United States: Taxpayers Achieve Administrative Procedure Act Victories

Two recent federal district court decisions evaluated whether the process historically utilized by the Department of Treasury and the Internal Revenue Service ("IRS") to issue guidance satisfied the requirements of the Administrative Procedure Act ("APA"). The decisions, CIC Services and Liberty Global, considered the validity of a transaction-of-interest notice and temporary regulations, respectively. The taxpayers contended the guidance required pre-promulgation notice and comment. The district judges agreed and invalidated the guidance.

CIC Services¹

Last year, the U.S. Supreme Court permitted CIC Services to proceed with its APA litigation against the IRS's micro-captive Notice (Notice 2016-66).² On remand, the district court determined that the Notice was a legislative rule subject to the APA's notice and comment procedures and other requirements. Because the IRS did not satisfy these APA requirements in the issuance of the Notice, the court ruled that the Notice was invalid under the APA.³

In addition, the court found that the Notice must be set aside under the APA as agency action that is arbitrary and capricious. The court's analysis on this point is consistent with that of the Tax Court in Altera where the court found that Treasury's unsupported belief that something is true is not sufficient to support a rule (in Altera, "Treasury's belief that unrelated parties entering into [qualified cost-sharing agreements] would generally share stock-based compensation costs" and, in CIC, the IRS's "belie[f] this transaction ('micro-captive transaction') has a potential for tax avoidance or evasion").⁴ We note that the Tax Court in Altera also discussed the deficient manner in which Treasury responded to the comments it received regarding the proposed cost-sharing rule as further grounds to conclude that Treasury's rule was arbitrary and capricious. These two critical facts, i.e., the unsupported nature of Treasury's belief and its procedural mishandling of relevant comments, together led to its conclusion that the cost-sharing rule violated the APA.

In CIC, the administrative record for the Notice contained no comments or other evidence of IRS engagement with the public. The court thus looked solely to the quality of support for the IRS's belief to evaluate whether it passed muster under the APA:

Thus, the court determined that the agency's bare belief without any factual support was enough to expose the Notice as proceeding from arbitrary and capricious conduct and thereby imposed an independent obligation on the IRS to gather relevant data and articulate a factual basis for its rule.

Liberty Global⁶

Remember Chamber of Commerce v. IRS?⁷ There, a district court held that certain temporary regulations issued under the anti-inversion rules of Internal Revenue Code ("IRC") section 7874, were invalid under the APA on the grounds that Treasury did not allow for public comments prior to issuance.⁸ The promulgation of these temporary regulations did not include any good cause statement, which, under the APA, would have at least facially satisfied an exception to the notice and comment requirement.

Enter the temporary regulations at issue in Liberty Global. Here, Treasury did set forth "good cause" grounds (four reasons set forth in several pages in the official publication of the preamble) to satisfy the exception to notice and comment under the APA. The district court, however, determined that the stated grounds did not satisfy the good cause requirement.

At issue, were temporary regulations under IRC section 245A. Congress enacted IRC section 245A as part of the Tax Cuts and Jobs Act ("TCJA") in 2017, which grants a domestic corporation a deduction with respect to dividends received from specified foreign corporations in which the domestic corporation is a U.S. shareholder. As part of TCJA, Congress also enacted IRC section 951A, the global intangible low-taxed income ("GILTI") rules, which subjects some portion of the income of such specified foreign corporations to current U.S. federal income taxation. Treasury argued that Congress intended the 245A exemption from dividends received from specified foreign corporations to apply only when such foreign corporations are subject to the GILTI regime. TCJA, however, allows for the 245A exemption to apply to dividends paid after December 31, 2017, whereas the GILTI regime applies to a foreign corporation's first tax year beginning after December 31, 2017. For foreign corporations (such as Liberty) with non-calendar year tax years, the mismatch in dates in the statute allowed for a foreign corporation to pay exempt dividends to its shareholders before its earnings became subject to the GILTI rules. The temporary regulations created additional criteria beyond the statutory framework to prevent taxpayers from taking advantage of this mismatch, which criteria Treasury admitted were "inconsistent with the literal application" of the statute.⁹

The district court found Treasury's four reasons wanting. The first ground, that the agency needed to take imminent and urgent action to prevent irreversible harm, is at the core of its assertion of the good cause exception. Treasury stated in the preamble that absent rules with immediate effect, taxpayers would take advantage of IRC section 245A to the tune of billions of tax dollars. The district court accepted the assertion at its face value. Nevertheless, the court found that Treasury had sufficient time to solicit and review comments, especially given the retroactive nature that could attach to any post-comment temporary regulations. With regard to Treasury's other reasons, the district court similarly rejected the notion that Treasury had insufficient time to allow for comments.

Don't Assume a Regulation or Rule Is the Final Word

While these decisions are likely to be appealed, there have also been (and will continue to be) appellate victories invalidating tax and non-tax agency rules on APA grounds. For example, in early March of this year, the Sixth Circuit reversed a district court's decision and ruled that an IRS notice regarding listed transactions was invalid under the APA.¹⁰ And, in late December of last year, the Eleventh Circuit reversed the Tax Court's decision and found that a portion of a conservation easement regulation was arbitrary and capricious and violated the APA's procedural requirements.¹¹

One lesson learned from the past several years of tax litigation is, when considering the potential impact of a regulation or rule, to evaluate the rule's genesis in the light of the APA. The judicial trend is to bring much of Treasury's and IRS's guidance within the strictures of the APA, and any substantive rule issued without notice and comment raises a potential APA violation.

The persistent genius of the APA is to require (with narrow exceptions) an agency to solicit input from the regulated in order to craft a rule that is grounded in reason and fact, and that will best serve the regulated in furtherance of the statute's purpose. Just as taxpayers must turn square corners when they deal with the government, the government must turn square corners when it deals with them.¹²

Footnotes

1 CIC Services, LLC v. Internal Revenue Service, 129 AFTR 2d 2022-1119 (D. Tenn 2022).

2 141 S. Ct. 1582 (2021).

3 In reaching its decision, the court found that the Sixth Circuit's analysis in Mann Construction, Inc. v. United States, 129 AFTR 2d 2022-885 (6th Cir. 2022), which also involved the validity of an IRS notice, was binding on the court and "applied equally" to the IRS's arguments in this case. In particular, the court noted that the Sixth Circuit "expressly rejected" the IRS's arguments in Mann Construction that "the notice was merely an interpretive rule, which did not require notice and comment and that, even if the notice was a legislative rule, Congress exempted it from the APA's requirements with respect to its disclosure rules." CIC Services, 129 AFTR 2d 2022-1119.

4 The Ninth Circuit reversed the Tax Court in Altera by sidestepping this aspect of the Tax Court's analysis. See Altera Corp. v. Commissioner, 122 AFTR 2d 2018-5984 (9th Cir. 2018) rev'g 145 T.C. 91 (2015) (dissent noting that "[t]he majority also glosses over the Tax Court's criticism that the final rule applied to all QCSAs but was based only on Treasury's beliefs about the subset of QCSAs involving 'high-profit intangibles' where stock-based compensation is a 'significant element' of compensation. Treasury's failure to explain this leap and the Commissioner's failure to defend it provides another reason that Treasury failed to comply with the APA." (internal citations omitted)); see also INSIGHT: Altera v. Commissioner—Administrative Procedure Act Under Siege?

Bloomberg Tax: Daily Tax Report (August 1, 2019). The Tax Court decision remains viable precedent in all other circuits.

5 129 AFTR 2d 2022-1119 (internal citations omitted).

6 Liberty Global, Inc. v. United States, 129 AFTR 2d 2022-__, (D. Colo.) (4/04/2022).

7 120 AFTR 2d 2017-5967 (W. D. Tex. 2017), appeal dismissed, 122 AFTR 2d 2018-5375 (5th Cir. 2018).

8 The temporary regulations amounted to a drive-by assault effectively invalidating specific pending transactions where the regulatory criteria were exquisitely tailored to stop those taxpayers.

9 See Liberty Global, Inc. v. USA 1:2020cv03501 | US District Court for the District of Colorado | Justia for docket.

10 Mann Construction, 129 AFTR 2d 2022-885.

11 Hewitt v. Commissioner, 21 F.4th 1336 (11th Cir. 2021). But note that the Sixth Circuit recently came to the opposite conclusion in Oakbrook Land Holdings LLC v. Commissioner, 28 F.4th 700 (2022).

12 We note that proposed regulations recently issued by Treasury would limit IRS Appeals review to exclude litigation hazard considerations of the taxpayer relating to an argument asserting a regulation, notice or revenue procedure is invalid unless there is a final court determination on the question. See 87 Fed. Reg. 176 at 55942-43 (September 13, 2022).