The Solicitor General Embraces Phantom Tax Regulations

November 9, 2022 by 2 Comments

Today we welcome back Professor Andy Grewal, the Orville L. and Ermina D. Dykstra Professor in Income Tax Law at the University of Iowa College of Law. In this post, which originally appeared in the blog Notice & Comment, Professor Grewal discusses the Sixth Circuit decision in Whirlpool v Commissioner, Whirlpool’s  petition for certiorari and the issue of phantom regulations. Following Andy’s original post, Whirlpool filed a reply to the government’s brief in opposition. And last week the Supreme Court announced that the case has been distributed for consideration at its upcoming conference on November 18, 2022. Les

As discussed in a prior post, the Sixth Circuit in Whirlpool v. Commissioner, 19 F.4th 944 (6th Cir. 2021), embraced phantom regulations. The court concluded that a statute that contemplated rules applying “under regulations” could operate regardless of whether regulations had been issued under the statute. Though in Whirlpool the Treasury had issued regulations relevant to the dispute, the court ignored them and decided the case based on its own beliefs of what the regulations should say (i.e., the court applied phantom regulations).

In June, Whirlpool filed a petition for certiorari. The Solicitor General recently filed her brief in opposition. Somewhat surprisingly, she has embraced phantom tax regulations.

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Whirlpool involves a complex statutory regime relating to U.S. corporations and their foreign business activities. However, one only needs to understand the basics to appreciate the significant administrative law issue raised by the case. A provision in the tax code, Section 954(d)(2), contemplates that a U.S. company may conduct foreign operations directly (i.e., through a branch) rather than through a separate subsidiary. The statute further contemplates that using a branch rather than a subsidiary may generate tax benefits for the U.S. company. If a U.S. company’s arrangements reveal these elements—that is, if the U.S. company (1) uses a branch and (2) would get tax benefits from using that branch—then, “under regulations prescribed by the Secretary,” the branch will be treated like a subsidiary. This means the U.S. company would lose out on its tax benefits. 

Section 954(d)(2)’s structure seems quite clear: If two conditions are met then, “under regulations,” claimed tax benefits may be denied. In Whirlpool, the Solicitor General maintains that the statute does not require regulations to operate. That is, to the Solicitor General, the statute exhibits a “self-executing nature.” Brief at 14. Though the Solicitor General acknowledges “Congress does sometimes ‘expressly condition’ the operation of a statute on agency regulations,” she claims that Congress has not done so under Section 954(d)(2).  One must wonder what words the Solicitor General would have wanted Congress to use here. Section 954(d)(2) covers complex material but any English speaker can understand its structure. If two conditions are met, regulations will prescribe a result. If someone were told that she faced consequences “under the law,” she would quite naturally assume that the law must be examined to determine those consequences.

To varying degrees, the Solicitor General, the Sixth Circuit, and the Tax Court claim that Section 954(d)(2)’s “literal” language independently mandates the denial of tax benefits. See Brief at 13-14. But by “literal” language, they mean Section 954(d)(2)’s language, shorn of its reference to regulations. They do not use “literal” literally.

The allegedly literal approach to Section 954(d)(2) becomes even more confounding when one sees how the government interprets “under regulations” in other contexts. In IRS Chief Counsel Adv. 201009013, the taxpayer attempted to claim tax benefits under Section 336(e). Section 336(e), like Section 954(d)(2), states that tax consequences will proceed “[u]nder regulations prescribed by the Secretary.” But unlike Section 954(d)(2), Section 336(e) prescribes favorable tax consequences. In this context, IRS Chief Counsel personnel found that the statute could not apply until regulations were issued, and that the taxpayer’s claim should fail. See also Regulations Enabling Elections for Certain Transactions Under Section 336(e), T.D. 9619, 78 Fed. Reg. 28467 (May 15, 2013) (regulations “permit” taxpayers to invoke Section 336(e) only as of the specified effective date). The government somehow believes that the phrase “under regulations” must be observed in Section 336(e) but ignored in Section 954(d)(2).

If the Supreme Court granted certiorari in Whirlpool, it likely would not bless the government’s opportunistic approach to statutory interpretation. Instead, the Supreme Court would remand the case to the Sixth Circuit. That court simply ignored the regulations issued under Section 954(d)(2). The Supreme Court would likely direct the Sixth Circuit to examine whether and how the regulations affected Whirlpool’s claimed tax benefits. Section 954(d)(2) alone could not dictate the result.

Possibly sensing a remand, and to discourage further review, the Solicitor General claims that the Sixth Circuit made a “statute-specific holding.” Brief at 16. That claim is true, in the sense that courts always reach holdings specific to the statutes in front of them. But there is nothing terribly unique about a statute that contemplates results “under regulations” prescribed by an agency. Statutes in that form pervade the United States Code. In that sense, Whirlpool is hardly “specific.” Instead, it raises tensions with the various Supreme Court and circuit court decisions that say references to regulations mean precisely what they say. See Grewal, Substance Over Form? Phantom Regulations and the Internal Revenue Code, 7 Houston Bus. & Tax J. 42 (2006). As always, whether the Court will grant certiorari remains unpredictable. The Solicitor General’s brief does a perhaps admirable job in opposing certiorari. It takes a relatively straightforward question presented and makes it appear wildly impenetrable, which discourages review. However, even if the Court does not now grant certiorari, issues over phantom regulations demand eventual clarification. As the last four decades have shown, the lower courts’ inconsistent and haphazard approach to them has yielded substantial confusion over numerous major areas of federal tax law. 

Filed Under: Regulations Tagged With:

When Regulatory and Sub-Regulatory Guidance Collides… (Part Two)

September 7, 2022 by 3 Comments

My previous post covered the curious case of IRS Notice 2006-68 and it’s (seemingly) direct contradiction of Treasury Regulation § 301.7122-1(h). As I’ve covered before (here, here and here), IRS Notice 2006-68 takes an extremely taxpayer unfriendly (and I believe substantively wrong) interpretation of the “deemed acceptance” rule of IRC § 7122(f).

It turns out IRS Notice 2006-68 also takes a rather taxpayer unfriendly interpretation of whether taxpayers may be entitled to a return of payments they submit with an Offer in Compromise that is returned or rejected. The rule used to be “you get the money back, because it is a deposit.” Indeed, that is arguably still the rule under the Treasury Regulation… but not under the Notice that came later, when the underlying statute was changed in TIPRA. What controls?

I would say a very strong case exists for challenging Notice 2006-68, should someone find their way into court on it (which as a jurisdictional matter would be done most easily through Collection Due Process, as I’ve suggested here). Let’s look at why it is susceptible to challenge…

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Three Reasons Why Notice 2006-68 Is Unpersuasive Under Admin Law Principles

First Reason: An Agency Can Only Amend a Final Regulation Through Proper Procedures

As far as I can tell, it is an uncontroversial proposition that an agency can only amend a final rule through new rulemaking. See Columbia Falls Aluminum Co. v. E.P.A., 139 F.3d 914, 919 (D.C. Cir. 1998) and Sierra Club v. E.P.A., 755 F.3d 968, 977 (D.C. Cir. 2014).

In this instance, there is a final rule (specifically, the Treasury Regulation) that unambiguously says payments made with an Offer that is withdrawn or returned are refundable deposits. If the Treasury wants to change this rule they are free to do so… but only if they follow the proper procedures. This flows pretty clearly from the APA: specifically, 5 § 551(5) which includes “amending or repealing” a rule as an act of “rule-making” and 5 § 553 which requires notice and comment for the rulemaking at issue here.

As it stands, it appears that the final rule (Treas Reg. § 301.7122-1(h)) was amended through Notice 2006-68 -how else to explain the direct contradiction in treatment of payments sent with Offers? But Notice 2006-68 did not go through notice and comment… if anything, it acted as the notice for comments and never did anything after that.

This is a problem for Notice 2006-68. But perhaps not an insurmountable one. Maybe, the argument goes, Notice 2006-68 isn’t amending the Treasury Regulation because it is addressing an entirely different issue -the TIPRA payments are qualitatively different than the “sums submitted with an Offer in Compromise” referred to in the regulation…

Second Reason: The IRS Is Bound to Its Regulations

Hopefully I didn’t set up a straw-man argument, but the idea that Notice 2006-68 can ignore the regulation because the TIPRA language came after the regulation is a tough one for me to swallow. Yes, the Treasury Regulations predate the specific TIPRA language. But does that change the fact that the Treasury Regulations unambiguously addresses “sums submitted with an offer in compromise,” which is exactly what TIPRA payments are?

I don’t think the IRS can just ignore its regulation on that point. Note that the TIPRA statute is ambiguous, and could reasonably allow for TIPRA payments to be treated as deposits. This isn’t an instance of a later statute directly changing the law underpinning an earlier regulation. There is an argument that under the “Accardi Doctrine” (so named for the Supreme Court case) the IRS has to follow the regulation.

Judge Holmes has discussed the Accardi Doctrine in an interesting order I blogged on before, and frankly I think the time is nigh for it to step into the limelight in (non-criminal) tax controversy.

The crux of Accardi is that agencies have to follow their own “rules” when individual rights would be affected if they deviated from them. The rules the agency must follow sometimes include sub-regulatory guidance, but always include “legislative” regulations. Which, as a matter of fact, Treas. Reg. § 301.7122-1(h) would be. Sounds to me like the IRS has to follow the Treasury Regulation, at least so long as it can be said to “affect individual rights” by failing to return the TIPRA payments on non-processed Offers.

I’ve also read some Accardi adjacent (non-tax cases) that quote the Supreme Court case of Morton v. Ruiz, 415 U.S. 199 (1974) for the proposition that where “the rights of individuals are affected, it is incumbent upon agencies to follow their own procedures.” That case is particularly interesting in the context of Notice 2006-68, since it involved an agency (the Bureau of Indian Affairs) trying to restrict payments to certain individuals through sub-regulatory guidance (an internal manual) rather than publishing in the Federal Register (which was supposed to be their practice). The Supreme Court was not impressed with this attempted end-run around the APA…

Third Reason: No Deference Under Auer/Seminole Rock

At the end of the day, practitioners just want to know how much the Court is going to persuaded or “bound” by the agency interpretation. (At least in litigation… but litigation isn’t easy to come by in tax collection issues. I will cover more on that and why Notice 2006-68 is so toxic as a non-litigated issue in a following post.)

Should a challenge to Notice 2006-68 ever actually make it to a judge, the court should find that it’s interpretations of the statute are not entitled to much, if any, real deference. The general rule is that sub-regulatory guidance gets Skidmore deference. (A point made in the Feigh case I argued and blogged on.) I often call this “worthless” deference, because it frequently isn’t much more than the deference that IRS Counsel gets for making a good point on a brief -the court isn’t really “deferring” to that good point, it is just being persuaded by its own force of reasoning.

To the extent that the IRS would want to “shoehorn” Notice 2006-68 into some level of deference “above” Skidmore, its only real option is Auer deference: the level of deference agencies can sometimes be given on their interpretation of their own regulations. But even if the IRS changed course and decided to actually argue for Auer deference (it has a policy of not doing so) that wouldn’t work in this instance.

The Supreme Court does not defer to an agency interpretation of a regulation when the regulation itself is not ambiguous. The reason why makes good sense, so I’ll go ahead and quote the Supreme Court on it: “To defer to the agency’s position would be to permit the agency, under the guise of interpreting a regulation, to create de facto a new regulation.” Christensen v. Harris County, 529 U.S. 576, 588 (2000). In other words, it would give the agency an end-run around their need to go through notice and comment to amend a final regulation.

The regulation on point is blessedly unambiguous. There is no way the IRS could argue that Notice 2006-68 is merely an interpretation of it. So no Auer deference. And probably no deference at all.

…And Yet It Persisted.

I’ve laid out a lot of reasons why Notice 2006-68 is susceptible to serious challenges, both for its interpretation of IRC § 7122(f) and its denial of TIPRA payments as deposits. I think it is largely indefensible on its interpretation of the statutory language, and clearly problematic as sub-regulatory guidance masquerading as a legislative rule.

Yet the fact remains that Notice 2006-68 is celebrating its 16th birthday, essentially unscathed, after affecting likely tens-of-thousands of taxpayers. Why might that be? Are my arguments just nonsense?

Perhaps. Nonetheless, in an eventual follow-up post I’ll go into why I really think Notice 2006-68 has survived without challenge, why it is a problem we need to fix, and why it is a good example of the checks we need on agency rulemaking in the tax world.

Filed Under: Offer in Compromise, Regulations

When Regulatory and Sub-Regulatory Guidance Collides… (Part One)

September 6, 2022 by Leave a Comment

Being tasked with “administering” the Internal Revenue Code is no easy job. Congress sometimes makes it even more difficult by having the IRS distribute direct payments (like the Economic Impact Payments (EIPs)) or by changing the law when filing season has already started (for example, by excluding unemployment benefits from income). Notice and comment rule-making takes time, and sometimes the IRS relies on the “quick guidance” that can be delivered through online FAQs or other sub-regulatory means.

While understandable as an interim action (really, just letting people know what the IRS “thinks” about the statute, but without force of law) it is problematic when “rights and obligations” flow from the guidance -believe it or not, sometimes the guidance is not well rooted in the statute (see posts on the incarcerated individuals and the EIP here, here and here).

It is similarly problematic when the quick guidance subtly morphs from temporary to permanent after years of inaction on finalizing regulations. And it is even more problematic (dare I say, inexcusable) when that quick guidance directly contradicts prior (still valid) notice and comment regulation. To hear more about one such instance that many PT readers have likely encountered without even realizing it, you’ll need to…

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Dream with me, if you will, of an individual that currently makes $35,000 but can’t afford to pay their back taxes. They used to work as an Uber driver where they were hammered with SE taxes. They’ve since become an employee, but they have virtually no disposable income. They submit an Offer in Compromise proposing to pay a $1,000 “lump-sum” to settle the back taxes. Per the Offer instructions, the individual includes $200 as a 20% payment on the Offer, as well as a $205 application fee.

Time passes. Months later, this individual gets a letter returning the Offer as “non-processible” because they have not made required quarterly tax payments. Oh, and on top of that, the $405 they sent in is not coming back.

Now this individual is in your office, regaling you with this tale of woe. You want to help them at least get back the 20% payment. You look at the Treasury Regulation (301.7122-1(h)) on point. Your eyes light up:

Sums submitted with an offer to compromise a liability […] are considered deposits and will not be applied to the liability until the offer is accepted[.] If an offer […]is determined to be nonprocessable […] any amount tendered with the offer, including all installments paid on the offer, will be refunded without interest.

You recall from your law school years that Treasury Regulations are basically the highest authority of agency rulemaking. Good as gold! Your client is getting the 20% payment back, right?

And yet you’ve grown so cynical over the years you doubt yourself: if the answer is so obvious, why is your client even here? You look over the IRS Form 656 that your client submitted. Under Section 7, Offer Terms, it reads:

(h) The IRS will keep any payments that I make related to this offer. I agree that any funds submitted with this offer will be treated as a payment. I also agree that any funds submitted with periodic payments made after the submission of this offer and prior to the acceptance, rejection, or return of this offer will be treated as payments.

You wonder why the IRS Form would include terms that seem to go against their own regulations. So you continue digging…

It turns out the regulations you were so thrilled with are a bit dated. The 20% payment requirement at issue was added as part of TIPRA in 2006 and the Offer regulations are from 2002.

Fortunately, in lieu of updated regulations there is an IRS Notice on point.

Unfortunately, that IRS Notice is IRS Notice 2006-68.

Yes, that same IRS Notice 2006-68 that I lambasted in no less than three separate posts. It is here again to haunt you. In relevant part, the Notice reads:

The Service will treat the required 20-percent payment as a payment of tax, rather than a refundable deposit under section 7809(b) or Treas. Reg. § 301.7122-1(h).

There you have it. The Treasury Regulation clearly says money sent with an Offer is a deposit. The Notice clearly says, “not so, if it is part of the 20% payment.”

We are now at the title of this post: When regulations and sub-regulatory guidance collide, which one controls?

A Look to the Statute Before We Look to Admin Law

If the statute is clear about how to treat the payments than it shouldn’t really matter what the regulatory or sub-regulatory guidance says. The problem is when the statutory language is unclear, and there is at least some room for interpretation delegated to the agency.

And that is what we have here. To me, this is a “clearly unclear” statute.

We know that a 20% payment is (generally) required to accompany an Offer. Per IRC § 7122(c)(1)(A)(i) “In General- The submission of any lump-sum offer-in-compromise shall be accompanied by the payment of 20 percent of the amount of such offer.”

But our question is whether you can get that payment back, not whether you must submit a payment in the first place. Is the payment a deposit towards the Offer, or a payment towards the underlying tax? TIPRA doesn’t quite address this, though it does provide some more guidance. Per IRC § 7122(c)(2)(A):

Use of payment- The application of any payment made under this subsection to the assessed tax or other amounts imposed under this title with respect to such tax may be specified by the taxpayer.

There is a comfortable amount of wiggle room in this otherwise dry language.

The taxpayer gets to specify the “application” of the 20% payment towards “assessed tax or other amounts imposed under this title.” If it just read “assessed tax” that would be much clearer and reasonably read as limited to designating among the assessed taxes comprising the Offer. But the very broad phrase “other amounts imposed under this title” seems to leave the door open. Is the “TIPRA” payment an amount imposed under this title? 

Note also that the statute does not say that all payments “must” be applied towards “assessed tax or other amounts imposed under this title.” It merely says that when such payments are applied, the taxpayer gets to choose how they are applied. This says literally nothing about if a returned, non-processed offer must have the payment applied to assessed taxes. That is an IRS (not Treasury) interpretation only.

You won’t find much illumination in the legislative history, though I would suggest that if anything it cuts against the IRS Notice 2006-68 interpretation. The Conference Report distinguishes the “user fee” from the “partial payment” by saying that the user fee “must be applied” to the tax liability. But it is silent as to whether the “partial payment” must be. In other words, it creates more ambiguity on the issue rather than resolves it.

Fundamentally, the question remains about the required 20% payment. Is it always a payment towards tax (non-refundable), or might it sometimes be a payment towards the Offer (potentially refundable)?

At present, all we have are the thoughts of IRS Counsel as memorialized in Notice 2006-68. Without further going into depth on the merits of its interpretation, it is time to turn to the admin law question: what about the fact that Notice 2006-68 seems to be contradicted by an actual, still enforceable, Treasury Regulation?

Let’s look to the admin law authorities… in our next post.

Filed Under: Deposits, Offer in Compromise, Regulations

What Is A Preamble Worth?

January 18, 2021 by 4 Comments

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.

Filed Under: Administrative Procedure Act (APA), Regulations Tagged With:

Consistency and the Validity of Regulations

October 9, 2020 by 3 Comments

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? 

Filed Under: Administrative Procedure Act (APA), Regulations

Conservation Easement Donation and the Validity of Tax Regulations

May 15, 2020 by 1 Comment

Monte Jackel returns to discuss the Tax Court’s latest attempt at squaring the APA and the tax regulation process. Les

In Oakbrook Land Holdings LLC (154 T.C. No. 10, May 12, 2020), the Tax Court, in a reviewed opinion, upheld the validity of a Treasury regulation (reg. §1.170A-14(g)(6)) issued under section 170 of the Code relating to conservation easement donations and the perpetuity requirement. A concurrently issued memorandum opinion issued the same day (T.C. Memo 2020-54) had held that if the regulation was valid, the taxpayer was in violation of it. 

At issue in the opinion was the validity of the regulation at issue. This commentary focuses its attention on the requirement of the Administrative Procedure Act (APA) that a “legislative rule” contain a concise statement of the basis and purpose of the proposed rule. The Chevron doctrine, also addressed by the court, is not discussed here. 

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The majority opinion first stated that the regulation at issue was a legislative rule and not an interpretative one because it set forth a substantive requirement (sharing of proceeds if easement terminated) that was not set forth in the statute and which, if violated, would cause loss of the deduction. 

Underlying this conclusion was the majority’s view of a legislative rule:

“Administrative law distinguishes between interpretive and legislative agency rules. “An interpretive rule merely clarifies or explains preexisting substantive law or regulations….A legislative rule, on the other hand, “creates rights, assigns duties, or imposes obligations, the basic tenor of which is not already outlined in the law itself.”…Legislative rules have “the force and effect of law.”….

The majority then turned to the APA that sets forth the notice and comment requirement for legislative rules:

“Legislative rules are subject to APA notice-and-comment rulemaking procedures. See 5 U.S.C. sec. 553(b)…To issue a legislative regulation consistently with the APA an agency must: (1) publish a notice of proposed rulemaking in the Federal Register; (2) provide “interested persons an opportunity to participate…through submission of written data, views, or arguments”; and (3) “[a]fter consideration of the relevant matter presented,…incorporate in the rules adopted a concise general statement of their basis and purpose.” See 5 U.S.C. sec. 553(b) and (c).”

It was the third requirement that was in dispute in the case (the “concise general statement of basis and purpose requirement”). The majority opinion concluded that the concise general statement of basis and purpose requirement was satisfied in this case. 

“The APA provides that a reviewing court shall set aside agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 U.S.C. sec. 706(2)(a). The scope of our review “is a narrow one” because “[t]he court is not empowered to substitute its judgment for that of the agency.”…We consider only whether the agency “articulate[d] a satisfactory explanation for its action.”…. While we cannot provide a reasoned basis for agency action that the agency itself did not supply, we will “uphold a decision of less than ideal clarity if the agency’s path may reasonably be discerned.”….“So long as an agency’s rationale can reasonably be discerned and that rationale coincides with the agency’s authority and obligations under the relevant statute, a reviewing court may not ‘broadly require an agency to consider all policy alternatives in reaching decision.’” …Indeed, “regulations with no statement of basis and purpose have been upheld where the basis and purpose w[ere] considered obvious.”….

The majority concluded that this test had been met even though the final regulation preamble did not specifically address the comment that pertained specifically to the regulation provision at issue. This was so principally because the point raised in the comments was only one comment out of many submitted and that specific comment did not fully address the provision at issue and alternatives to what was proposed. The majority stated:

“[A]n agency cannot reasonably be expected to address every comment it received. The APA “has never been interpreted to require the agency to respond to every comment, or to analyze every issue or alternative raised by the comments, no matter how insubstantial.” …“We do not expect the agency to discuss every item of fact or opinion included in the submissions made to it.” …“An agency need not respond to every comment.”…. In any event, “[t]he administrative record reflects that no substantive alternatives to the final rules were presented for Treasury’s consideration.” …“A comment is * * * more likely to be significant if the commenter suggests a remedy for the purported problem it identifies.”…. The APA requires “consideration of the relevant matter presented” during the rulemaking process. 5 U.S.C. sec. 553(c). 

The majority then laid out the reasons for denying the assertion of an APA violation:

“Our review of the administrative record leaves us with no doubt that Treasury considered the relevant matter presented to it…. And we find equally little merit in petitioner’s assertion that Treasury failed to “incorporate in the rules adopted a concise general statement of their basis and purpose.” See 5 U.S.C. sec. 553(c)…. No court has ever construed the APA to mandate that an agency explain the basis and purpose of each individual component of a regulation separately. “[T]he detail required in a statement of basis and purpose depends on the subject of the regulation and the nature of the comments received.” …This statement need only “contain sufficient information to allow a court to exercise judicial review.”….

There was also a concurring opinion and a dissenting opinion in the case. 

The concurring opinion, among other issues, separately addressed the APA procedural point. After concluding that the text of the statute precluded the deduction, the concurring opinion nevertheless set forth its views on both Chevron and the APA. 

On the latter point, which is the focus of this commentary, the concurrence states:

“Treasury might not have found itself in this predicament under Chevron if it had followed more carefully the APA’s procedural requirements, which are designed to help agencies consider exactly this type of issue before a rule becomes final. 

And then came the dissenting opinion. The dissent, as one would expect, disagreed with the majority’s reasoning on the APA procedural point. It states:

“In today’s case, we hold that the Treasury Department gets to ignore basic principles of administrative law that require an agency “to give reasoned responses to all significant comments in a rulemaking proceeding.” ….A court is supposed to ensure that an agency has taken “a ‘hard look’ at all relevant issues and considered reasonable alternatives.”…But if the majority is right, the Treasury Department can get by with the administrative-state equivalent of a quiet shrug, a knowing wink, and a silent fleeting glance from across a crowded room…. [T]he majority, I fear, has missed the main root of [the taxpayer’s] argument–that at the time of the regulation’s promulgation, commenters made significant comments, and Treasury failed to address them in its statement of the regulation’s basis and purpose…. The Final Rule’s statement of basis and purpose shows absolutely no mention of the [regulation provision at issue]–and no reasoned response to any of the public’s comments on those provisions…. 

The dissent then zeroed in on its objections to the conclusions of the majority:

“[W]hile we don’t demand a perfect explanation for Treasury’s decisionmaking, …we should demand some,… And here, there wasn’t any….. [T]he analysis shouldn’t stop there–what is the nature of a comment that triggers an agency’s obligation to respond? The caselaw tells us to look at a comment’s significance. Agencies must “give reasoned responses to all significant comments in a rulemaking proceeding.”….This is because “the opportunity to comment is meaningless unless the agency responds to significant points raised by the public.”….“It is not in keeping with the rational process [of APA section 553(c)] to leave vital questions, raised by comments which are of cogent materiality, completely unanswered”). So, though an agency doesn’t have to respond to all comments, it must respond to all significant comments.

The dissent then cites a series of Treasury decisions that, as a matter of fact, make the same statement that “all comments were considered” or words of similar import. But, as the dissent states, “the APA,…has no provision for agencies to use ritual incantations to ward off judicial review.” 

Where does this take us? This case shows that the Treasury and IRS need to pay more attention as to (1) what is a legislative rule as compared to an interpretative rule, and (2) has it considered all “significant” public comments and fully addressed them in the final rule. 

And for commenters to regulations, this case seems to indicate that a comment letter should state that the issue is material, fully discuss the issue, and propose a practical alternative if one is available.

All of this is clearly an area to watch in the near future.

Filed Under: Administrative Procedure Act (APA), Regulations Tagged With:

Invalidating an IRS Notice: Lessons and What’s to Come from Feigh v. C.I.R.

June 17, 2019 by 26 Comments

A few weeks ago, the United States Tax Court decided Feigh v. Commissioner, 152 T.C. No. 15 (2019): a precedential opinion on a novel issue involving the Earned Income Tax Credit (EITC) and its interplay with an IRS Notice (Notice 2014-7). The petitioners in the case just so happened to be represented by my clinic, and the case just so happened to be a A Law Student’s Dream: fully stipulated (no pesky issues of fact), and essentially a single (and novel) legal issue. Because the opinion will affect a large number of taxpayers, I commend those working in low-income tax to read it. What I hope to do in this blog post is give a little inside-baseball on the case and, in keeping with the theme of this blog, tie it in a bit with procedural issues.

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Posture of the Case

I frequently sing the praises of Tax Court judges in working with pro se taxpayers. This case provides yet another example. My clinic received a call from the petitioners less than a week before calendar. Apparently, the Tax Court (specifically Judge Goeke) had recognized that this was a novel issue of law and suggested to the low-income, pro se petitioners that they may benefit from contacting a Low-Income Taxpayer Clinic for help with the briefing.

By the time the client contacted me (again, only a few days before calendar) the IRS had moved for the case to be submitted fully stipulated under Rule 122. The Court had not yet ruled on the motion but I mostly found the stipulations unobjectionable (with one minor change, which the IRS graciously did not object to). Rather, what concerned me was the fact that it was designated as an “S-Case.” I wanted this case to be precedential, and I wanted to be able to appeal –neither of which are possible for S-Cases. See IRC § 7463(b). Yes, the Court can remove the designation in its own discretion (see post here), but I didn’t want to leave anything to chance. After consulting with my clients the first order of business was to move to have the S designation removed -which again saw no objection from the IRS. Now the table was set for briefing on the novel issue.

What’s At Issue?

I’m going to try hard not to dwell on the substantive legal issues in this case, important though they are. Nevertheless, an ever-so-brief primer on what was going on is necessary.

Our client (husband and wife) received Medicaid Waiver Payments for the services the wife provided to her disabled (non-foster) child. From conversations with local VITA organizations I already anecdotally knew that some people received these payments, but since taking this case on I have come to appreciate exactly how vast the Medicaid Waiver program is. For our client, the Medicaid Waiver Payments were made in the form of rather meager wages (a little over $7,000) that were subject (rightly or wrongly) to FICA. They were the only wages my clients had. When my clients went to file their income tax return, however, it looked like they were getting a fairly raw deal: namely, missing out on an EITC and Child Tax Credits cumulatively worth almost $4,000. Why? Because in 2014 the IRS decided that these Medicaid Waiver Payments were excluded from income as IRC § 131 “Foster Care” payments.

An exclusion from income sounds to most taxpayers like a good thing: it’s always better to have less taxable income, right? But the tax code is a complicated animal, and for lower-income taxpayers the exclusion of wages was actually a curse: to be considered “earned income” for both the EITC and Child Tax Credit (CTC), wages must be “includible” in income. By the IRS’s logic, this meant that you must exclude your $7,000 Medicaid Waiver Payment (with a tax benefit of $0 in some cases) and couldn’t thereafter “double-benefit” by also getting the EITC/CTC for those excluded wages.

It doesn’t quite seem fair for those who saw little or no tax benefit from the exclusion.

It seems even less fair when you consider that those who would actually phase out of the EITC (say, by receiving a large Medicaid Waiver Payment over $52,000, which has happened) not only would get a larger tax benefit from the exclusion, but could still potentially get the EITC if they had other wages (say, from the other spouse). Theoretically, a couple making $100,000 could get the EITC in this case if the greater portion of the income were Medicaid Waiver Payments. This would be the case because such payments would be disregarded for EITC eligibility calculation altogether. Probably not what Congress (or even the IRS) had in mind.

My clients felt like they should do something about this unfairness. So they did: they took both the exclusion of IRS Notice 2014-7 and the EITC based on the excluded wages. This of course led to a notice of deficiency and culminated in the precedential Feigh decision.

Our Legal Arguments

Because of our client’s novel stance, we had two points we had to make for our client to win: (1) that the wages could be included in income, and (2) basically, that was it. We wanted to make it a simple statutory argument: If the wages could be included, then they were “includible,” and that was all that was required of the EITC under IRC § 32(c)(2)(A)(i).

As to the first point -whether the payments could (maybe, should) be “included” in income- history was on our side. Prior to 2014 courts and the IRS agreed that such payments had to be included in income. Payments for adopted or biological children clearly did not meet the statutory language of excluded “Foster Care Payments” under IRC § 131. The only thing that changed in the intervening years was the IRS issuance of Notice 2014-7: there was no “statutory, regulatory, or judicial authority” that could anchor the change in treatment. As we argued, the IRS essentially transformed “earned income” into “unearned income” on its own. And that sort of change is a massive bridge too far through subregulatory guidance.

We won on that first issue handily. The Court noted that “IRS notices –as mere statements of the Commissioner’s position—lack the force of law.” Then, the Court applied Skidmore deference (see Skidmore v. Swift & Co., 323 U.S. 134 (1944)) to see whether the interpretation set forth by IRS Notice 2014-7 was persuasive.

It was not.

And the IRS could not, through the notice, “remove a statutory benefit provided by Congress” -like, say, eligibility for the EITC. That sort of thing has to be done through statute. For administrative law-hawks, the Tax Court reigning in the IRS’s attempts to rule-make without going through the proper procedures is probably the bigger win. (As an aside, I’m not entirely positive even a full notice-and-comment regulation could do what Notice 2014-7 tries to: I don’t think any amount of deference would allow a reading of IRC § 131 the way Notice 2014-7 does.)

So we cleared the first hurdle: the IRS can’t magically decree that what was once earned income is no more through the issuance of subregulatory guidance. But what of the second hurdle -the fact that our client undeniably did not include the wages in gross income?

Courts have (rightly) treated the terms “allowable” and “allowed” differently, as well as “excludible” vs. “excluded” in previous cases. The breakdown is that the suffix “able” means “capable of” whereas the suffix “ed” means “actually occurred.” See Lenz v. C.I.R., 101 T.C. 260 (1993). Coming into this case I was keenly aware of this distinction because of a law review article I read while writing a chapter on the EITC for Effectively Representing Your Client Before the IRS. Indeed, it was that aspect of the EITC statutory language (and not my familiarity with Notice 2014-7 or Medicaid Waiver Payments) which made me want to take this case from the beginning. I feel compelled to raise the value of that law review article (James Maule, “No Thanks, Uncle Sam, You Can Keep Your Tax Break,”) because so many law professors joke that no one reads law review articles, or that most articles are impractical (no comment on the latter).

Consistently with the distinction of “allowed” vs. “allowable,” the Court has previously ruled on the nuance of “included” vs. “includible.” See Venture Funding, Ltd. v. C.I.R., 110 T.C. No. 19 (1998). “Included” means it was reported as income, “includible” means that it could/should be reported in income. Since the Tax Court already found that we met the first hurdle (our client could include the payments in income and Notice 2014-7 can’t take that away), we were in the clear: it was “includible.”

And so our client has excluded income and the earned income credit derived from it… Impermissible double-benefit, you (and the IRS brief) say?

I disagree. Not only does treating excluded payments as earned income apply the statutory language correctly, and more in line with what Congress would want, I contend that it is the better way to protect the integrity of the EITC. To see why this is you have to look again at how the EITC is calculated, and how the phase-out applies. In so doing we see that the real problem would be in disregarding excluded income altogether.

The Integrity of the EITC

The EITC is means tested, but it calculates the taxpayers means through two separate numbers: (1) “earned income” and (2) “adjusted gross income (AGI).” See IRC § 32(a)(2) and (f).  Excluded income isn’t reflected in AGI, so people with high amounts of excluded income might escape the AGI means testing prong of the EITC -unless the excluded income is specifically caught through other IRC 32 provisions like limits on investment income or foreign income exclusions. (Note that excluded alimony payments post TCJA would not be incorporated in the means testing.)

However, if excluded income like Medicaid waiver payments is considered “earned income” (that is, if we don’t require that earned income be “included”) then people with large amounts of excluded earned income do begin to phase out under the “earned income” means testing prong. In other words, it more appropriately reserves the credit only for those who working and are (truly) of limited means, while denying it to those who (truly) are not. I think Congress would approve. I’d also note that the exclusion is necessarily worth more to higher income earners than to lower-income earners -and frequently worthless to EITC recipients, many of whom may not actually have a tax liability at all (thus providing a $0 benefit to the exclusion).

Finally, I’d note (and did in the brief) that Congress has essentially addressed this problem of excluded earned income before -only with non-taxable Combat Pay. A little history is helpful on that point.

For the majority of the EITC’s existence (from 1978 to 2001), earned income actually didn’t have to be “includible” in gross income. Then, in an effort to make the credit easier to compute (not an effort to limit eligibility), Congress added the includible requirement as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. Mostly, Congress made this change because it wanted information returns to give taxpayers (and the IRS) all the information needed for calculating the EITC.

Unfortunately, this meant that active duty soldiers receiving combat pay (which is a mandatory statutory exclusion, and thus not “includible” under IRC § 112) could not treat that pay as qualifying for the EITC. A GAO report noted that this was likely an unintended consequence (see page 2), that accrued the bulk of the benefits to those that made the most money. The Congressional fix was IRC § 32(c)(2)(B)(vi), which allows taxpayers to “elect” to treat excluded combat pay as earned income (it still isn’t taxed). Congress had to make this change to fix an unintended consequence of their own (statutory) making. However, it would be absurd (we argued) to require Congress to fix an unintended consequence wholly created by the IRS through Notice 2014-7.

What Happens Next?

I’ve been in contact with the local VITA providers in my community that see Medicaid Waiver Payments on the front lines -apparently fairly frequently. Their main question is a practical one: what do we tell taxpayers now? The IRS VITA guidance before had been “you can’t get credit for those payments towards the EITC.” In the aftermath of Feigh, can they both exclude and get credit now (as my client did)?

That is an excellent question, which brings up some excellent procedural issues (finally: I promised I’d get to them). The main issue is whether the IRS may now consider Notice 2014-7 completely moribund, such that there is no exclusion period and the Medicaid Waiver Payments must be included. The Court noted that the IRS did not raise the argument that the payments should be includible in income for my client, so it was conceded. But is the IRS stuck with that position now? Can the IRS take a position that is contrary to its own published guidance? What if that guidance is essentially invalidated?

The best case on point for this sort of situation may be Rauenhorst v. Commissioner, 119 T.C. 157 (2002). In that case, the IRS essentially said it wasn’t bound by its own guidance (in that instance in the form of a Revenue Ruling) when the Commissioner took a litigating position directly contrary to it. After receiving something of a slap-down from the Tax Court, the IRS issued Chief Counsel Notice CC-2003-014 (sorry, I couldn’t find any free links), which provided that “Chief Counsel attorneys may not argue contrary to final guidance.” Final guidance includes “IRB notices” (i.e. notices that are published in the Internal Revenue Bulletin), which Notice 2014-7 was.

Further, it does not appear to matter that Feigh essentially invalidated Notice 2014-7. The Chief Counsel Notice specifically includes a section headed “Case law invalidating or disagreeing with the Service’s published guidance does not alter” the rule that Chief Counsel shouldn’t take a contrary position that is unfriendly to taxpayers. In other words, so long as IRS Counsel follows the CC Notice, they should continue to let taxpayers exclude the Medicaid Waiver Payments… And since they’ve already lost on whether those excluded payments are earned income, it is perhaps best of both worlds for taxpayers moving forwards.


Perhaps. But I’m not sure I’d bet the farm on the IRS following the Chief Counsel’s Notice in all cases (and especially for taxpayers working with IRS agents or appeals, rather than Counsel).

But the final procedural point I want to make takes the long-view of things: which is that this never should have happened in the first place, because the IRS never should have overstepped its powers by issuing Notice 2014-7 masquerading as substantive law without, at the very least, following the rigorous notice and comment procedures required of substantive regulations. Had the IRS done so the tax community could well have seen this before the regulation was finalized and it could have been addressed. This may echo from my soapbox, but Notice 2014-7 undoubtedly caused real harm to some of the most vulnerable taxpayers. I know from conversations in the tax community that many low-income earners lost out on a credit they rightfully deserved. I don’t think for a second that was the intention of the IRS when they issued Notice 2014-7. Nor does Judge Goeke in the opinion (see footnote 7).

But, again, tax is a complicated animal: legislating new rules should not be done lightly. Procedure, in other words, matters.

Filed Under: Regulations

Ninth Circuit Reconsideration in Altera v. Commissioner

October 23, 2018 by 2 Comments

We welcome back guest blogger Stu Bassin. Stu has blogged with us on several occasions. He is a practitioner based in DC with an extensive controversy practice and provided a discussion of the Altera case earlier here. Les

Last week bought the latest twist in the saga of a challenge to a critical transfer pricing regulation—a rehearing by the Ninth Circuit of a since-vacated ruling upholding the regulation. The original unanimous reviewed decision by the Tax Court in Altera Corp. v. Commissioner, 145 T.C., No. 3 (2015), invalidated the regulation. A divided panel in the Ninth Circuit reversed, upholding the validity of the regulation over a strong dissent. The majority opinion was soon vacated and the case was reargued on October 16, 2018. Given the importance of the specific regulation at issue in transfer pricing cases, as well as the continuing discussion regarding questions concerning Administrative Procedure Act challenges to IRS regulations, the reargument has generated substantial attention in the tax community.

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The underlying dispute involves a cost-sharing agreement governing allocation of stock-based compensation costs between entities related to the taxpayer and invocation by the IRS of Section 482 to recharacterize the terms of that agreement. Section 482 provides:

In any case of two or more organizations . . . owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

The taxpayer relied upon the undisputed fact that the terms of its cost-sharing agreement were consistent with the prices which unrelated parties would employ in comparable arms-length agreements, thereby satisfying the legal standard historically applied in evaluating cost-sharing agreements under Section 482. The IRS recharacterized the terms of the agreement, relying upon a regulation which specifically required affiliates to share stock-based compensation costs in a manner “commensurate with the income attributable to the intangible.” The taxpayer disagreed, contending that the regulation was invalid under the APA because it deviated from the comparable arms-length transaction test.

The Tax Court unanimously ruled in favor of the taxpayer, invalidating the regulation and rejecting the proposed Section 482 adjustment, focusing upon the second stage of the regulation validity inquiry mandated by Mayo Foundation v. United States, 562 U.S. 44 (2011) — whether the determinations reflected in the regulation were arbitrary and capricious. The opinion concluded that the regulation was invalid because the IRS failed to engage in actual fact-finding, failed to provide factual support for its determination that unrelated parties would share compensation costs in their cost-sharing agreements, failed to respond to significant comments, and acted contrary to the factual evidence before Treasury.

The IRS appeal to the Ninth Circuit was initially heard by a panel consisting of Chief Judge Thomas, Senior Judge Reinhardt, and Judge O’Malley of the Federal Circuit. Judge Thomas, joined by Judge Reinhardt, wrote the opinion for the court reversing the Tax Court opinion and upholding the validity of the regulation. He reasoned that the 1986 amendment of Section 482 (which added the language containing the “commensurate with income” standard) mandated that the IRS adopt regulations employing the commensurate with income standard in addition to the comparable arms-length transaction standard. Judge O’Malley dissented, urging invalidation of the regulation because it deviated from the arms-length standard.

Because the decisive vote was cast by Judge Reinhardt, who died after the argument and roughly 100 days before the opinion was issued. A footnote to the opinion states that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion prior to his death.” A procedural issue arose when Altera petitioned for rehearing. The remaining members of the panel were deadlocked, so the court withdrew the original opinion, assigned Circuit Judge Susan Graber (a Clinton appointee) to replace Judge Reinhardt on the panel, and scheduled the case for reargument last week.

At the argument, Judge Thomas was silent and Judge O’Malley appeared to reiterate the position stated in her dissent. So, all eyes focused upon Judge Graber, who was new to the panel and the likely decisive vote on the merits. She focused her inquiry upon statutory construction issues and the relationship between the historic standard of “comparable arms-length transactions” embodied in the first sentence of Section 482 and the “commensurate with income” standard embodied in the second sentence of Section 482. Noting that the statutory language of the second sentence applies only to “the income with respect to such transfer or license [of intangible property],” she questioned whether the cost sharing agreement was a “transfer or license” within the meaning of the statute. The taxpayer argued that its cost-sharing agreement was not a narrow “transfer or license” and that the second sentence’s “commensurate with income” standard was therefore inapplicable. In contrast, the government contended that the indirect role of the cost-sharing agreement in establishing the pricing on the arrangement between the two subsidiaries was sufficient to render the “commensurate with income” standard applicable and controlling.

Judge Graber also asked a series of questions focused upon reconciling the commensurate with income standard with the general requirement under Section 482 that the IRS must allocate costs in a manner consistent with the arms- length standard. The government argued that the legislative history reflects a congressional policy judgment and determination that, in those cases involving transfers of intangible property, only an allocation based upon the “commensurate with income” standard would satisfy the arms-length standard. The taxpayer countered by stating that the legislative history did not support such a construction and observed that, if the government’s construction were adopted, relatively few transactions would remain governed by the traditional arms-length standard.

Finally, Judge Graber inquired whether there was a factual basis or economic theory which supported the regulation’s finding that stock-based compensation costs must be allocated in a manner   commensurate with income to satisfy the arms-length standard. The taxpayer noted the absence of a factual record or economic theory supporting the IRS findings, arguing that the only evidence before the agency supported a finding that comparable arms-length transactions did not allocate stock-based compensation costs in the manner required by the IRS. In contrast, the government stated that such evidentiary support was not required to support the IRS determination.

Interestingly, the argument gave relatively little attention to the second stage of the Mayo analysis—the arbitrariness of the IRS determination. The degree of deference accorded regulations under Chevron was hardly discussed. Both sides and the court focused upon the statutory authority for the regulation. They all seemed to agree that, if the statute authorized the IRS to deviate from the arms-length standard, the regulation would survive.   Otherwise, the regulation was invalid.

The panel gave no indication of when it would render its decision. Full opinions on appeals to the Ninth Circuit tend to take a long time and the initial panel decision was not released until nine months after the argument. So, it seems likely that a decision will not be issued until early 2019.

 

Filed Under: Advanced Pricing, Regulations Tagged With:
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