post regarding the regulations that were not before the Tax Court case.  I highlighted (because Les pointed it out to me) that the Tax Court’s language was akin to language used when tossing a regulation under Chevron.  Dean agreed, and provided additional insight:

The language used by the Tax Court – plain language and enforce the terms – is, as you know, right in step with the language we see from Courts when they are rejecting agency regulations under Chevron.    While the Regulations are not at issue here – see footnote 9 – it is difficult to imagine the Regulations withstanding a challenge given this holding.  However, the real hope is that the administration will not appeal the decision and seize the ruling as a chance to make the correct policy decision (as you note) and embrace the commonsense decision by the Court on defining collected proceeds broadly.

Footnote 9, for those of you interested, states both parties agree the regulations are not at issue, as the decision regarding the award was rendered prior to the effective date of the regulations.

Many thanks to Dean for his comments on the case, and congratulations on a great result.

Administrative Law Grab Bag: Chevron and State Farm Developments

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

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

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

Proposed Legislation on Chevron

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

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

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

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

Does Chevron Make a Difference?

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

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

Supreme Court Developments on State Farm

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

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

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

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

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

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

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

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

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

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

Some Parting Thoughts

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

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

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

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.

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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.

 

Fifth Circuit Tackles Intersection of TAO Rules and Statutes of Limitation

Generally, under the doctrine of sovereign immunity, the government can avoid civil liability unless there is a statute that gives a party the right to sue the government. Earlier this week in Rothkamm v US, the Fifth Circuit issued an opinion that considered whether a wife’s application for a Taxpayer Assistance Order (TAO) concerning a recovery of funds levied from her bank account to satisfy her husband’s tax debt tolled the nine-month wrongful levy statute of limitations. The Fifth Circuit held that the wife’s application for assistance to the Taxpayer Advocate Service tolled the statute, thus preventing the government from using sovereign immunity as a defense to the suit.

The case is important. It touches on the intersection of requests for assistance from TAS and statutes of limitation generally, and contains a full-throated consideration of the effect of requests for Taxpayer Assistance Orders on the time for bringing an action for a wrongful levy. That alone merits consideration in PT but the case’s reasoning and spirited dissent also suggest that it will have an impact on other matters that are subject to Taxpayer Advocate Service assistance requests.

In this post I will summarize the facts and highlight the main points in the majority and the dissenting opinion.

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Summary of Facts

Kathryn Rothkamm and her husband filed separate tax returns. Kathryn also had a separate bank account which she claimed consisted of her separate property.  IRS issued a notice of levy on March 6, 2012 to collect on the husband’s tax debt. In response, the bank remitted the full amount of account (over $73,000) to the IRS on April 18, 2012. Within two weeks of the bank remitting the funds pursuant to the IRS levy, Kathryn filed an application for assistance with Taxpayer Advocate Service. In October of 2012 TAS responded to Kathryn and said it could not help. By May 15, 2013 Kathryn filed an administrative claim for wrongful levy under Section 6343(b) with the IRS. IRS denied the claim in July 2013. In September of 2013 Kathryn filed a suit for wrongful levy.

Statutory Background—Is the Wife a Taxpayer for These Purposes?

There is a nice labyrinth of statutes here and I will lay them out in this section.

Section 7426(a) provides the authority for a person “other than the person against whom is assessed the tax out of which such levy arose” to bring a suit for a wrongful levy in federal district courts.

Section 7426(i) provides that the nine-month statute of limitations in Section 6532(c)(1) applies for those suits. Section 6532(2) generally suspends the sol during the administrative consideration of the wrongful levy claim under Section 6343(b).

Superimposed on the scheme for wrongful collection claims and suits is Section 7811(a), which authorizes the NTA to issue Taxpayer Assistance Orders when “the taxpayer is suffering or about to suffer a significant hardship as a result of the manner in which the internal revenue laws are being administered by the Secretary…”

Section 7811(b)(1) and Section 7811(b)(2) provide that a TAO can be issued to “require the Secretary to release property of the taxpayer levied upon”, or “to cease any action, take any action as permitted by law, or refrain from taking any action, with respect to the taxpayer” pertaining to a variety of matters, including collection.

Section 7811(d) provides the tolling provision that was the key to the case (and which I will return to later):

The running of any period of limitation with respect to any action described in [7811(b)] shall be suspended for—

(1) the period beginning on the date of the taxpayer’s (emphasis added) application under [7811(a)] and ending on the date of the National Taxpayer Advocate’s decision with respect to such application, and

(2) any period specified by the National Taxpayer Advocate in a Taxpayer Assistance Order issued pursuant to such application.

Those provisions also relate to Section 7701(a), which defines terms in Title 26 “where not otherwise distinctly expressed or manifestly incompatible with the intent thereof…” In particular, Section 7701(a)(14) provides that the “term “taxpayer” means any person subject to any internal revenue tax.”

Bringing it Back to Rothkamm

The issue as the Fifth Circuit discussed was thus the following:

As the district court explained, the IRS levied Rothkamm’s account on April 18, 2012. Thus, the general statute of limitations would have expired on January 18, 2013, absent any tolling. Rothkamm’s administrative wrongful levy claim, which she filed on May 15, 2013, would toll the running of the statute of limitations if filed within the statute of limitations. Thus, the core question is whether, as Rothkamm contends, the statute of limitations was tolled while her application for a TAO was pending before the TAS. If so, her administrative claim under § 6343(b) would also have been timely, and the statute of limitations for filing suit would have been suspended until January.

In a nutshell, the Fifth Circuit concluded that the district court was wrong when it found that Kathryn was not the taxpayer for purposes of Section 7811(d):

In this case, we conclude the district court erred in determining the definition of “taxpayer” under § 7811 by failing to supply the Internal Revenue Code’s generally applicable definition set out in § 7701; and the court further erred in its interpretation of § 7811(d)’s tolling provision by failing to follow theplain language of the statute and associated regulations.

The opinion is dense on this point, but here are some of the highlights.

There is a discussion of how Section 7701(a)(14) defines the term taxpayer and how the 1995 Supreme Court decision US v Williams found that a third party who paid an assessed tax to remove a federal tax lien from her property was a “taxpayer” that was entitled to bring an administrative refund claim:

Following Williams, Congress did not revise § 7701(a)(14), so the Supreme Court’s interpretation stands. Thus, under § 7701(a)(14), the word “taxpayer” means not only the person against whom a tax is assessed (here, Rothkamm’s husband) but also the person who actually pays the tax (here, Rothkamm herself). Pursuant to § 7701(a), that definition applies throughout Title 26 “where not otherwise distinctly expressed or manifestly incompatible with the intent thereof.

On appeal, IRS attempted to distinguish the significance of Williams with the 2007 Supreme Court case EC Term of Years Trust. In the lower court’s view that case provided support for the “proposition that the definition of “taxpayer” is somehow limited to the person against whom the tax is assessed in the wrongful levy context.”

The Fifth Circuit disagreed. EC Term of Years Trust held that a third party had to use the 9-month SOL under 7426 rather than the general refund suit SOL under 28 USC 1346. The Fifth Circuit found that EC Term of Years Trust did nothing to alter its conclusion that taxpayer should be defined to include third parties like the wife in this case:

All of which is to say that Williams defined “taxpayer” broadly under§ 7701(a)(14) to include not only the assessed taxpayer but also a person who actually pays the tax, and the 2007 Supreme Court decision EC Term of Years Trust did nothing to alter that definition. It simply held that a third-party (relative to the assessed taxpayer) whose property is wrongfully levied must bring suit under § 7426(a)(1) rather than § 1346(a)(1) because § 7426(a)(1) specifically covers that situation. In this case, Rothkamm brought suit under § 7426(a)(1) and has always conceded that the nine-month statute of limitations applies to her case.

Recall, however, that Section 7701(a) in the introductory language provides an out if an alternate statute contradicts the language or is “manifestly incompatible” with the definitional parts of 7701(a)(14). The Fifth Circuit opinion discusses how the TAO statute (section 7811) does not limit the definition of taxpayer so that in its view the definition in Section 7701(a)(14) controls:

 Similarly, the statute governing TAOs, § 7811, neither “specifically expresses” a more limited definition of “taxpayer” nor is “manifestly incompatible” with § 7701(a)(14)’s broad definition.

Nor in its view did the regulations under Section 7811 alter the conclusion that Kathryn was a taxpayer:

The associated regulations also do not “specifically express” a more narrow definition of “taxpayer.” Indeed, at least four of the ten example situations set out in the regulations, all concerning wrongful levies, are written without specifying whether the TAO applicant is an assessed taxpayer or a third-party taxpayer who pays the tax assessed to another. In short, neither the statutes (§§ 7803 and 7811) nor the regulations are “manifestly incompatible” with § 7701(a)(14)’s broad definition of “taxpayer.” Thus, the district court erred in holding that Rothkamm is not a “taxpayer” under § 7811.

(citations omitted)

Focus on Section 7811(d)-Even if The Wife is the Taxpayer Does The 7811(d) Tolling Provision Apply?

The opinion is perhaps more significant for its view on Section 7811(d). It rejected the district court’s alternative holding that even if the wife was a taxpayer the statute itself did not provide for tolling in her circumstances. The majority opinion did so because it felt that the statute made no reference to which party should benefit from the tolling.

The district court held that the tolling related to situations when the application for assistance prejudiced the IRS; in other words the tolling was a tool to help IRS with its assessment or collection but not taxpayers who sought assistance and then sought for example a refund or return of levied funds.

Here is language from the district court:

But even if the Court assumes for sake of argument that Rothkamm is a taxpayer within the meaning of 26 U.S.C. § 7811, she still cannot prevail because a plain reading of section 7811(d) shows that the time periods tolled relate to actions available to the IRS, not actions available to the taxpayer. See 26 U.S.C. § 7811(c), (d). This conclusion is reinforced by the relevant administrative regulations, which state unequivocally: “A taxpayer’s right to administrative or judicial review will not be . . . expanded in any way as a result of the taxpayer’s seeking assistance from TAS.” 26 C.F.R. § 301.7811–1 (emphasis added); see Demes v. United States, 52 Fed. Cl. 365, 373 (Fed. Cl. 2002) (“I.R.C. § 7811(a) . . . . does not go to the tolling of the statute of limitations in court, but rather confers the IRS with discretion to effect tolling upon a taxpayer’s request. Plaintiffs therefore cannot sue in a court for a refund under this provision, nor can the court use it as a basis to toll the statute of limitations in plaintiffs’ case:”

The district court’s interpretation was consistent with internal IRS advice, such as PMTA 2007-00429, which noted that it was possible to read Section 7811(d)’s tolling provision as applying to all matters before the TAS in a TAO request but that in its view that was an improper reading of the statute:

Section 7811 (d) provides for the suspension of any period of limitations relating to an action described is section 7811 (b). The actions identified in section 7811 (b) generally relate to the assessment or collection of tax. Treasury Regulation § 301.7811-1 (e) states that in general the limitations period for any action that is the subject of a TAO shall be suspended. The regulation does not specifically address the part of the statutory provision requiring the action to be one described in section 7811(b). Without addressing action under section 7811 (b), it could be inferred from the regulation that the filing of an application for a TAO results in the suspension of the applicable period of limitation for any action included therein. We do not believe that the regulatory provision should be interpreted this broadly. Such an interpretation would be inconsistent with the statutory language and inconsistent with the examples provided in the regulation, which specifically link suspension periods to actions described in section 7811 (b) of the statute.

Therefore, a filed application for a TAO will suspend the running of limitations periods for assessment or collection of tax under IRC §§ 6501 and 6502, because the failure to suspend the running of these periods of limitations could potentially prejudice the interests of the Service. A filed application for a TAO will not however, suspend the period of limitations for filing refund claims. If the intent of section 7811(d) is to provide protection to the Service while a taxpayer’s issue/problem is being addressed, failing to suspend the limitations period in section 6511 (b) does not injure or prejudice the interests of the Service. The interests of the taxpayer can be protected by filing a protective claim for refund.

The majority opinion flatly rejects the district court view of the scope of the tolling provision, looking to what it believes is a plain reading based on the statutory language in Section 7811(d) which refers to all actions in Section 7811(b) overall rather than any limiting language:

By its plain terms, § 7811(d)(1) applies to toll the running of any statute of limitations for any action described in § 7811(b) from the time the taxpayer files an application for the optional TAO until a decision is reached. Section 7811(d)(1) does not require that a TAO actually be issued or that any relief be granted. It simply provides that any statute of limitation for an action described in subsection (b) is tolled from the time an application is filed until the National Taxpayer Advocate reaches a decision.

It is plain from the language of the statute that because subsection (d) applies to all of subsection (b), it benefits both the IRS and the taxpayer, essentially pausing the running of the statutes of limitations applicable to both parties so that neither one is prejudiced by the TAO process. For instance, subsection (d), through subsection (b)(2)(A), tolls the statute of limitations for collection actions by the IRS, meaning the IRS does not lose any time to pursue collections when a taxpayer pursues a TAO. Likewise, subsection (d), through subsection (b)(1), tolls the statute of limitations for actions “to release property of the taxpayer levied upon.” By definition, such an action is one by the taxpayer, and any tolling on such an action necessarily benefits the taxpayer. (It is also, of course, precisely the action at issue in this case.) Thus, the taxpayer may pursue a TAO without fear that the process—which Congress expressly designed to assist taxpayers—will prejudice her administrative or judicial rights in the event she does not obtain TAO relief. Subsection (d)’s plain language means that neither the IRS nor the taxpayer is any worse off when a taxpayer decides to pursue TAO relief because all relevant statutes of limitations are tolled. Under the plain terms of the statute, this tolling occurs automatically until the National Taxpayer Advocate reaches a decision on the TAO application, without regard to any discretion on the part of the IRS.

Chevron and the Regulations Under Section 7811

The Fifth Circuit took aim at the district court’s view of the regulations under Section 7811 as well as cases that concluded that tolling was subject to IRS discretion.

The key regulatory provision in the district court’s view was Reg Section 301.7811-1(b). That provides that “[a] taxpayer’s right to administrative or judicial review will not be diminished or expanded in any way as a result of the taxpayer’s seeking assistance from TAS.”

The Fifth Circuit believed that the statutory analysis above was clear so that there was no need to even get into the weeds of the regulations under 7811:

First, under Chevron, if the language of the statute, § 7811(d), clearly provides for tolling (i.e., a waiver of sovereign immunity), then that ends the inquiry. The regulation cannot alter what Congress has clearly set out in the statute.

Moreover, the Fifth Circuit noted that the regulation the district court relied on (Reg Section 301.7811-1(b)) does not address tolling but only pertains to a general discussion of TAOs. In contrast, in the regulation addressing tolling, 301.7811-1(e), the court found no limitations on tolling once the TAO request is made:

[The]relevant language of section 301.7811-1(e) and the associated examples show that the running of the statute of limitations is tolled until a decision on the TAO application is reached. Importantly, this specific subsection on tolling says nothing about tolling being subject to the IRS’s discretion. Rather, the regulation notes that the Ombudsman (i.e., the representative of the Office of the Taxpayer Advocate, not the IRS) has the authority to lengthen—but not shorten—the period of tolling beyond the decision date…

The opinion goes on to criticize case such as Demes, a Court of Federal Claims opinion from 2002 (at page 25) which concluded that tolling is subject to IRS discretion as citing “no relevant support” for its conclusion.

Dissenting Opinion

This is an interesting dissent, looking to the broader context of the statute and also touching on its view of the regulations under 7811(d) as supporting the IRS position. The main difference between the majority and dissenting views revolves around the relationship between Section 7811(d) and 7811(b), with the dissent adopting the view that the tolling in Section 7811(d) relates to only actions implicated in Section 7811(b)(2) rather than Section 7811(b) generally:

In short, the majority holds that subsection (d) suspends the period of limitation for “any action described in subsection (b)” and subsection (b)(1) describes a wrongful levy action. That is, the period of limitation for filing an administrative request was tolled during the pendency of Rothkamm’s application for a Taxpayer Assistance Order (“TAO”), and she can rely on § 6532(c)(2).

 

Appealing in its simplicity, this plain language argument does not survive closer scrutiny for it steps past critical language. Subsection (d) provides that an application for a TAO suspends the running of the period of limitation for “action[s] described in subsection (b).” We should not assume that Congress’s use of the word “action” was accidental. To the contrary, “[a] normal rule of statutory interpretation is that when Congress uses the same word in different parts of a statute, it intended each to carry the same meaning.” In this case, this rule dictates that “action” has the same meaning in subsection (b) that it does in subsection (d). That is, subdivision (d) suspends the period of limitation only for the suits and proceedings in subdivision (b) that Congress described using the word “action.” Since Congress did not use the word “action” in subsection (b)(1), § 7811(d) did not toll the period of limitation for Rothkamm’s wrongful levy claim – and her suit is untimely.  

The majority counters that this reading of § 7811 ignores that subsection (d) refers to all “action[s]” in subsection (b), not just those in subsection (b)(2). But this argument fails on its own terms; I contend only that subsection (b)(1) does not describe an “action,” not that subsection (d) does not apply to, or embrace, subsection (b)(1). If Congress had intended to suspend the period of limitation for all suits or proceedings described in subsection (b), it could have used either of those words – but it chose not to do so.

The dissent also looks to the overall role of TAS as supporting the IRS view in the case:

Although it may seem inequitable that subsection (d) only suspends the period of limitations for actions brought by the IRS, this was a sensible choice given that TAS – the agency that issues TAOs – lacks the power to direct taxpayers to do anything. As a result, nothing prevents a taxpayer from pursuing other remedies while seeking a TAO. In fact, a TAO “is intended to supplement existing procedures if a taxpayer is about to suffer or is suffering a significant hardship,” not “to be a substitute for an established administrative or judicial review procedure.”

In addition to disagreeing with the majority’s statutory analysis, the dissent also points out that the IRS’s own interpretation of the regulation in the IRM and Program Manager Technical Advice was subject to at least Skidmore deference.  As I discuss above, in the PMTA, the IRS had noted that the regulation might be read in a way that the majority opinion does but that in its view that was the incorrect result.

Recall that the majority sidestepped the issue of whether and to what extent the IRS should be entitled to deference in its view of the regulation because in its view the statute was clear in supporting tolling. The dissent disagreed, suggesting that the statute was plausibly read in a way consistent with the IRS view, thus leading to under Chevron a dismissal of the suit as untimely so long as the IRS view was reasonable (and in its view it was).

Conclusion

The case is a messy one and seems to turn in part on what the majority felt was an unfair outcome. The fairness here though is one that is in the eye of the beholder. Consider that the dissent also criticized the wife’s diligence; it was not clear why she waited several months after TAS did not help her before she filed her administrative wrongful levy claim, which she still could have filed in the 9-month period had she done so promptly.  That delay suggests that her lack of diligence was not enough for equitable tolling to have applied though the court does not mention whether this 9-month period can or cannot be equitably tolled, an issue we have discussed on many occasions and which the Ninth Circuit in Volpicelli has concluded can be equitably tolled (though the dissent in footnote 29 refers to a Third Circuit case pre-Volpicelli holding no equitable tolling in a wrongful levy context).

Moreover, as the dissent points out there is a compelling reason for taxpayers to have a short window of time to bring these actions, that is to allow the IRS to go after other assets if in fact it has improperly levied on assets.

The majority opinion raises many questions. For example, how far does it extend in other cases when taxpayers request TAOs? When precisely is the tolling triggered and when does it end? As a policy and legal matter, what should trigger the tolling?  I frankly had not thought much about these and other questions in considering the impact of Section 7811 on a variety of statutes of limitation. Steve and I are in the process of rewriting the Saltz/Book chapter on statutes of limitation, and this case will cause us to think hard about the reach of the statute.

Tax Court Opinion Reaffirming Validity of Regulations Addressing Foreign Earned Income Exclusion Illustrates Chevron Application

Courts have been flexing their muscles when it comes to inquiring into the validity of regulations. We have discussed some high profile cases, such as Loving, Florida Bankers and Altera, (e.g., see Pat Smith’s guest post last month discussing Altera v Comm’r and the Tax Court’s striking down regulations under section 482 dealing with cost-sharing agreements for the development of intangibles).

Last month the Tax Court in McDonald v Commissioner again considered a challenge to regulations; this time involving regs that have been around a while that mandate the time when taxpayers can elect to exclude foreign earned income under Section 911. The case applies the Chevron two-step inquiry in finding that the regulations are valid and reminds us that challenges to regulations face a pretty tough standard. At the same time, the Tax Court’s Chevron Step Two inquiry in McDonald does show that the courts are willing to look carefully at Treasury’s reasoning in promulgating regulations, including whether in issuing final regs Treasury was responsive to comments.

I’ll briefly summarize the facts and explore the court’s Chevron inquiry.

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Background and Main Taxpayer Argument

Ms. McDonald lived and worked abroad for part of 2009 and failed to timely file a return. The IRS prepared a substitute for return and then issued notice of deficiency in April 2012. Not petitioning Tax Court, she filed a Form 1040 in May 2012 attaching a Form 2555, “Foreign Earned Income”, claiming a Foreign Earned Income Exclusion of about $23,000. With the return McDonald filed she also sent in about $3,000 which was the balance due taking into account the exclusion. The IRS then issued another notice of deficiency disallowing the exclusion because she failed to file the Form 2555 in accordance with the regulatory deadlines I discuss below. Ms. McDonald filed a petition challenging the disallowance as well as the IRS’s imposition of civil penalties. The case came up on a partial summary judgment motion addressing the exclusion.

At issue in the motion was whether the IRS should allow McDonald’s late filed Form 2555 and thus permit her to elect the exclusion to which she would have been entitled to take had she filed it earlier.

While Section 911 is silent on when taxpayers must file a 2555 or comparable form electing the exclusion, Treasury promulgated regs addressing the issue. Reg. Section 1.911-7(a)(2)(i)(A)-(C) provides three main deadlines: 1) with the original return, 2) at a time that would be timely under Section 6511(a) for filing refund claims, or 3) within one year of the due date of the original return (without regard to extensions).

1.911-7(a)(2)(i)(D) also allows for a taxpayer to elect the exclusion if the taxpayer does not satisfy any of the three options above and either of the following applies:

(1) The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or

(2) The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

The Chevron Inquiry

Ms. McDonald could not satisfy any of the above requirements when it came to timely filing her election, which she filed about three years after the original due date, after the IRS discovered the lack of an election and with a return reflecting a tax liability, even with the exclusion. Her principal argument she made in Tax Court was that the regulation’s timing requirements were not valid:

Ms. McDonald challenges the validity of the regulation on two bases: she argues that the regulation is an invalid interpretation of the statute because the statute creates the only legal standard that she needs to satisfy and the additional timing requirement that the regulation imposes is absent from the statute. Next, she argues that the 12-month deadline in [1.911-7(a)(2)(i)(C)] is arbitrary and “is neither necessary or appropriate to carry out the purposes of Section 911.”

To determine the regulation’s validity the Tax Court looked to the Chevron two-step inquiry, a standard becoming well-known for tax practitioners:

Determining whether a regulation merits deference under Chevron involves a two-step process: We first determine whether Congress has directly spoken to the precise question at issue. Chevron, 467 U.S. at 842. If the answer is yes, we must give effect to congressional intent. Id. at 842-843. In order to determine whether Congress has directly spoken, we “employ[] traditional tools of statutory construction”. United States v. Home Concrete & Supply, LLC, 566 U.S. __, __, 132 S. Ct. 1836, 1844 (2012) (quoting Chevron, 467 U.S. at 843 n.9). If, employing those tools, we determine that Congress has not directly spoken to the precise question at issue, we proceed to the second Chevron step and determine whether the agency’s chosen interpretation is a “reasonable interpretation” of the enacted statutory text. Chevron, 467 U.S. at 843- 844. If it is a reasonable interpretation, the regulation will stand. It will be ruled invalid only if it is found to be “‘arbitrary or capricious in substance, or manifestly contrary to the statute.’” Mayo Found. 562 U.S. at 53 (quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)).

Step One Analysis

Ms. McDonald’s main challenge seemed to fit with Step One, essentially arguing that the statute’s lack of addressing the timing meant that the inquiry should end there and not push the court into the second step:

It appears that Ms. McDonald disagrees and would, in effect, halt the analysis at step 1. Her argument questions whether, in section 911, the “silence” about any deadline really creates a gap that can be legitimately filled by regulation. Ms. McDonald seems to suggest that the statute, by including no deadline, reflects a congressional intention that there be no deadline.

To buttress her position, Ms. McDonald noted that the specific statutory hook in Section 911 authorizing the Secretary to promulgate regs does not address timing.

Unlike in cases like Loving, where the DC Circuit found that the IRS lost at Step One because its regulatory efforts were “foreclosed by the statute”, here the court had little trouble dispensing with that argument, looking to Section 7805(d), which provides the IRS with wide latitude in setting deadlines:

Except to the extent otherwise provided by this title, any election under this title shall be made at such time and in such manner as the Secretary shall prescribe. [Emphasis in original opinion.]

That Section 911 itself did not address the timing in the court’s view just opened the door into the reasonableness of the timing requirements that the regulations imposed.

Step Two: Like a Good Neighbor State Farm is There Too

After pointing the Code’s statutory authority giving the IRS discretion to set deadlines for elections, the opinion moved to Step Two. Ms. McDonald argued that setting deadlines was unreasonable and thus the reg was invalid. The Tax Court noted that it had previously considered in Faltesek v Commissioner 92 T.C. 1204 (1989) a challenge to the first three regulatory deadlines under Section 911 and found that those regs were valid. Given that Treasury promulgated the fourth option in 1.911-7(a)(2)(i)(D) after Faltesek, the taxpayer attempted to distinguish that case, but the Tax Court dismissed that distinction:

[W]e find the rationale and holding of Faltesek equally applicable here, because the amended regulation with new subdivision (i)(D) is even more permissive than the former version. The amended regulation provides a taxpayer with an additional method for making the election if the taxpayer does not otherwise meet the requirements of subdivision (i)(A) through (C). Thus, if the pre-amendment version of the regulation was reasonable, as we held in Faltesek, then the more permissive amended version must also be reasonable.

In setting the table in discussing the Step Two arbitrary and capricious analysis, the Tax Court notes the similarity in a Step Two analysis to the inquiry that courts undertake pursuant to State Farm, i.e., that the agency satisfies a hard look reasoned decision making standard. In rewriting and updating Chapter 3 of Saltzman and Book IRS Practice and Procedure we have discussed extensively the manner in which courts have undertaken Step Two analyses in the context of tax cases. As we state in Chapter 3.02[4][c] in Step Two, “[u]nder State Farm hard look, the agency not only needs to engage in reasoned decision making, but must also provide contemporaneous explanations of its reasoning.”

The Tax Court early in the McDonald opinion notes the confluence of the Step Two and State Farm inquiries. In McDonald, Judge Gustafson, who did not join the Tax Court in the Altera opinion, could have found for the IRS by stating that the precedent of Faltesek (a pre-Mayo case but still a regular Tax Court opinion) foreclosed the inquiry. Instead, he also emphasized how in Faltesek the Tax Court affirmed the regulations in part because in the regulatory process the IRS “responded favorably to public comment and criticism that the originally proposed periods were too narrow and did not account for the difficulties of communicating with overseas taxpayers” and eventually promulgated regulations that were more liberal than originally proposed.

In assessing the validity of regulations, courts will inquire into the IRS’s acknowledging and responding to comments, and the McDonald opinion reminds us that while it is not easy for taxpayers to successfully challenge regulations, courts will be looking carefully at the give and take of the notice and comment process. While the McDonald opinion is an important government victory, it also stands to remind that Step Two is not meant to be a rubber stamp allowing any regulation to stand.

Sophy: Ninth Circuit Gives Little Deference to Chief Counsel Advice and Allows Unmarried Co-Owning Taxpayers Greater Mortgage Interest Deduction

Last week the Ninth Circuit decided the consolidated cases of Voss v Commissioner and Sophy v Commissioner, involving the debt limitations under Section 163 relating to qualified residence interest, and in particular whether the limitations are on a per-taxpayer basis or on a per-residence basis when involving unmarried co-owners of a qualified residence. The Ninth Circuit held that the limitations are on a per-taxpayer basis, reversing the Tax Court, which had held that the statute’s limits were tethered to the residence when unmarried taxpayers co-own a qualified residence.

Sophy is a high-profile case, and when the Tax Court decided this in 2012 (pre-Windsor when the landscape was quite different for same-sex couples) many commentators noted its significance. See, for example, Tony Nitti in Forbes referring to the case as one of the most significant in 2012, and that how the Tax Court dealt “a blow to wealthy gay or unmarried couples. …”

The statute is a significant individual income tax case, but it also has interesting procedural implications in that the majority minimized the importance of an IRS Chief Counsel advisory opinion, which had (not surprisingly) supported the IRS’s litigating position. In this post, I will discuss the majority’s approach to minimizing deference to the CCA.

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The statutory thicket under Section 163 is challenging, as the Ninth Circuit accurately explains:

This section of the Tax Code, like much of the Code, is complex—it requires attention to definitions within definitions and exceptions upon exceptions.

There is in Section 163 debt limitations that prevent taxpayers from deducting an unlimited amount of interest on residences that would otherwise qualify as a primary residence. The Ninth Circuit accurately summarizes the dispute at issue in the case as follows:

Although the statute is specific with respect to a married taxpayer filing a separate return, the Code does not specify whether, in the case of residence co-owners who are not married, the debt limits apply per residence or per taxpayer. That is, is the $1.1 million debt limit the limit on the qualified residence, irrespective of the number of owners, or is it the limit on the debt that can be claimed by any individual taxpayer? That gap in the Code is the source of the present controversy.

Much of the majority and dissenting opinion involves how best to resolve that gap. The majority essentially spends about 25 pages looking at the statute in detail, concluding that “a per-taxpayer reading of the statute’s debt limit provisions is most consistent with § 163(h)(3) as a whole.”

I will not go through the 25 pages in detail this post, but one of the issues the majority grappled with was the import of the Chief Counsel advisory opinion from 2009, CCA200911007.The CCA’s analysis was about a paragraph long and the Ninth Circuit limited its importance in resolving the dispute:

As the dissent acknowledges, the IRS’s Chief Counsel Advice is only entitled to the “measure of deference proportional to 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.’” Christopher v. SmithKline Beecham Corp., 132 S. Ct. 2156, 2168–69 (2012) (quoting United States v. Mead Corp., 533 U.S. 218, 228 (2001)); see also Christensen v. Harris Cnty., 529 U.S. 576, 587 (2000) (“Interpretations such as those . . . in policy statements, agency manuals, and enforcement guidelines, all of which lack the force of law—do not warrant Chevron-style deference.”).

In other words, the majority pegs deference to the informal guidance as dependent on context. Here is I think the most important procedural aspect of the opinion, when the Ninth Circuit applies those standards to the case, essentially minimizing the value of a one-paragraph internal IRS memo that barely scratched the surface of the complex issue:

A review of these factors suggests the 2009 Chief Counsel Advice should be given limited weight. To start, the 2009 Chief Counsel Advice is hardly thorough or exhaustive—its analysis interpreting how the statute should apply to unmarried co-owners consists of just one paragraph. It treats the question as one governed by the “plain language of the statute,” IRS Chief Counsel Advice No. 200911007, at 4, yet as our exchange, the briefs of the parties, the Tax Court’s decision, and the statute itself demonstrate, it is anything but “plain.” The Chief Counsel Advice does not grapple with the statute’s taxpayer-specific definition of “qualified residence” or repeated references to a taxpayer’s taxable year, nor does it explain how the married-person parenthetical is anything but surplusage under a per-residence reading of the statute. (emphasis added).

Moreover, the Ninth Circuit distinguished the situation in Sophy from Hall v US involving intersection of the bankruptcy code and IRC (whether a post-petition farm sale is “incurred by the estate” under the Bankruptcy Code) where the Supreme Court had noted that the IRS’s informal interpretation was consistent over a longer period, was found in multiple informal sources and supported by commentators:

The situation here is a far cry from that in Hall v. United States, 132 S. Ct. 1882, 1890 (2012), a case the dissent cites. See Dissent at 38 n.2. In Hall, the Supreme Court “s[aw] no reason to depart from those established understandings” of bankruptcy courts, bankruptcy commentators, and the IRS’s consistent position for over a decade in an IRS Chief Counsel Advice memorandum, the Internal Revenue manual, and an IRS Litigation Guideline Memorandum. See Hall, 132 S. Ct. at 1889–90. Here, by contrast, there is no comparable consensus. Aside from the IRS’s litigation position in this case, it appears that the 2009 Chief Counsel Advice—which is just six years old—is the IRS’s only The agency’s guidance is closer to a “mere[] . . . litigating position” than to an “agency interpretation of ‘longstanding’ duration.” Dissent at 43 (quoting Alaska Dep’t of Envtl. Conservation v. EPA, 540 U.S. 461, 487–88 (2004)).

The dissent, while noting and agreeing with the majority that the CCA’s were not precedential, stated that in the absence of regulations on point the court should have deferred to the IRS position as reflected in the CCA. Moreover, the dissent cited Skidmore (which the majority did not cite) and noted that courts should “consider the specialized and technical expertise of the agency.”

Its differing view of deference was in part based on its view that the majority’s approach “would result in a windfall to unmarried taxpayers.” In other words, under the majority approach unmarried taxpayers co-owning residences could have a larger mortgage interest deduction than married taxpayers:

There is no basis to infer that Congress intended to allow unmarried co-owners of a qualified residence filing separately to deduct interest on up to $2.2 million of debt, while limiting married co-owners of a qualified residence to deduct interest on only half that (only up to $1.1 million of debt). A more logical inference is that the deduction was aimed at promoting home ownership for ordinary folks, not to help wealthy individuals purchase mansions that are encumbered with more than $1.1 million of debt.

The majority was not troubled by the marriage penalty incumbent in its interpretation:

Congress may very well have good reasons for allowing that result, and, in any event, Congress clearly singled out married couples for specific treatment when it explicitly provided lower debt limits for married couples yet, for whatever reason, did not similarly provide lower debt limits for unmarried co-owners.

Some Parting Thoughts

Practitioners should be mindful of informal guidance such as Chief Counsel advisory opinions and their role in resolving ambiguous issues. Despite some high-profile cases invalidating regs, it is much less likely that under Chevron a court will disagree with the IRS’s views as expressed in formal guidance. Sophy is a useful reminder that while the IRS has a much easier time issuing informal guidance courts are much less likely to defer to less formal agency interpretations like CCA’s or other guidance. This is especially true when there is a lack of multiple informal pronouncements and none of the sources thoroughly reviews the issue.

Labels attached to differing standards of deference are to me often frustratingly unhelpful. Despite lip service given to some deference given to informal guidance (expressed often as Skidmore deference), the sliding scale of deference to agencies is generally tilted toward “no deference” when the agency view is found in only one informal memo with a limited discussion of the issue. Court should reward an agency for a more transparent and thorough discussion of issues.

Judges face a more challenging issue when their views may differ from multiple informal agency sources, or if one source itself thoroughly discusses the issue. For example, if the CCA implicated in Sophy had a 20-page discussion of the issue along the lines found in the Tax Court and dissenting opinion would the Ninth Circuit have decided this case differently?

In part because of staffing problems, the IRS these days seems to be issuing less formal guidance.  Its inability to issue formal guidance will have an impact in cases such as this.  This is perhaps yet another cost of Congress’ decision to underfund the IRS. With more IRS positions staked out in informal guidance, I suspect we will be considering these often abstract deference questions in differing settings.

 

The Implications for Tax Litigation of the Supreme Court’s Decision in Michigan v. EPA

We welcome back Patrick J. Smith of Ivins, Phillips & Barker. Pat discusses Michigan v EPA, a Supreme Court decision from earlier this week. Somewhat lost in the shuffle of the Court’s major decisions on ACA and same-sex marriage, Michigan v EPA is a significant administrative law case that may come into play when there are challenges to the validity of select tax regulations, including the Florida Bankers challenge to regulations requiring the reporting of interest income earned by non-resident aliens. Les

On Monday of this week, the last day on which it issued decisions for the current term, the Supreme Court issued its opinion in Michigan v. EPA. This case involved a challenge to the validity of a regulation issued by the EPA. The statutory provision that was at issue in the case directed the EPA to regulate hazardous air pollutant emissions by fossil-fuel-powered electric generating plants if the agency determined that regulating these emissions was “appropriate and necessary.” As part of its analysis, the agency determined that the annual cost for the generating plants to comply with this type of regulation would be $9.6 billion and that the direct annual health benefits of imposing this type of regulation would be $4 to $6 million. However, the agency also determined that “costs should not be considered” in making the decision as to whether it was “appropriate” to regulate these emissions. The agency determined based on other considerations that regulation of these emissions was “appropriate” and “necessary.”

The regulation was challenged on the basis that the EPA’s refusal to consider costs in making the decision as to whether regulation of these emissions was “appropriate” was improper. The D.C. Circuit rejected this challenge in a split decision, with Judge Kavanaugh dissenting from the conclusion that it was proper for the EPA to exclude costs from its decision-making on whether it was “appropriate” for the agency to regulate the emissions that were at issue in this case.

The Supreme Court, in a 5-4 decision, with the majority opinion written by Justice Scalia, reversed the D.C. Circuit and agreed with Judge Kavanaugh that the EPA was wrong to exclude any consideration of costs from its decision-making on whether regulation of these emissions was “appropriate.” While the challenge to the regulation was based on Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., nevertheless, the opinion also included significant citations to the Supreme Court’s 1983 landmark decision in Motor Vehicle Manufacturers Association v. State Farm Mutual Automobile Insurance Co., in which the Court provided important guidance on the Administrative Procedure Act’s “arbitrary and capricious” standard for courts to use in reviewing agency action.

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The Court’s Analysis: Arbitrary and Capricious

In fact, the Court’s analysis began with an invocation of principles applicable under the arbitrary and capricious standard, rather than with Chevron:

Federal administrative agencies are required to engage in “reasoned decisionmaking.” “Not only must an agency’s decreed result be within the scope of its lawful authority, but the process by which it reaches that result must be logical and rational.” It follows that agency action is lawful only if it rests “on a consideration of the relevant factors.” Motor Vehicle Mfrs. Assn. of United States, Inc. v. State Farm Mut. Automobile Ins. Co., 463 U. S. 29, 43 (1983) (internal quotation marks omitted).

Only after this beginning did the Court turn to Chevron:

Chevron directs courts to accept an agency’s reasonable resolution of an ambiguity in a statute that the agency administers. Even under this deferential standard, however, “agencies must operate within the bounds of reasonable interpretation.” EPA strayed far beyond those bounds when it read §7412(n)(1) to mean that it could ignore cost when deciding whether to regulate power plants.

Thus, although Justice Scalia does not explicitly refer to the two steps of the Chevron test, the foregoing passage suggests that under that framework, this decision fits under step two rather than step one. The Court elaborated on its conclusion as follows, once again invoking State Farm rather than Chevron:

Congress instructed EPA to add power plants to the program if (but only if) the Agency finds regulation “appropriate and necessary.” §7412(n)(1)(A). One does not need to open up a dictionary in order to realize the capaciousness of this phrase. In particular, “appropriate” is “the classic broad and all-encompassing term that naturally and traditionally includes consideration of all the relevant factors.” 748 F. 3d, at 1266 (opinion of Kavanaugh, J.). Although this term leaves agencies with flexibility, an agency may not “entirely fai[l] to consider an important aspect of the problem” when deciding whether regulation is appropriate. State Farm, supra, at 43.

Read naturally in the present context, the phrase “appropriate and necessary” requires at least some attention to cost. One would not say that it is even rational, never mind “appropriate,” to impose billions of dollars in economic costs in return for a few dollars in health or environmental benefits….No regulation is “appropriate” if it does significantly more harm than good.

There are undoubtedly settings in which the phrase “appropriate and necessary” does not encompass cost. But this is not one of them. Section 7412(n)(1)(A) directs EPA to determine whether “regulation is appropriate and necessary.” (Emphasis added.) Agencies have long treated cost as a centrally relevant factor when deciding whether to regulate. Consideration of cost reflects the understanding that reasonable regulation ordinarily requires paying attention to the advantages and the disadvantages of agency decisions. It also reflects the reality that “too much wasteful expenditure devoted to one problem may well mean considerably fewer resources available to deal effectively with other (perhaps more serious) problems.” Against the backdrop of this established administrative practice, it is unreasonable to read an instruction to an administrative agency to determine whether “regulation is appropriate and necessary” as an invitation to ignore cost.

The decision in Michigan v. EPA is clearly an extremely important administrative law decision, and its importance is clearly not limited to the context of the particular statute at issue here or to regulations issued by the EPA. The degree to which agencies may or must consider cost in their issuance of regulations has been an important open issue.

While this case dealt most directly with the meaning of the term “appropriate” in a particular provision in a particular environmental statute, nevertheless, by emphasizing that it is not even “rational” for an agency to ignore costs when the costs of an agency action far outweigh the benefits of that action, this decision is broadly applicable to virtually any agency decision-making exercise. It is also significant that the Court distinguished one of its prior decisions which held that in a particular statutory context it was not appropriate for the agency to consider cost:

American Trucking thus establishes the modest principle that where the Clean Air Act expressly directs EPA to regulate on the basis of a factor that on its face does not include cost, the Act normally should not be read as implicitly allowing the Agency to consider cost anyway.

Thus, the fact that a particular statutory provision authorizing or directing agency action does not explicitly refer to cost as one of the relevant considerations does not by itself mean that cost is not relevant, unless the provision does explicitly refer to other factors and omits any mention of cost. However, the Court also explicitly limited its holding in one respect. It emphasized that it was not telling the agency, in this case at least, that a formal cost-benefit analysis was required:

Our reasoning so far establishes that it was unreasona­ble for EPA to read §7412(n)(1)(A) to mean that cost is irrelevant to the initial decision to regulate power plants. The Agency must consider cost—including, most importantly, cost of compliance—before deciding whether regulation is appropriate and necessary. We need not and do not hold that the law unambiguously required the Agency, when making this preliminary estimate, to conduct a formal cost-benefit analysis in which each advantage and disadvantage is assigned a monetary value. It will be up to the Agency to decide (as always, within the limits of reasonable interpretation) how to account for cost.

State Farm and Chevron

Michigan v. EPA is also significant for the way it blends State Farm and Chevron. Another significant administrative law issue that has been the subject of some uncertainty is the relationship between the State Farm analysis and the Chevron analysis. The D.C. Circuit has treated State Farm and Chevron step two as overlapping if not essentially equivalent. Michigan v. EPA clearly confirms the correctness of that approach. In this regard, another passage from Judge Kavanaugh’s dissent in the D.C. Circuit seems particularly relevant:

In this case, whether one calls it an impermissible interpretation of the term “appropriate” at Chevron step one, or an unreasonable interpretation or application of the term “appropriate” at Chevron step two, or an unreasonable exercise of agency discretion under State Farm, the key point is the same: It is entirely unreasonable for EPA to exclude consideration of costs in determining whether it is “appropriate” to regulate electric utilities under the MACT program.

 Justice Thomas and Separation of Powers Issues

Another significant aspect of Michigan v. EPA is Justice Thomas’s concurring opinion. In a prior post, I discussed the Court’s decision in Perez v. Mortgage Bankers Association earlier this year, including the fact that Justice Thomas, in his concurring opinion in that case, for the first time expressed his view that the Auer deference principle, under which an agency is given deference for its interpretations of its own regulations, may be vulnerable to challenge as an unconstitutional violation of separation of powers principles. While his analysis in that concurring opinion by implication extended to Chevron as well as Auer, in his concurring opinion in Michigan v. EPA the application of that argument to Chevron becomes explicit.

Impact on Florida Bankers and Tax Litigation

Finally, there is the question of the potential application of the holding in Michigan v. EPA in tax litigation. While it is probably the case that in many challenges to tax regulations, the cost of compliance with the regulation may not be a realistic basis for challenge, there is no principled reason why in appropriate cases, the cost of compliance with a tax regulation might not form part or all of the basis for challenge.

A case that is currently pending in the D.C. Circuit, Florida Bankers Association, presents an example of a challenge to a tax regulation where the adverse economic impact that the challengers contend flowed from the regulation at issue was the major basis for their substantive challenge to the regulation. This case involved a challenge by bankers associations to regulations issued by the IRS that required banks to report to the IRS information regarding the amount of interest income earned by non-resident aliens on accounts with the banks, even though such individuals are clearly not subject to U.S. tax on that income. The IRS argued that this information reporting was justified on the basis that it was necessary in order for the U.S. to comply with information sharing agreements it has entered into with other countries regarding interest earned in each country by citizens of the other country.

The bankers associations argued that because of fears by non-resident aliens that the information reported to the IRS would be misused by their home countries, such non-resident aliens would respond to the regulation by withdrawing substantial amount of funds from U.S. banks, thus harming the banks and the U.S. economy. The bankers associations claimed that the IRS in issuing this regulation had incorrectly concluded that the magnitude of such withdrawals would be minimal, and that this error violated the arbitrary and capricious standard.

The district court rejected this challenge, and the bankers associations appealed to the D.C. Circuit. Judge Kavanaugh is on the D.C. Circuit panel that heard oral argument on this case in early February. In light of Judge Kavanaugh’s involvement in the D.C. Circuit opinion that was reversed by Michigan v. EPA, it seems likely that the D.C. Circuit decision in Florida Bankers was held waiting the Supreme Court’s decision. If this speculation is correct, then it seems likely that Michigan v. EPA will play a significant role in the D.C. Circuit’s decision in Florida Bankers.

In a recent Tax Notes article and in prior posts here, I discussed the Anti-Injunction Act issue in Florida Bankers, and the fact that it seems likely that the D.C. Circuit opinion in the case will provide insight on whether I am correct that the Supreme Court’s decision in March in Direct Marketing will mean that the Anti-Injunction Act will be read more narrowly in the future than it has been. The Supreme Court’s decision in Michigan v. EPA provides another reason to look forward to the D.C. Circuit decision in Florida Bankers with anticipation.