What Type of Fruit is a Polar Bear? Petaluma and Interpretive Choice

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Today’s guest post is a return to the blog for Professor Andy Grewal of the University of Iowa College of Law who continues his discussion of novel issues raised in Petaluma FX Partners v. United States, a case on appeal in the DC Circuit Court of Appeals. Les

Two weeks ago,in TEFRA Jurisdiction and Sham Partnerships-Again? I wrote about how the Supreme Court’s resolution of the jurisdictional issue in United States v. Woods might not have resolved the jurisdictional issue in Petaluma. Today, I want to discuss the merits issue and show how the Court’s opinion also leaves that issue open.


In Woods, the Court held that the Section 6662 gross valuation misstatement penalty applies when a partnership is disregarded under the economic substance doctrine and a partner’s outside basis is consequently reduced to zero. In so holding, the Court focused on whether the reduction of the basis was “attributable to” a valuation misstatement, as required to trigger the penalty.   But the Court noted my argument (see pages 20-21 of my brief) that Treas. Reg. 1.6662-5(g), which extends the gross valuation misstatement penalty to zero basis circumstances, may be invalid. The taxpayer, however, chose not to embrace that argument, so the Court said it would assume the validity of the regulation for purposes of deciding the case.

In Petaluma, the taxpayer makes the argument that the Woods taxpayers did not. Petaluma squarely argues that the gross valuation misstatement penalty applies only when a taxpayer’s claimed basis is “400 percent or more” of the true basis, and the percent by which its claimed basis (about $25M) exceeds its true basis ($0) is undefined. Consequently, the statutory condition is not satisfied (“undefined” does not mean “400 percent or more”), and the Treasury regulation that simply treats zero basis circumstances as satisfying that standard is invalid.

Believe it or not, circuit precedent about “division by zero” actually supports the taxpayer’s position. See Lee’s Summit v. Surface Transp. Bd., 231 F. 3d 39, 41–42. But I’d like to skip the doctrinal analysis and address a more fundamental issue:   When does a statute give rise to ambiguity such that an agency’s interpretation merits deference?

To understand that issue, one must draw a distinction between nonsensical questions and ambiguous ones. Consider this question, for example:

What type of fruit is a polar bear?

This question is nonsensical. A polar bear is an animal, and it makes no sense to classify it as any type of fruit.

But this question is not ambiguous. There are no interpretive choices between, for example, classifying a polar bear as a banana as opposed to a peach. And if Congress passed a statute taxing the sales of bananas and peaches, a Treasury regulation that treated a polar bear as either one would be invalid.

Petaluma, of course, does not involve questions about Arctic beasts. Rather, the merits question asks:

Is the claimed $25M basis 400 percent or more of the true $0 basis?

Maybe it’s harder to see than in the question about polar bears and fruits, but this question makes no sense and consequently leaves no room for Treasury rulemaking authority. To determine what percent one number is of another number, one must divide the first number by the second number. So, for example, 5 is 500 percent of 1, because 5/1=5.00, and 12 is 300 percent of 4, because 12/4 = 3.00. But in Petaluma, one must divide by zero ($25M/0) to apply the statutory formula, and that makes no sense. You can explain to someone what it means to divide a pizza into ten pieces, but how do you explain what it means to divide a pizza into zero pieces?

When a statute, as applied to a particular set of factual circumstances, makes no sense, an administrative agency does not enjoy the authority to re-write the statute to reach those circumstances. The Treasury can no more fit zero-basis circumstances into the valuation misstatement penalty regime than can it classify a polar bear as a fruit.

Too often, though, courts ignore this commonsense principle. Rather than ask whether a statute suffers from some ambiguity, a court will blandly acknowledge confusion over a statutory regime and approve of an agency’s rulemaking authority to address that confusion.

It would be far better for courts to focus on whether the relevant statutory language yields some interpretive choice for the agency. That is, an administrative agency enjoys authority to fill gaps within the statutes that it oversees, but it cannot re-write them to reach its preferred policy result.

Going back to Petaluma,readers should watch how the D.C. Circuit addresses the scope of the Treasury’s rulemaking authority. When it comes to administrative law matters, the D.C. Circuit stands in the shadow of only the Supreme Court, and the hypertechnical nature of the court’s inquiry should not hide the fundamental nature of the issues it will address.


  1. This is a very interesting issue.

    If the question is whether a $25M basis is 400% or more greater than the taxpayer’s true basis, then one can look at the penalty regime as establishing a threshold, which in this case is $6.25M. If the true basis is higher than the threshold, then there is not a gross valuation missatement. If the true basis is $6.25M or lower, as it is in Petaluma, then there is a gross valuation misstatement.

    Now, as you point out, if you run the math for the zero basis case, then you get an anomoly at that value. Whether this makes the statute ambiguous or nonsensical for the zero basis case is certainly something that is open for debate. After thinking about this for a while I still have not been able to form an opinion on which should be the right answer. However, while there is no right way to classify the polar bear no matter how one looks at the problem, the zero basis case in the 6662 penalty regime can be part of a sensical interpretation depending on one’s perspective.

  2. Brian,

    Thanks for the comment. I think you’re absolutely right that we could construct a rule under which it would be sensible to apply the valuation misstatement penalty here. That is, we might say that if the property’s true basis was $2M, and the taxpayer claimed $25M, the penalty would obviously apply to the $23M overstatement. We might therefore conclude that where the true basis is zero, the penalty should of course also apply. After all, where the true basis is $0 rather than $2M, that means the taxpayer has done something even worse — he’s overstated his basis by $25M rather than $23M.

    I think that’s a sensible rule for Congress to provide, but the statute as written does not embody that approach. Nonetheless, my brief freely acknowledged that courts applied a purposive approach in this context and routinely extended the valuation misstatement penalty to zero basis circumstances. But notwithstanding the consensus among the lower courts, the Supreme Court still thought it was an issue worth flagging and reserving on. The Court even did independent research on the issue — the Lee’s Summit case, cited by the Court, was not mentioned in my brief or in any other brief. So, some Justice likely sent a hapless law clerk to research the “division by zero” argument, which suggests that it might have legs.

    However the D.C. Circuit handles the issue, it should make for an interesting opinion.

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