Update on CIC Services: The Scope of Relief Available if A Court Finds That An Agency’s Rulemaking Violates the APA

Following the Supreme Court decision in CIC Services, the matter was remanded back to the district court. Last month the district court granted CIC Services’ motion for preliminary injunction, finding that the Notice 2016-66 was a legislative rule and its issuance violates the notice-and-comment provisions of the APA.  Following CIC Services’ victory, however, it filed a motion to reconsider.

Why would CIC file a motion for reconsideration? Last month’s district court’s opinion narrowly enjoined the IRS from enforcing the Notice against CIC Services. In its motion, CIC Services has requested that the court broaden the relief and issue a national outright injunction that would prevent the IRS from enforcing it against anyone.

Readers may recall that in CIC Services: Now that AIA Issue Resolved, On to Some Meaty Administrative Law Issues I discussed the lurking issue as to the extent of any relief that a court could grant if it were to find that the IRS issuance of the notice violated the APA. In that piece I pointed to an excellent Notice & Comment blog post, Do you C what I C? – CIC Services v. IRS and Remedies Under the APA. In the post Professor Mila Sohoni provides context on the debate within administrative law. She argues that a district court has the power to set aside the Notice for everyone and should not be constrained to focus only on the application of the Notice to the plaintiff.

In the motion CIC Services acknowledges that there is uncertainty as to the scope of relief but argues that the court’s power to vacate the notice is broad (citing to the Notice & Comment blog). It also discusses the particular harm that CIC Services faces in the absence of a national injunction, including how it must incur costs to assist its nationwide clients who still have to comply and how the order “does not explicitly relieve CIC Services of the on-going and compulsory record-keeping that Notice 2016-66 requires.”

This is an important issue not only for tax administration. It has wide implications for administrative law.

CIC Services: Now that AIA Issue Resolved, On to Some Meaty Administrative Law Issues

We have followed the CIC Services case for years, starting with the first district court opinion through the recent Supreme Court opinion. Following the unanimous Supreme Court opinion, the case has been remanded to the district court, and CIC Services has filed a motion for a preliminary injunction.

There are a few important issues at the intersection of tax procedure and administrative law that the court will address. For example, is the Notice a legislative rule under the APA, and if it is, do the regulations that allow the IRS to define reportable transaction through other IRB guidance satisfy the notice and comment requirements? (For brief background, see my post here.)

There is another issue that has received less attention in the tax community lurking in the CIC Services case. That issue pertains to the nature of the relief that a court can grant when it finds that the IRS (or another agency) has failed to comply with the procedural requirements under the APA.  That gets to the scope of an injunction that a court may issue if it finds that CIC Services is correct on the merits.

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The IRS in the briefing following the remand has argued that if CIC Services prevails on getting the court to issue an injunction, any injunction should be limited to CIC Services and not have universal application. CIC Services, however, has argued for a broader sweep, and has asked that the court set aside the Notice not only for it specifically, but for everyone.

This an issue that is hot among some administrative law scholars. I flagged the issue in a post earlier this summer. In that post I discussed the terrific Notice & Comment blog post, Do you C what I C? – CIC Services v. IRS and Remedies Under the APA. In the post Associate Dean and Professor Mila Sohoni of the University of San Diego Law School provides context on the debate within administrative law and argues that a district court has the power to set aside the Notice for everyone and should not be constrained to focus only on the application of the Notice to the plaintiff.

Essentially Professor Sohoni notes that the Supreme Court in CIC Services views the request for injunctive relief and the request to set aside the Notice as two sides of the same coin. Professor Sohoni has written more extensively on the broader topic concerning the remedy of universal vacatur in APA challenges. See, for example, a 2020 George Washington Law Review article, The Power to Vacate a Rule.

As the briefing on the preliminary injunction has concluded, the court is likely to issue an order soon.

How Tax Regulations Are Made

Today’s post is by frequent guest poster Monte Jackel, Of Counsel at Leo Berwick. In today’s post, Monte discusses his reactions to an article written by Shu-Yi Oei of Boston College Law School and Leigh Osofsky of the University of North Carolina at Chapel Hill. A few years ago they wrote an insightful article on the process that led to the 199A regs; Keith discussed their article in a 2019 post. In this post Monte draws on his decades both in and out of the government to suggest changes to the process of reg drafting. Les

A relatively recent article (Shu-Yi Dei and Leigh Osofsky, Legislation and Comment: The Making of the §199A Regulations-Article ) provides a useful discussion of how public commentary, both pre and post the issuance of proposed regulations, affects the ultimate content of final Treasury regulations. 

For me, having experienced this process firsthand, the following reforms should be seriously studied and if appropriate instituted:

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1. The most important reform that could be instituted would require the Congress to amend the Freedom of Information (FOIA) part of the Administrative Procedure Act, 5 USC 552 (APA), to require disclosure by the tax agency holding the government record, the IRS and/or Office of Chief Counsel, to proactively disclose those records to the public (either through the Federal Register or the Internal Revenue Bulletin), instead of the current law which requires that the record relating to pre-proposed regulations comments be disclosed to the public  only upon a FOIA request (post-proposed regulations are generally required by law to be disclosed in the Federal Register as part of final regulations). What a reader of, for example, Tax Notes typically sees is that this tax publication was sent a separate copy of the comment letter or other government record so it could publish it in the public interest (which it often does). But the problem with waiting for a FOIA request to disclose government records is that often the requestor would need to know a record exists before requesting it. That is backwards. See references in the Internal Revenue Manual

2. Under 5 USC 552(f)(2), a “record” and any other term used in reference to information includes—(A) any information that would be an agency record subject to these requirements when maintained by an agency in any format, including an electronic format; and (B) any information described under subparagraph (A) that is maintained for an agency by an entity under Government contract, for the purposes of records management. The term “records” are defined in various statutes, including the Federal Records Act and the Freedom of Information Act.

Although there is a required collection of emails and such (and voice discussions should be documented as well) by the tax agency, all that is done at present, to my understanding, is to send the material (such as an email from an outside party on a substantive issue) to the Procedure and Administration units at IRS Chief Counsel to be available if and when there is a FOIA request. See IRM 30.11.1 FOIA Requests for Chief Counsel Records, and FOIA Guidelines.  This practice should be changed to make the disclosure of such records proactive without request to the agency. Appropriate FOIA protections would continue to apply.

3. There is a practice by some to take oral comments and not document them in writing or to return written materials to the presenter at a private meeting with outside parties and then take the position that FOIA is not required-ever. That practice should be negated via a change to the APA. 

4. Pre-proposed regulatory meetings and commentary should be discouraged unless immediate public disclosure also occurs. That is item 1 above. The argument against this is that no one will comment during that period if it became public but, assuming that is true, the question comes down to whether public disclosure is more important to the process than is feedback from outside technical experts and “those in the know”.  Those comments do add value but at what cost? 

5. The agency should have a duty to search for articles and similar commentary and take those comments and commentary into account in drafting proposed and final regulations. Due diligence is all this would require. Current law would allow articles to be ignored unless they are part of the proposed regulation comment process.

6. Most technical and substantive regulations have a very limited number of readers and there are few in number who will truly read and understand the regulations. In light of that reality, substantive regulations should, generally, be made more general principles oriented as compared to innumerable and detailed rules.

APA Offers No Avenue For Relief For Challenge to Offshore Transition Rules Penalty Regime

Harrison v IRS, a recent opinion from the federal district court for the District of Columbia, nicely explains the relationship between the tax refund process, the Anti Injunction Act (AIA) and the Administrative Procedure Act (APA). For good measure it also illustrates the uphill battle facing challenges based on violations of procedural due process. 

Harrison and spouse Sprinkle had lived abroad and maintained an undisclosed Swiss bank account. Like many with undisclosed assets and income they entered the Offshore Voluntary Disclosure Program (OVDP).  IRS established OVDP in 2009, which allowed for the payment of a single miscellaneous penalty. In 2014, IRS implemented “Streamlined Domestic Procedures” (SDP) for individuals with unreported foreign accounts who were not in the OVDP plan and who certified that the failure to previously report their accounts was “non-willful. The SDP allowed for a lesser penalty rate than OVDP. IRS, through a FAQ, also established transition rules for people, like Harrison and Sprinkle, who were in OVDP but who wanted to transition to SDP. Unfortunately for Harrison and Sprinkle, IRS determined that their conduct was willful and thus they were not eligible for SDP. Following the denial of their application to SDP, they paid over $500,000 in back taxes and penalties as part of the OVDP. This led to their executing a closing agreement where they agreed that they would not file a refund suit. 

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About two years after signing the closing agreement and paying the penalty and back taxes, they filed a suit challenging the IRS’s transition rules, claiming 1) that their promulgation without notice and comment violated the APA, 2) that the application of the transition rules to their circumstances violated the APA because it was arbitrary and capricious, 3) that the absence of procedural protections in the transition rules violated due process, and 4) that the closing agreement should be voided because they signed it under duress.

The government filed a motion to dismiss the suit. 

The opinion dealt with the APA claims first. The government argued that the court did not have jurisdiction to hear those claims because the FAQ was not final agency action and in any event the taxpayers had an alternative path to challenge the rules. The opinion did not reach the final agency action issue as it held that they had an alternate remedy via a refund suit. (Side note: in Scholl v Mnuchin, involving a similar APA challenge to the IRS’s illegal use of FAQs to bar the incarcerated from receiving pandemic relief/EIPs, a district court in CA held that the FAQ in that instance was final agency action, a conclusion buttressed by statements from Chief Counsel that the FAQs were all the guidance IRS would issue on the topic; see a post from Keith with a link to the district court’s order here).

One of the requirements for a court’s subject matter jurisdiction under the APA is that there is no adequate other remedy at law. The DC Circuit, like other courts, has held that a refund proceeding provides a cause of action for the recovery of taxes (and penalties) allegedly unlawfully or illegally collected.  As such, absent the closing agreement, Harrison and Sprinkle could have brought their APA claims in a refund proceeding.  But that that they entered into a closing agreement forbidding the filing of a refund suit did not mean that they had no other adequate remedy. As the court explained at note 4 “that Harrison and Sprinkle relinquished their right to file a refund suit by entering the Closing Agreement does not affect whether “no other remedy exists…. Parties cannot waive their way into federal jurisdiction where Congress has not granted it.” In other words, the closing agreement’s terms preventing them from filing a refund suit did not mean that that there was no adequate remedy at law. They could have brought their APA claims in a refund proceeding if they chose to not participate in the OVDP and agreed to pay whatever tax and penalty that awaited them following examination. They then could have filed a refund suit for the difference between the liability determined and what would have been owing under the streamlined procedures.

In finding that the refund procedures were an adequate remedy, the opinion notes that while Harrison and Sprinkle were asking the court to provide declaratory relief they were effectively asking for a refund.  Longtime readers of PT and other tax procedure nerds at this point might wonder why the government did not raise the AIA and Declaratory Judgment Act (DJA) as separate grounds for a bar to the suit. In fact, in Maze v IRS, a case I discussed in Important DC Circuit Opinion on Anti-Injunction Act and Offshore Disclosure Regime, the DC Circuit relied on the AIA and DJA to dismiss a similar challenge to the transition rules. The difference in this case, however, is that the taxpayers had fully paid the taxes and penalty, whereas in Maze the taxpayers had not fully paid the taxes and penalties. Yet the AIA analysis is instructive, because the AIA does not bar a suit if there is no adequate remedy at law, a similar inquiry under the APA. As the DC Circuit in Maze held that the refund procedures were adequate for AIA purposes, it was an easy leap for the district court to consider the same procedures adequate for APA purposes.

The opinion gave relatively short shrift to the argument that the closing agreement should be invalidated due to duress. The argument that Harrison and Sprinkle made was that the IRS’s denial of their request to use the transition rules amounted to their holding a sword of Damocles over their heads: 

The couple argues that their execution of the Closing Agreement was the improper product of duress because the “alternative [to signing] would be to face an examination with the prospect of devastating penalties by the same agency that already found [that they] willfully violated the law.”

That was not enough to rise to the level of duress. Informing a party about the possibility of legislatively mandated penalties is “no more coercive than informing a counterparty of the potential outcomes of litigation.”  While the IRS had rejected the couples’ non-willful certification if they had opted out of the OVDP and succeeded in later convincing the IRS or a court that their conduct was non-willful they would have paid substantially less. 

The opinion also rejected the claim that the transition procedures violated their procedural due process rights. The argument that the taxpayers made was that the same procedural infirmities that were underlying the claim that the rules violated the APA amounted to a constitutional infirmity under procedural due process principles. In rejecting that argument, the court acknowledged that under cases like Mathews v Eldridge, courts traditionally employ a test that weighs (1) “the private interest that will be affected by the official action;” (2) “the risk of an erroneous deprivation of such interest through the procedures used, and the probable value, if any, of additional or substitute procedural safeguards;” and (3) “the Government’s interest, including the function involved and the fiscal and administrative burdens that the additional or substitute procedural requirement would entail.” Usually, as the court notes, this requires a right to a pre-deprivation hearing. Pointing to cases that have treated tax as exceptional in procedural due process claims (a line of cases I discuss in a recent essay published in the Pittsburgh Tax Review issue highlighting Nina’s time as NTA), the court held that the ability to access post deprivation refund proceedings was constitutionally sufficient, and not a denial of due process.

Conclusion 

The upshot of this case is that the IRS’s actions and rules that it published in the FAQ are immune from judicial challenge under the APA. The needle can still be thread: if someone else  has fully paid and is not subject to a closing agreement they could bring a refund suit in federal court and get a court to consider the merits of the APA challenge. 

It of course is somewhat odd to think of an FAQ as a rule for APA purposes. Yet a “rule,” is defined rather broadly to include any “agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or describing the organization, procedure, or practice requirements of an agency.”  Whether the rule is subject to notice and comment requirements, as Harrison and Sprinkle claimed, will have to wait another litigant. 

The case also highlights one of the big policy issues at play in the upcoming CIC Services v IRS case in the Supreme Court.  Will CIC Services, as some have argued, open the door for pre-enforcement challenges to rulemaking? Or will litigants like Harrison and Sprinkle continue to have to shoehorn APA claims into existing tax enforcement proceedings?

What Is A Preamble Worth?

We welcome back guest blogger Monte Jackel, Of Counsel at Leo Berwick, who discusses the legal significance of preambles to regulations. Les

Introduction

Regulation preambles are a part of the reading cycle of a tax professional. If I can be taken as a typical or average tax regulation reader, the first thing I do when reviewing a regulation package as a reader is to look carefully through the regulation preamble before I review the text of a regulation. This is because the regulation preamble, much like legislative history to a statute, provides meaning and context to the regulation text.

Regulation preambles add one additional feature that is more difficult to discern as to its legal significance. Often, or at least not infrequently, a regulation preamble contains a substantive rule that is not in the regulation text itself. (A recent example is the final section 163(j) regulations issued within the past week or so that contains a rule only in the preamble that items omitted from the final regulation but that are contained in the proposed regulations can be relied on until new final rules are issued for the omitted items. There are more.)

At that point it would be appropriate to ask the question: What legal import, if any, does this “special preamble rule”, if I may call it that, have?

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It Is Just Not Clear

Unfortunately, it is not clear that a taxpayer can rely on statements in a preamble that are not in the text of the regulation as “authority” for purposes of avoiding accuracy related penalties under section 6662 of the Internal Revenue Code. Regulation §1.6662-4(d)(3)(iii), which determines the types of authority that can be relied on to avoid the substantial understatement penalty, states that “[P]roposed, temporary and final regulations construing [the Internal Revenue Code]” is an authority.

However, the next question to ask is: Whether the regulation preamble is considered part of “the regulation” construing the statute for this purpose as the quoted language from section 1.6662-4(d)(3)(iii) does not say anything on this question one way or the other. (A search for the regulatory history on this particular regulation has not turned up anything relevant to this discussion. The ability to rely on regulations for this purpose is derived from section 6661, the predecessor to section 6662, which references only “Treasury regulations”. JCS-38-82, Dec. 31, 1982, p.217.).

So Can We Rely On Preambles Then?

As much as logic dictates that the preamble should be considered part of “the regulation” for this purpose, where does it expressly say that in the regulation text or even in a regulation preamble dealing with the subject? I can find nothing.

It is not subject to doubt that a regulation preamble can be used as background and context much like legislative history in interpreting a regulation. But the key question at issue here is what if the preamble contains a substantive rule of law that is not contained in the text of the regulation itself as sometimes occurs? Is that naked (non-textual) statement in the preamble an “authority” that can be relied on?

The Office of the Federal Register Document Drafting Handbook, chapter 2.2, requires a preamble, for whatever it is worth, to be part of the submission to the Federal Register. However, the preamble is not published in the Code of Federal Regulations as it is not regulation text. (1 CFR sec. 18.12 also requires a preamble to be part of a regulation in order to be published in the Federal Register). The Administrative Procedure Act (APA) at 5 USC sec. 552 requires federal agencies to publish their regulations in the Federal Register in order to be legally effective, and 5 USC 553(c) sets forth the requirement for a regulation to contain the basis and purpose of or for the rule.

The reg. §1.6662-4 rules were issued in December 1991 (T.D. 8381) but 1 CFR sec. 18.12 was issued in 1976 and thereafter amended in 1989. Thus, there can be no doubt that the requirement to have a regulation preamble existed before reg. §1.6662-4 was finalized or even proposed.

Does this mean that the reference to the term “regulation” in §1.6662-4 must mean it includes a preamble because regulations had to have one to be published in the Federal Register? Or, since the CFR does not include regulation preambles when they are published there (IRS regulations are in title 26 of the CFR), does it mean that the term “regulation” does not include preambles because they are not expressly included when published there? Which inference should you draw here?

This needs regulatory text clarification, more urgently now than ever as there is an increasing trend to include substantive or applicability date rules and reliance rules in only the regulation preamble.

A Closing Comment On Avoiding the 60-Day CRA Rule For Regulations

The Congressional Review Act (CRA) contains a requirement that absent “good cause”, regulations shall not take effect for 60 days after they are published in the Federal Register (or when submitted to Congress if later). 5 USC 801(a)(3), 808. In a recent slate of regulations scheduled for publication in the Federal Register on January 19, the day before inauguration day (and the assumed date of a Biden regulatory freeze order for regulations not published by then), the IRS asserted that there was “good cause” for the waiving of the 60-day CRA period. This was done so the regulations could be both effective and published before the new administration assumes power on January 20.

The statute provides that “good cause” means that the 60-day delay is impractical, unnecessary or contrary to the public interest. 5 USC 808(2). (The good cause language also appears in the APA at 5 USC 553(b)(3)(B)). The justifications used by the IRS in these waiver cases is principally that the rules at issue explain or clarify the law and therefore should be effective immediately. Well, if that is the case, then a vast number of regulations could avoid the 60-day period because most rules explain or clarify the law-that is their principal purpose.

If either the new administration (or a court) finds that the CRA was violated, that should mean that the regulations were not legally effective when filed with the Federal Register, and therefore not lawfully published there and can, as a result, be subject to any regulatory freeze order of the Biden administration when it comes into power. Can taxpayers safely assume that the CRA 60-day delay rule was effectively waived for reliance purposes? Could a court years later make the determination that the waiver was invalid and the regulation is and always was void?

Comments and insight to this blog are clearly welcome.

A Brief Look At Section 7805(b)

We welcome back Monte Jackel, Of Counsel at Leo Berwick, who returns to discuss regulations that are made public but that are not published in the federal register prior to the end of a presidential administration. Les

Section 7805 was amended as part of the second Taxpayer Bill of Rights in 1996, P.L. 104-68, JCS-12-96, p. 44. Subsection (b), headed “Retroactivity of regulations”, describes the circumstances where retroactivity, that is where a “taxable period”, an undefined term, cannot be subject to a regulation filed or issued before certain dates, is permitted. Section 7805(b)(1)(A) references the date the regulation is filed with the Federal Register. The date of filing is a clearly known term given that the Office of the Federal Register uses that term as the date the document is available for public inspection before it is published there. Section 7805(b)(1)(B) also uses the filing date with the Federal Register to set the retroactivity that is permitted. However, section 7805(b)(1)(C) uses the term “issued” to the public when referencing the permitted retroactivity. That term is not defined although 5 USC 552(a)(1) (the APA) requires federal agencies to publish their regulations in the Federal Register. The term “issued” is not used there. Section 7805(b)(2), relating to promptly issued regulations, references the term “filed or issued” but defines neither. The legislative history does not add anything to this either. However, it is probably safe to assume that “issued” means “published”. 

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There has been some commentary recently about the upcoming change in administrations and what happens to regulations that are made available to the public before they are filed with the Federal Register but are not published there by the time a new incoming administration orders that all regulations not yet published (and maybe even those that are) be returned to the issuing agency. Attached at the end of this post is the text of a letter to the editor that I recently published in Tax Notes describing some of these issues. 

The practice of the IRS and Treasury releasing to the public a copy of a regulation with a disclaimer at the top of the first page saying that only the copy published in the Federal Register is the legal copy, should be discouraged. I can find no provision in either the Internal Revenue Code or the APA that authorizes this practice or gives any legal significance to it. And while this is not the first time in our history that presidential orders of a new administration put a “freeze” on the publication of regulations to evaluate them first, this practice only adds to the natural confusion created when a new administration takes power. The situation is exasperated when the text of the regulations are made available to the public but those regulations do not apply to any taxable period beginning before the regulations are published. What positions do taxpayers take in the interim. 

I think there should be a new federal statute that prohibits the issuance of regulations within 60 to 90 days before a new administration comes on board absent “extreme need” or other such standard, which is subject to review later. Alternatively, a new statute could describe the legal impact of these regulatory freezes. I much prefer the former. What do others think?

Text of Letter to the Editor, “Potential Danger of Making Public Pre-Release Versions of Regulations”
170 Tax Notes Federal 299, Jan. 11, 2021

To the Editor:

The Office of Information and Regulatory Affairs website says that the final section 163(j) regulations were released from OIRA on December 30, 2020. These regulations were, based on past IRS practice, posted on IRS.gov on January 5, 2021. Under the Congressional Review Act, the final regulations state that they will be effective on the date filed with the Federal Register. That date was either yesterday or today or will be shortly thereafter. But those regulations may not make it to be published in the Federal Register by January 20. That day, or the next day or so by the latest, a presidential executive order will be issued by the new administration ordering the Federal Register to return regulations not yet published there.
Emily L. Foster addressed the issue in her story last week [in Tax Notes] titled “Final Interest Regs Provide Clarifications for Taxpayers” but the story is a bit misleading when it discusses what happens if the regulations are pulled back by a new administration before they’re published in the Federal Register. It’s true that the regulations are effective on the date filed with the Federal Register under the CRA (assuming that the explanation given for the expedited effective date by the IRS stands up to challenge if it comes to it). That date was either January 5 or 6, or will be shortly thereafter.

But that only means that the regulations are legal documents upon filing with the Federal Register. However, the applicability date of the regulations is for tax years beginning on or after 60 days from the date of publication in the Federal Register. If the regulations are never published or publication is delayed for months, the regulations will not be mandatorily applicable to taxpayers and neither will the proposed regulations.

However, the final regulations state that taxpayers can elect to apply the final regulations to periods before they are applicable. Also, the final regulation preamble (but not the text of the regulation) says that prior to the applicability date, taxpayers can apply the proposed regulations instead. In addition, the final regulation preamble (but not the text of the regulation) states that if there is a rule from the proposed regulations that is not in the final regulations, taxpayers can nevertheless apply the proposed regulation rule until final regulations are published at a later date that deal with the omitted items. It is unclear what happens if the final regulations are never published in the Federal Register. In other words, can taxpayers rely on the proposed omitted items forever like they have for the proposed section 465 regulations (since the late 1970s)?

Eric Yauch wrote about the omitted items and other partnership rules in the final regulations in a story titled “Trading Partnership Approach Remains in Final Interest Regs”. The omitted rules from the proposed regulations were, principally, the creation of inside tax basis “out of thin air” upon a complete redemption of a partner and the application of section 734(b), and all the tiered partnership rules.
The latter rules were incoherent and difficult to follow and apply, even for partnership experts. But the final regulation preamble (but not the regulation text) says if a rule is omitted from the final regulations that was in the proposed regulations, a taxpayer can apply the proposed rules anyway.

That action could end up with the omitted rules being like the proposed section 465 regulations, which, as noted, have been proposed and not finalized since the late 1970s. This “can rely on the omitted rules” rule will literally be the case even if the final regulations are never published in the Federal Register or are published months from now. In the interim period before the omitted rules are addressed and finalized in one form or another, taxpayers are not obligated to apply the missing omitted rules from the proposed regulations, but they will have to apply a reasonable approach based on the statute and its legislative history.

Since the IRS does not explain why the omitted rules were not finalized, what other approach would be considered reasonable? Would a pure aggregate approach to tiered partnerships suffice? Can there be a situation when the “create basis out of thin air rule” applies without relying on how the proposed regulations handle that rule? How long will it be until these issues are resolved, if ever? The final regulation preamble states only that the partnership rules continue to be studied. Although that explanation sounds good, it’s probably truer to say that the omitted rules had technical and other issues and that the IRS could not figure out what changes should be made. They then ran out of time because the IRS powers that be wanted the final regulations pushed out the door before the new administration comes into power.

Is this course of behavior by the current IRS and Treasury advisable? The other regulations now pending at OIRA may also get posted to IRS.gov by January 20, but it is unlikely that those regulations will make it out as published in the Federal Register by that date. The section 1061 carried interest regulations come to mind. [Those regulations ended up being released to the public after this letter was submitted to Tax Notes]. That means that all those pre-publication regulations will most likely not be mandatorily applicable to taxpayers for months, if ever. Taxpayers can elect to apply those unpublished rules in the interim, but they don’t have to. Why do this?

In other words, if the OIRA-reviewed regulations have already been returned to the IRS, they may end up being a set of pre-publication regulations posted on IRS.gov which has, as a matter of law, absolutely no legal effect unless taxpayers elect that they apply. But what if they don’t so elect?

Such is the case with the section 163(j) final regulations. And it will be a race for other federal agencies to get their regulations filed and then published in the Federal Register by no later than the close of business on January 19, the day before inauguration day. If not, the same mess as with section 163(j) applies.

If pre-publication regulations that have been publicly released don’t make the January 19 Federal Register publication date, there will, as noted, be an executive order by the new administration shortly thereafter sending all unfiled and/or unpublished regulations back to the agency issuing them. At this point, it will likely be months before activity occurs on those regulations.

In the interim, how many taxpayers will gamble on the “new rules” that would apply to them once the regulations are resubmitted to the Federal Register by the new administration, and how many taxpayers will just apply the proposed regulations? Is it even safe to assume that the statements made by the current administration in the final section 163(j) regulations (that taxpayers can rely on those rules today) will not be changed by the new administration?
That latter action would be the height of unfairness but what stops a new administration from doing so? At that point, the Administrative Procedure Act would come into play in terms of how to render uneffective those regulations deemed effective by the good cause exception under the CRA? Would it be revocation and reissuance, or would it just be revocation under the CRA?
Is this good or bad tax policy for the current administration? To me, the answer is that it is resoundingly bad. What do others think?

Phantom Regulations Under The APA

Today’s guest post by Monte A. Jackel explores whether courts can and should fill the gap when Treasury fails to exercise discretionary regulatory authority. Les

Introduction 

In recently finalized small business accounting regulations (T.D. 9942, Dec. 23, 2020), the IRS and Treasury refused to promulgate regulations dealing with providing an exception to the syndicate tax shelter rule for small business taxpayers. The grant of regulatory authority was discretionary in this case (Congress used the words “if the Secretary determines”) and, ordinarily, that would mean that the taxpayer and the courts are and were powerless to compel such promulgation and for the courts to fill in the gap. 

However, in today’s environment where the Administrative Procedure Act (APA) is taking more prominence in tax rulemaking, the question has become whether, if the IRS and Treasury take it upon themselves to address the reasons why they are not exercising their discretionary regulation authority and the explanation does not “jive with reality”, meaning that it is arbitrary and not grounded in sound reasoning, can the courts fill in the gaps if a taxpayer litigates the issue and, in effect, force the government to in substance issue the very same regulations it refused to issue? See my prior PT post, Conservation Easement Donation and the Validity of Tax Regulations  I think the answer is or should be yes. 

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Analysis

In the seminal article dealing with the issue of the courts filling in the gaps for missing tax regulations (See Philip Gall,  Phantom Tax Regulations: The Case Of Spurned Delegations, 56 Tax Law 413 (2002-2003)), the author correctly described the case law at that time as precluding the courts from filling in the gaps with phantom regulations where the regulatory delegation was what is called a “policy delegation”, that is, a delegation where it is discretionary with the IRS whether to issue regulations or not. 

I am not disputing the correctness of that assertion in the article generally but, rather, I am questioning the correctness of that statement today in cases where the IRS offers a reason(s) for its refusal to issue regulations in response to public comments asking for the regulatory grant to be exercised and that explanation(s) is not sufficiently well reasoned and responsive to the intent of the Congressional grant as to pass muster. In those cases, I believe that the courts should be free to promulgate phantom regulations on the issue. 

The key question for a future court is did the IRS provide an adequate answer (see below) to taxpayer comments asking it to exercise its regulatory authority? I think not because the grant of authority in section 1256(e)(3)(C)(v) (“if the Secretary determines (by regulations or otherwise) that such interest [in an entity] should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax avoidance purposes”) was added in the tax act of 1981 to allow certain passively held interests to be treated as active and thus not a syndicate under section 1256 and thereby eligible for the hedging exception to mark to market treatment under section 1256. 

The fact that the TCJA in 2017 did not say anything about providing an exception for certain syndicates as tax shelters, as the IRS asserted as an explanation in the final regulation preamble for not issuing regulations, should not lead to any inference one way or the other. The Congress merely provided statutory cross references in the TCJA to other statutes in providing an exception to the small business carve-out for tax shelters, and the grant of regulatory authority should be viewed in that light. (For background and analysis of this tax shelter carve-out generally, see Monte Jackel, Small Business Tax Shelters Under the Business Interest Expense Limitation, 165 Tax Notes Federal 607, Oct. 28, 2019). 

The principal defect in the government’s position on the syndicate issue is that the explanation(s) given for the refusal to issue regulations would lead to the conclusion that all passive investments are established or maintained for tax avoidance purposes. Without the government explaining why that is the case, I believe that the failure to issue regulations in at least some cases involving passive investment is contrary to the Congressional intent that there could be cases where passive investment should be deemed active and, thus, not a tax shelter. The government’s statement in the final regulation preamble that allowing a passive investment exception would be “overbroad” and lead to the conclusion that no syndicates are tax shelters is and was just plain wrong. It is the failure of the government to either state (1) that all passive investment syndicates are tax shelters per se and explain why that is so, or (2) that it is not administratively possible to provide for any passive investments to not be syndicates, that results in an arbitrary application of the tax law that a court should not allow to stand. What do you think?

FROM THE FINAL SMALL BUSINESS ACCOUNTING REG PREAMBLE

“Several comments were received concerning issues related to tax shelters, including the definition of “syndicate,” under proposed §1.448-2(b)(2)(i)(B). Some commenters recommend using the authority granted under section 1256(e)(3)(C)(v) to provide a deemed active participation rule to disregard certain interests held by limited entrepreneurs or limited partners for applying the Section 448(c) Gross Receipts Test if certain conditions were met. For example, conditions of the rule could include that the entity had not been classified as a syndicate within the last three taxable years, and that the average taxable income of the entity for that period was greater than zero.

“The final regulations do not adopt this recommendation. The Treasury Department and the IRS have determined that it would be inappropriate to provide an exception to the active participation rules in section 1256(e)(3)(C)(v) by “deeming” active participation for small business taxpayers. The Treasury Department and the IRS believe that the deeming of active participation in this context would be overbroad and would run counter to Congressional intent. Sections 448(b)(3) and (d)(3), 461(i)(3) and 1256(e)(3)(C) were not modified by the TCJA, and the legislative history to section 13012 of the TCJA does not indicate any Congressional intent to modify the definition of “tax shelter” or “syndicate.” By not modifying those provisions, Congress presumably meant to exclude tax shelters, including syndicates, from being eligible to use the cash method of accounting and the small business taxpayer exemptions in section 13102 of the TCJA, even while otherwise expanding eligibility to meet the Section 448(c) Gross Receipts Test.”

PROPOSED REGULATION PREAMBLE

“One commenter expressed concern that the definition of syndicate is difficult to administer because many small business taxpayers may fluctuate between taxable income and loss between taxable years, thus their status as tax shelters may change each tax year. The commenter suggested that the Treasury Department and the IRS exercise regulatory authority under section 1256(e)(3)(C)(v) to provide that all the interests held in entities that meet the definition of a syndicate but otherwise meet the Section 448(c) gross receipts test be deemed as held by individuals who actively participate in the management of the entity, so long as the entities do not qualify to make an election as an electing real property business or electing farm business under section 163(j)(7)(B) or (C), respectively. The Treasury Department and the IRS decline to adopt this recommendation. The recommendation would allow a taxpayer that meets the Section 448(c) gross receipts test to completely bypass the “syndicate” portion of the tax shelter definition under section 448(d)(3). Neither the statutory language of section 448 nor the legislative history of the TCJA support limiting the application of the existing definition of tax shelter in section 448(d)(3) in this manner.”  

Consistency and the Validity of Regulations

Guest contributor Monte Jackel discusses guaranteed payments and how differing regulations inconsistently approach whether such guaranteed payments are indebtedness. While the post highlights substantive technical issues it also flags a procedural issue: the difficulty in challenging tax regulations outside normal tax enforcement procedures. That procedural issue, present in the current teed up Supreme Court case CIC v Commissioner which is now set for oral argument on December 1, as Monte suggests and as I discussed last year in Is It Time To Reconsider When IRS Guidance Is Subject to Court Review?, may call for a legislative fix. Les

How can a guaranteed payment on capital under section 707(c) of the Internal Revenue Code be both an actual item of “indebtedness” if, but only if, there is a tax avoidance motive for purposes of section 163(j)’s limitation on business interest expense but only be “equivalent to” but not actually be indebtedness for purposes of the foreign tax credit? Well, if you are the IRS with the “pen in hand”, anything is possible.

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Section 163(j)(5) defines “business interest” for purposes of section 163(j) as “any interest paid or accrued on indebtedness properly allocable to a trade or business.” Thus, the key term here is “indebtedness”. More on that later. 

Similarly, income equivalent to interest is referenced in section 954(c)(1)(E) and in regulation §§1.861-9(b)(1) and 1.954-2(h)(2) and specifically refers to guaranteed payments on capital as equivalent to interest expense at regulation §1.861-9(b)(8). On the other hand, the very same guaranteed payment on capital is treated as actual interest expense under regulation §§1.469-2(e)(2)(iii) and 1.263A-9(c)(2)(iii). 

It is very hard to either see or to justify treating guaranteed payments on capital under section 707(c) as both actual interest expense or as equivalent to interest expense for purposes of different provisions of the Internal Revenue Code. Either a guaranteed payment represents interest on indebtedness under all provisions of the Internal Revenue Code or it does not, unless a specific provision of the Code expressly treats guaranteed payments on capital a certain way. Merely because a statute or implementing regulation treats a guaranteed payment on capital as equivalent to interest does not mean that it can be both actual indebtedness for some but not all provisions of the Code and as equivalent to but not actual interest on indebtedness for purposes of other provisions of the Code. 

The recently finalized foreign tax credit regulations, T.D. 9922, had this to say about the issue:

The Treasury Department and the IRS have determined that guaranteed payments for the use of capital share many of the characteristics of interest payments that a partnership would make to a lender and, therefore, should be treated as interest equivalents for purposes of allocating and apportioning deductions under §§1.861-8 through 1.861-14 and as income equivalent to interest under section 954(c)(1)(E). This treatment is consistent with other sections of the Code in which guaranteed payments for the use of capital are treated similarly to interest. See, for example, §§1.469-2(e)(2)(ii) and 1.263A-9(c)(2)(iii). In addition, the fact that a guaranteed payment for the use of capital may be treated as a payment attributable to equity under section 707(c), or that a guaranteed payment for the use of capital is not explicitly included in the definition of interest in §1.163(j)-1(b)(22), does not preclude applying the same allocation and apportionment rules that apply to interest expense attributable to debt, nor does it preclude treating such payments as “equivalent” to interest under section 954(c)(1)(E). Instead, the relevant statutory provisions under sections 861 and 864, and section 954(c)(1)(E), are clear that the rules can apply to amounts that are similar to interest.

OK, so the IRS is saying here that a guaranteed payment on capital is not and does not have to “indebtedness” for the item to be treated the same as interest expense under the enumerated statutory provisions. This is so without regard to there being a tax avoidance reason for the taxpayer to have used a guaranteed payment on capital instead of actual indebtedness. Technically true in the case of the enumerated provisions but does it make good policy sense or is it merely “talking out of both sides of your mouth” and, thus ultra vires? 

Take a look at how guaranteed payments on capital recently fared under the final section 163(j) regulations (T.D. 9905). The final regulation preamble had this to say about the issue:

Proposed §1.163(j)-1(b)(20)(iii)(I) provides that any guaranteed payments for the use of capital under section 707(c) are treated as interest. Some commenters stated that a guaranteed payment for the use of capital should not be treated as interest for purposes of section 163(j) unless the guaranteed payment was structured with a principal purpose of circumventing section 163(j). Other commenters stated that section 163(j) never should apply to guaranteed payments for the use of capital….In response to comments, the final regulations do not explicitly include guaranteed payments for the use of capital under section 707(c) in the definition of interest. However, consistent with the recommendations of some commenters, the anti-avoidance rules in §1.163(j)-1(b)(22)(iv)…include an example of a situation in which a guaranteed payment for the use of capital is treated as interest expense and interest income for purposes of section163(j).

Without getting into the merits of the example the IRS added to the anti-avoidance rule, suffice it to say that acting “with a principal purpose” of tax avoidance in preferring a guaranteed payment on capital to actual interest on indebtedness is a very low barrier for the IRS to meet. After all, “a principal purpose”, based on existing authority is merely an important purpose but need not be the predominant purpose and the test can be met even if there is a bona fide business purpose for using the guaranteed payment in lieu of actual indebtedness and even though the transaction has economic substance. 

But what about how the U.S. Supreme Court and the IRS itself treated a short sale for purposes of interest deductibility and the unrelated business income tax, respectively? In Rev. Rul. 95-8, 1995-1 C.B. 107, the issue was whether a short sale of property created “acquisition indebtedness” for purposes of the unrelated business income tax under section 514. The IRS concluded, in a revenue ruling that is still outstanding, that the answer was no:

Income attributable to a short sale can be income derived from debt-financed property only if the short seller incurs acquisition indebtedness within the meaning of section 514 with respect to the property on which the short seller realizes that income. In Deputy v. du Pont, 308 U.S. 488, 497-98 (1940), 1940-1 C.B. 118, 122, the Supreme Court held that although a short sale created an obligation, it did not create indebtedness for purposes of the predecessor of section 163.

In turn, the U.S. Supreme Court had this to say about what is “indebtedness” under the Internal Revenue Code (Deputy v. du Pont, 308 U.S. 488 (1940)): 

There remains respondent’s contention that these payments are deductible under § 23 (b) as “interest paid or accrued . . . on indebtedness.” Clearly [the taxpayer] owed an obligation….But although an indebtedness is an obligation, an obligation is not necessarily an “indebtedness” within the meaning of § 23 (b)…. It is not enough….that “interest” or “indebtedness” in their original classical context may have permitted this broader meaning.  We are dealing with the context of a revenue act and words which have today a well-known meaning. In the business world “interest on indebtedness” means compensation for the use or forbearance of money. In [the] absence of clear evidence to the contrary, we assume that Congress has used these words in that sense. (footnotes omitted). 

And so, the U.S. Supreme Court says that “interest on indebtedness” means “compensation for the use or forbearance of money”. A guaranteed payment on capital is a return on equity and cannot be transformed into interest on indebtedness based on some general regulatory authority under section 7805(a), no matter how abusive the IRS views a transaction. And effectively treating a guaranteed payment on capital as “equivalent to interest” but not actually indebtedness for purposes of certain enumerated provisions (such as section 901) seems to be overreaching given the mandate of the U.S. Supreme Court on an economic equivalent to interest on indebtedness at that time, a short sale. 

Can the IRS write a regulation that circumvents the dictates of the U.S. Supreme Court using a general grant of regulatory authority under section 7805(a)? I would think that the answer is clearly and obviously no. But what is the price that the IRS will ultimately pay if the results enumerated here are overruled by a court several years down the road? Other than spending taxpayer dollars unnecessarily, it does not appear that there is any downside in doing so. 

Note that this bifurcated treatment of a guaranteed payment on capital “infects” other recent regulations because in one case (T.D. 9866, the GILTI final regulations) there is an explicit cross reference to the definition of interest income and expense under section 163(j) (which presumably includes the application of the interest expense anti-abuse rule in those final regulations), and in another case (T.D. 9896, the section 267A final regulations) the substance of the definition of interest expense and the anti-avoidance rule exception were incorporated into those regulations.

How can this practice be effectively stopped? Will it require court litigation and years of uncertainty or is there a mechanism for, in effect, penalizing the IRS for taking positions that, if the IRS were a tax advisor to a client other than itself, it could not have concluded the way it does without disclosure on the equivalent of form 8275? 

Could section 7805(a) be amended to curtail this IRS practice? For example, could a sentence or two be added there to say that “the IRS cannot issue regulations or other guidance inconsistent with the literal words of a provision of the Internal Revenue Code unless Congress expressly grants that power”? 

Now, some will say that doing such a thing contravenes the ability of the courts to adjudicate tax disputes and so is perhaps unconstitutional but clearly inadvisable. Others will say that the regulatory guidance process would grind to a halt because of the forceful taking by the Congress of administrative discretion and expertise. 

I don’t think the status quo is acceptable. On the other hand, I do recognize the implementation problems. Is there any solution other than to throw up your hands in disgust and move on to something else?