Federal Circuit Deals Utilities a Major Victory on Interest Capitalization and Invalidates Regulation on APA Grounds
Last year’s decision in Mayo Found. for Med. Educ. and Research v. United States, 131 S. Ct. 704 (2011), was generally hailed as a big victory for the government in holding that deference to Treasury Regulations would henceforth be governed by the generally applicable Chevron standards, not by the less deferential National Muffler Dealer standards that had previously applied in tax cases. See our report here. In Dominion Resources v. United States, CAFC No. 2011-5087 (May 31, 2011), however, the Federal Circuit reminded Treasury that being treated like every other agency is not always a bed of roses – for example, you can have your regulations invalidated for the agency’s failure to provide an adequate supporting rationale when the regulations were promulgated. Together with the Supreme Court’s recent decision in Home Concrete, the courts have flashed a yellow caution light in the face of those who thought that the practical effect of Mayo would be to give Treasury almost unfettered authority to legislate by regulation.
Dominion Resources involved a complicated capitalization issue important to the utility industry. Specifically, it addressed the validity of a regulation issued under Code section 263A. In general, the Code requires that costs of improving property must be capitalized, not deducted. Certain indirect costs, like taxes and interest, must be capitalized to the extent those costs are “allocable” to improving property. Under section 263A(f)(2), allocable interest includes not only obvious expenditures like interest on a loan taken out to fund the improvements, but also interest on other indebtedness “to the extent that the taxpayer’s interest costs could have been reduced if production expenditures . . . had not been incurred.” This section implements a notion of “avoided cost” by including “interest costs incurred by reason of borrowings that could have been repaid with funds expended for construction.” S. Rep. No. 99-313, at 144.
The regulation at issue in Dominion Resources defines “production expenditures” for purposes of this avoided-cost calculation, and it includes in that amount the adjusted basis of property that must be temporarily withdrawn from service to complete the improvements. Treas. Reg. § 1.263A-11(e)(2)(ii)(B). In this case, Dominion replaced coal burners in two of its plants and had to shut them down for a few months to do the work. It challenged the validity of the regulation, which had the effect of requiring it to capitalize, rather than deduct, a larger portion of its interest on unrelated indebtedness because of the inclusion of the adjusted basis of those properties as “production expenditures” for allocation purposes.
The Court of Federal Claims ruled for the government, in an opinion that appeared to highlight the difficulty of attacking regulations that are entitled to Chevron deference. The court expressed considerable skepticism about the logic of the regulation, stating that “[i]t is stretching the statute quite far to say that the associated-property rule ‘is a “reasonable interpretation” of the enacted text’” (quoting Mayo). The government’s suggested rationales for including adjusted basis, in the court’s view, were “not very satisfying.” Indeed, one suggested rationale (the idea that the property could be sold at a value equal to its basis in order to pay down the debt) was “removed from reality” because the property was intended to remain in service. The court also suggested that the regulation was bad policy because it created a tax disincentive to improvements. In the end, however, the trial court concluded that it is a “very close case” and that it “cannot say that the Treasury overstepped the latitude granted by the statute to adopt regulations” – in other words, the Chevron Step 2 bar of being a “reasonable” interpretation of the statute is sufficiently low that the regulation should survive despite the court’s criticism.
The Court of Federal Claims also responded to the taxpayer’s argument that the regulations failed to comply with the Administrative Procedure Act. Treasury regulations traditionally have not often been challenged on APA grounds, but Mayo’s holding that such regulations should be given the same deference as regulations issued by other agencies has brought to the fore the idea that other general administrative law principles, including APA rules, should apply equally to Treasury regulations. (Judge Holmes of the Tax Court has been particularly outspoken about the applicability of the APA and general administrative law principles to tax cases – both on the bench (see his concurring opinion in the Intermountain case, 134 T.C. 211, 222-23 (2010), which was recently upheld by the Supreme Court on other grounds in Home Concrete) and off the bench (see Shamik Trivedi, Mayo Increases Taxpayer Chances of Success, Judge Says, Tax Notes, June 27, 2011, p. 1319)).
In Dominion Resources, the taxpayer argued that the regulation ran afoul of the APA’s “arbitrary [and] capricious” standard on the grounds addressed in Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). The Supreme Court there stated that an agency must “articulate a satisfactory explanation for its action,” that is, “cogently explain why it has exercised its discretion in a given manner.” Id. at 43. The trial court in Dominion Resources found that it was “a stretch to conclude” that Treasury had provided this cogent explanation, but observed that Treasury’s “lack of exactitude and the ensuing confusion do not signify that Treasury acted to establish the final rule in an arbitrary and capricious manner.” Instead, the court seized on the Supreme Court’s statement in State Farm that “a decision of less than ideal clarity” can be upheld “if the agency’s path may reasonably be discerned.” Id. The court held that Treasury’s “‘path’ . . . can be ‘discerned,’ albeit somewhat murkily,” and on that basis it rejected the APA challenge.
The Federal Circuit was less forgiving, and it invalidated the regulation. The majority (Judges Rader and Reyna) agreed with both of the taxpayer’s primary arguments. With respect to the Chevron analysis, the majority echoed the trial court’s criticisms of the regulation and concluded that they required a different outcome. The majority stated that the regulation passed Chevron Step 1, “but only because the statute is opaque” and therefore “ambiguous.” But the regulation failed the Step 2 reasonableness test because, in the majority’s view, it “directly contradicts the avoided-cost rule that Congress intended the statute to implement.” Moreover, the court stated, the regulation “leads to absurd results” because it “can require capitalizing vastly different amounts of interest for the same improvements” – if the different properties had different adjusted bases. The court noted that the Court of Federal Claims had correctly described the government’s argument that the property owner could have sold the unit in order to pay the debt as “removed from reality,” but found that the trial court erred in excusing that “fiction [as] a ‘policy choice’ by the agency and thus permissible.” Because the government’s proffered rationale was unreasonable, “the regulation is not a reasonable interpretation of the statute.”
The Federal Circuit also ruled that the trial court had erred in rejecting the taxpayers’ APA argument. The court stated that the notice of rulemaking “provides no explanation for the way that use of an adjusted basis implements the avoided-cost rule” and hence failed to satisfy the State Farm requirement that “the regulation must articulate a satisfactory or cogent explanation.”
Judge Clevenger concurred in the result, agreeing with the majority’s APA analysis but disagreeing with its Chevron analysis. In his view, the majority’s approach swept too broadly because it “creates a binding rule . . . that the government can never re-promulgate its associated-property rule for property temporarily withdrawn from service, no matter how well-formed its reasoning.” Judge Clevenger would have preferred a narrower resolution that deemed the regulation “procedurally unlawful” for the government’s failure to “articulat[e] any rational explanation for many details of the regulation . . . up to the current date.” That approach “would give the government another chance to explain and justify its view that the adjusted basis of property temporarily withdrawn from service can be taken into account in determining production expenses.”
Judge Clevenger then went on to provide a possible rationale for the regulation, describing it as an attempt to approximate “opportunity costs” — that is, “the lost value associated with the withdrawal of property from service” — in a way that does not present overwhelming administrative difficulties. He did not dispute the majority’s criticism of the notion that the taxpayer could have sold the property to service the debt as “fiction.” But he asserted that “the avoided cost rule is in its entire concept a fiction,” and therefore this was not enough of a reason to conclude that the regulation fails Chevron Step 2.
The Dominion Resources opinion is significant on two levels. First, the specific holding concerning whether adjusted basis plays a role in determining how much interest must be capitalized to improvements resolves a recurring issue that is particularly important in the utility industry and can involve significant amounts of tax. Second, the APA holding that Judge Clevenger characterized as “narrower” may in fact have an even broader impact. It is not unusual for Treasury regulations to be accompanied by a less-than-illuminating explanation of how the regulation implements the statutory purpose. In the wake of Dominion Resources, taxpayers can be expected to raise APA challenges to such regulations, and some of those may succeed. As Judge Clevenger stated, the impact of invalidation on State Farm grounds presumably can be limited by repromulgating the regulation with a satisfactory explanation. But unless retroactive application of the repromulgated regulation can be justified, Treasury would stand to lose the benefit of the regulation for a significant period. Thus, one ancillary effect of increased scrutiny of Treasury regulations on State Farm grounds could be increased litigation over Treasury’s power to issue retroactive regulations – an issue that the Supreme Court did not touch in Home Concrete (see our report here).
Given the significance of the decision, it would not be surprising for the government to seek further review. A petition for rehearing en banc would be due on July 16.
On December 7th, oral argument was held in the Fifth Circuit in the NPR case before Judges Dennis, Clement, and Owen. You can find a detailed explanation of the issues here but in summary the questions involve whether, in the context of a Son of BOSS case: the gross valuation penalty applies when the basis producing transaction is not invalidated solely due to a bad valuation; whether other penalties apply; how the TEFRA jurisdictional rules function as to those penalties; and whether an FPAA issued after a non-TEFRA partnership no-change letter falls afoul of the no-second-FPAA rule.
Although both parties appealed, as the initial appellant DOJ began the argument. DOJ counsel argued that the Supreme Court’s decision in Nat’l Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), allowed Treas. Reg. § 1.6662-5(d) to override the Fifth Circuit’s position in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), that a valuation misstatement cannot apply where there are grounds for invalidating the transaction other than an incorrect valuation — such as where the transaction is totally disallowed under economic substance or on technical grounds. In this regard, DOJ requested that the court submit the matter for en banc review to address this issue and to consider the impact of Weiner v. United States, 389 F.3d 152 (5th Cir. 2004), which counsel characterized (as DOJ had in the brief) as calling the “total disallowance” rule into question.
As to the substantive application of penalties, DOJ argued that the complete concession by the taxpayer of the substance of the transaction compelled the conclusion that the position lacked substantial authority. Furthermore, counsel argued that there was no substantial authority at the time the transaction was reported on the taxpayer’s return. In this regard, DOJ posited that although Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), had held that a contingent liability was not a liability for purposes of section 752, it did not address the questions of buying and selling offsetting options and of contributing them to a partnership only to arrange for a distribution and sale. As to these points, the only authority on point was Notice 2000-44, which stood for the proposition that the transaction did not work. This appears to be a repackaged version of the argument that there can never be substantial authority for transactions lacking economic substance.
Argument transitioned to the question of whether the district court had jurisdiction to consider a penalty defense put on by the partners and not by the partnership in this partnership action. For a prior discussion of this confusing question see our analysis here. Citing Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), DOJ counsel argued that the Fifth Circuit had already decided that an individual reasonable cause argument (such as one based on a legal opinion issued to the partner) cannot be raised in a TEFRA proceeding. The court seemed to recognize the impact of Klamath on this point. DOJ counsel then attempted to box the partnership in (as it had in the brief) on the question of whether the defense was raised by the partner or the partnership (several statements in the district court’s opinion seem to view the defense as a partner-level defense).
Moving on to the question of the merits of the reasonable cause position, DOJ argued that the district court erred in considering reliance on the tax opinion (which was written by R.J. Ruble) to be reasonable. Initially, counsel questioned whether the partners’ testimony that they did not believe Ruble had a conflict was reasonable in light of the partners’ knowledge of fee sharing and of the fact that Ruble had written opinions for other shelters for the same promoter. The court seemed to be honed in on this question. In closing, DOJ attempted to poison the well of partner good faith by reminding the Court that the partners in this case were repeat tax-shelter offenders and had attempted to hide the Son-of-BOSS losses as negative gross revenue from their law firm business.
Perhaps indicating a weakness on the penalty issues raised by DOJ, taxpayer’s counsel spent most of his time on the question of whether the second FPAA was invalid. The Court focused counsel on the fact that an error on the tax return (the Form 1065 did not check the TEFRA box although it did check the flow-through partner box (which would indicate a TEFRA partnership)) led the agent originally to pursue the case as non-TEFRA. Undeterred, counsel argued that this error was not material and that the agent had indicated in a deposition that he eventually learned that the partnership was TEFRA. Testimony was also offered in the district court that the reporting was an innocent mistake and not negligent or deceptive. The Court spent significant time questioning why the agent did not testify at trial (which appears to have been due to a mix-up on the part of DOJ). In summarizing his position, taxpayer’s counsel tried to focus the court on the language of the partnership no-change letter but to us it appears that the real question has to be whether the agent intended this to be a TEFRA audit. An FPAA simply cannot come out of a non-TEFRA audit. Based on the agent’s deposition transcript it seems clear that he did not believe he was involved in a TEFRA audit when he opened the audit and thus it is impossible that the initial notice was an FPAA.
Rebutting DOJ’s reasonable cause position, taxpayer’s counsel focused on the trial testimony and factual determinations by the district court that the taxpayers were acting reasonably and in good faith. On the question of jurisdiction, the taxpayer reverted to the tried and true (but not very strong) argument that requiring a later refund suit to address the reasonable cause question would be a waste of judicial resources and, in essence, a meaningless step. A cynic might say that the purpose of TEFRA is to waste judicial resources and create meaningless steps.
In rebuttal, DOJ counsel focused on the no-second-FPAA question and did a good job from our perspective. He noted that you have to have a TEFRA proceeding to have a TEFRA notice. Undermining the district court’s determination that the finality of the notice is relevant, counsel noted that all non-TEFRA notices are “final” but that doesn’t mean they are FPAAs. TEFRA is a parallel audit procedure and it is simply not enough that the IRS intended a final determination in a non-TEFRA partnership audit. The question is whether the IRS intended to issue a final notice in a TEFRA proceeding; since there was no “first” TEFRA proceeding, there was no “first” FPAA. We think this argument is right on target.
With limited questions coming from the Court it is difficult to see where this is headed. Our best guess is that the partnership will prevail on the reasonable cause position (it is difficult for an appellate court to overturn credibility determinations of witnesses) but lose on everything else including the no-second-FPAA issue.
The NPR case (involving penalty application and TEFRA issues in the context of a Son of BOSS transaction: see latest substantive discussion here) has been calendared for argument in New Orleans on December 7th in the East Courtroom.
As we mentioned in our last post, the only brief remaining to be filed in NPR was the taxpayer’s reply brief. That brief has now been filed and with it a DOJ motion to strike part of that reply as an inappropriate sur-reply. The motion concerns a section in the reply in which the taxpayer takes on DOJ for arguing (in its previously filed reply brief ) that the only relevant factor in determining the incidence of the valuation misstatement penalty (between partnership and partner) is whether there are partnership items involved and not where the specific misstatement results in a loss.
The taxpayer’s view is that DOJ is trying to have its cake and eat it too – arguing that the penalty applies at the partnership level because it is related to partnership items but refusing to allow section 6664 arguments to be heard on the grounds that those are specific to the partner. DOJ’s position is that it would be barred from raising the penalty outside of the context of a partnership proceeding because the penalty relates to a partnership item (or items) and that it is not inconsistent to require section 6664 intent to be evaluated at the partner level (and, in any event, it is required by the regulations). All of this, as we have extensively discussed, is intertwined in the silliness of trying to separate partner and partnership intent between TEFRA levels something the regulations perhaps should not have done but clearly do. It will be interesting to see how the Fifth Circuit handles the case.
It has been a while since we published an update on NPR (please no comments on Supreme Court Justices, schoolchildren, and bloggers taking summers off). Since our last post discussing the government’s opening brief, the taxpayer filed its brief responding to the government and opening the briefing on their cross-appeal. The government also filed its response/reply. All that remains now is the taxpayer’s reply brief on its cross-appeal, currently due on August 15. There are a slew of technical TEFRA issues that are raised by the parties. The taxpayer is appealing the district court’s rulings regarding whether a no change letter can ever be an FPAA and, if it can be, whether an erroneously checked box on the tax return (claiming that the partnership was not a TEFRA partnership) can constitute a misrepresentation of a material fact such that the no-second-FPAA rule of section 6223(f) is inapplicable. As we discussed last post, the parties are jointly briefing — in the government’s appeal — the application of the Heasley/Weiner line of cases to the taxpayer’s concession strategically made to circumvent the gross valuation misstatement penalty. Mayo is implicated by the application of Treasury Regulation section 1.6662-5(d) (DOJ relies on Brand X to argue that the regulation controls over the contrary rule previously announced in Heasley).
However, as we discussed in prior posts, the main issue here is good faith reliance on counsel — R.J. Ruble — by the taxpayer for purposes of the section 6664 reasonable cause defense and when, procedurally, that defense can be raised. The government continues to hew to the line that reliance is inappropriate (because of a technical conflict and because reliance was just not reasonable under the circumstances). DOJ also argues that the defense can be raised only in a partner-level proceeding pursuant to then Temporary Treasury Regulation section 301.6221-1T(d) (the judges may want to get a cholesterol test with all of this Mayo being spread around). For its part, the taxpayer argues that the district court already determined — after seeing the witness testimony — that the reliance was in good faith. Furthermore, since one of the partners is the TMP, the reasonable cause defense is being raised by the partnership as much as by the partners. Setting aside whether you believe the testimony (which the district court judge did), if we could decide cases based on the fact that section 301.6221-1T(d) of the TEFRA penalty regulations is stupid, this would be easy. As we have said before, separating partner and partnership intent in a transaction involving a partnership that was purposefully created by the partners to implement that very same transaction is like trying to dance on a headless pin. With deference under Mayo, however, “stupid is as stupid does” is not the test for striking down regulations. We will just have to wait and see how much patience the Fifth Circuit has for this Forrest Gump of a regulation.
Federal Circuit Adds to Intermountain Conflict by Deferring to New Regulations That Apply Six-Year Statute to Overstatements of Basis
The Federal Circuit has ruled for the government in Grapevine, throwing the circuits into further disarray by adopting an approach that differs from all three of the courts of appeals that have previously addressed the Intermountain issue subsequent to the issuance of the new regulations. Because the Federal Circuit had already rejected the government’s construction of the statute in Salman Ranch, the Grapevine case starkly posed the question whether the new regulations had the effect of requiring the court to disregard its prior decision and reach the opposite result. As we previously reported, at oral argument the day after the decision in Mayo Foundation, the government told the Federal Circuit that Mayo compelled that result. The court has now agreed.
A key section of the court’s opinion considers whether the Supreme Court’s decision in Colony defeats the government’s deference argument. The court says it does not because Colony itself stated that it did not regard the statutory text as unambiguous and, even considering the Colony court’s review of the legislative history, the court did not believe that “Congress’s intent was so clear that no reasonable interpretation could differ.” Therefore, Colony did not resolve the case under Chevron Step 1 and, under Brand X, Treasury was free to issue a regulation that contradicts Colony. (In its analysis, the Federal Circuit appears to have sided with the view, based on footnote 9 of Chevron, that legislative history can be considered at Chevron Step 1 (see our previous post)). The court then applies the Chevron analysis to the new regulations and concludes that they are reasonable based on exactly the same government arguments that the court rejected in Salman Ranch when it was construing the statute in the absence of a regulation. Finally, the court rules that Treasury did not abuse its discretion in applying the new regulations retroactively to years that were still open under the six-year statute.
The Grapevine decision is significant in the specific context of the Intermountain cases, as it virtually ensures that a circuit conflict on the issue will persist even if the Seventh Circuit reconsiders its decision in Beard. And it is the first appellate decision to address in detail the merits of the government’s primary argument that it can overturn the prior adverse decisions in this area by regulation. More generally, the case is a great illustration of Treasury’s power under the combination of Mayo and Brand X. The Federal Circuit was keenly aware of the implications of its decision, summarizing it as follows: “This case highlights the extent of the Treasury Department’s authority over the Tax Code. As Chevron and Brand X illustrate, Congress has the power to give regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.” Presumably, Treasury will continue to test the limits of how far it can go in exercising that “primary responsibility.”
I will be participating in what promises to be an interesting panel discussion on the Mayo Foundation decision on Monday February 28 at 1:00 EST. The other two distinguished members of the panel are: Gil Rothenberg, Chief of the Appellate Section of the United States Department of Justice’s Tax Division, who is also currently serving as Acting Deputy Assistant Attorney General for Review and Appellate; and Emily Parker, partner at Thompson & Knight LLP, and former Acting Chief Counsel and Deputy Chief Counsel for the IRS.
Information on how to register for the program can be found here.
We will be discussing the Mayo decision and its ramifications for future litigation and the regulatory process from both the government and taxpayer perspectives.
The Fourth Circuit, in an opinion authored by Judge Wynn and joined by Judges Wilkinson and Gregory, has solidified the circuit conflict on the Intermountain issue by ruling for the taxpayer in the Home Concrete case. (See our original post on these cases here.) First, the court held that the statutory issue was resolved by the Supreme Court’s decision in Colony, rejecting the argument recently accepted by the Seventh Circuit in Beard (see here) that Colony addressed the 1939 Code and should be understood as applying to identical language in the 1954 Code only to the extent that the taxpayer is in a trade or business. The court concluded that “we join the Ninth and Federal Circuits and conclude that Colony forecloses the argument that Home Concrete’s overstated basis in its reporting of the short sale proceeds resulted in an omission from its reported gross income.”
Second, the court held that the outcome was not changed by the new Treasury regulations. The court held that the regulations by their terms could not apply to the 1999 tax year at issue, because “the period for assessing tax” for that year expired in September 2006. See Treas. Reg. § 301.6501(e)-1(e). The government argued that the new regulations apply to all taxable years that are the subject of pending cases, but the court held that this position could not be squared with the statutory text of Code section 6501. In any event, the court continued, no deference would be owed to the regulations under the principles of Brand X because the Supreme Court had already conclusively construed the term “omission from gross income” in Colony and therefore there was no longer any room for the agency to resolve an ambiguity by regulation.
Judge Wilkinson wrote a separate concurring opinion to elaborate on this last point. He observed that Brand X allows a regulation to override a prior court decision only if that decision was not based on a Chevron “step one” analysis — that is, on a conclusion that the statute is unambiguous. This can be a difficult inquiry when examining pre-Chevron decisions in which the court had no reason to analyze the case through the lens of the two-step Chevron framework. Judge Wilkinson explains why he “believe[s] that Colony was decided under Chevron step one,” concluding that the Supreme Court’s statement that it could not conclude that the 1939 Code language is unambiguous was “secondary in importance to the thrust of the opinion” and the Court’s assessment of the statutory purpose. (As previously discussed here, this question of whether Colony should be viewed as a “step one” decision, and the related question of how relevant legislative history is at “step one,” was the focus of the Federal Circuit’s attention in the oral argument in Grapevine.)
Judge Wilkinson then goes on to make some more general observations about the limits of Chevron deference in the wake of the Mayo Foundation case. He states that Mayo “makes perfect sense” in affording “agencies considerable discretion in their areas of expertise.” He cautions, however, that “it remains the case that agencies are not a law unto themselves. No less than any other organ of government, they operate in a system in which the last words in law belong to Congress and the Supreme Court.” In Judge Wilkinson’s view, the government’s attempt to reverse Colony by regulation “pass[es] the point where the beneficial application of agency expertise gives way to a lack of accountability and a risk of arbitrariness.” He concludes that “Chevron, Brand X, and more recently, Mayo Foundation rightly leave agencies with a large and beneficial role, but they do not leave courts with no role where the very language of the law is palpably at stake.”
The Fourth Circuit’s decision seems to eliminate the slim possibility that the Intermountain issue could be definitively resolved short of the Supreme Court. There are now two circuits (the Fourth and the Seventh) that have come down on opposite sides, though both had the opportunity to consider the recent developments of the final regulations and the Mayo decision. At this point, the government is likely to seek Supreme Court review, either by acquiescing in a taxpayer certiorari petition (possibly in Beard) or by filing its own petition in Home Concrete. Unless petitions for rehearing are filed, the parties have 90 days from the date of final judgment to file a petition for certiorari in these cases.
The government has filed its reply brief in the D.C. Circuit in Intermountain. Although there are no surprises, the brief is a useful resource because it contains in one place the government’s arguments concerning three recent developments favorable to its case, which it has been calling to the attention of other courts piecemeal in supplemental filings. Those developments are the Seventh Circuit’s Beard decision (see here); the Supreme Court’s decision in Mayo Foundation (see here), and the issuance of final regulations (see here). Despite its recent victory in Beard on purely statutory grounds, the government still seems to believe that Chevron deference to the new regulations is its best bet. The reply brief devotes 3 pages to the statutory argument and 23 pages to the regulatory deference argument.
Oral argument is scheduled for April 5.
It took less than a day for the government to try out its new Mayo Foundation toy – that is, the Supreme Court’s ruling that deference to Treasury regulations is governed by the same Chevron principles that apply to regulations issued by other agencies. (See our report on the Mayo decision here.) The Intermountain-type litigation posed the perfect opportunity to examine the impact of Mayo, as the regulations at issue in those cases clearly are more vulnerable under the National Muffler approach of looking to factors like whether the regulation is contemporaneous or designed to reverse judicial decisions. Accordingly, the government promptly filed notices of supplemental authority in those cases calling the various courts’ attention to Mayo.
The Federal Circuit did not have much time to ruminate on the supplemental filing, as oral argument in Grapevine was set for the next day. Even so, the government was not bashful about embracing Mayo. Acting Deputy Assistant Attorney General Gil Rothenberg began his argument by telling the court that Mayo “foreshadows” how the case should be decided because of the “striking . . . parallels” between Mayo and Grapevine. That opening triggered immediate pushback from an active panel (Judges Bryson and Prost, with Judge Lourie remaining mostly silent during the argument). The judges pointed to the obvious difference between the cases, the existence of a Supreme Court decision (The Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958)) that has already construed the statutory language at issue in Grapevine. What ensued was a lively oral argument that focused almost entirely on the rules for Chevron analysis and very little on any topics that would be standard fare for a tax practitioner.
The Chevron jurisprudence issue that dominated the argument is the scope of the Supreme Court’s decision in Nat’l Cable and Telecommunications Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005). As noted in our first post on these cases, Brand X says that Chevron deference is owed even to a regulation that conflicts with judicial precedent – as long as that judicial precedent did not hold that the statute was unambiguous (a so-called Chevron Step 1 conclusion that would leave no room for interpretation by the agency). That limiting principle arguably defeats the deference argument in the Intermountain cases because the Supreme Court in Colony had construed the “omission from gross income” language as not covering cases of overstated basis. On the other hand, in reaching that conclusion, the Court had remarked that the statutory text was not “unambiguous” and had looked to legislative history as well. 357 U.S. at 33. Thus, the government argues that the Brand X limiting principle does not apply because the Supreme Court did not declare the statutory text unambiguous.
The case thus raises a fundamental question of Chevron jurisprudence: to what extent, if any, can a court look beyond the statutory text at Chevron Step 1? Chevron itself clearly answered this question. In defining Step 1 in which no deference is owed if the regulation conflicts with the “unambiguously expressed intent of Congress,” the Court explained in a footnote that a court is to determine Congress’s intent “employing traditional tools of statutory construction,” which presumably allows reference to legislative history. Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843 n.9 (1984). Brand X stated that “[t]he Chevron framework governs our review.” 545 U.S. at 980. So did Brand X reaffirm the statement in Chevron that the Step 1 analysis goes beyond the text and includes analysis of the legislative history? Not so fast. The Brand X opinion was authored by Justice Thomas, no fan of legislative history, and that opinion’s formulation of Chevron Step 1 in Brand X was notably more restrictive; deference is owed unless the “prior court decision holds that its construction follows from the unambiguous terms of the statute.” 545 U.S. at 982 (emphasis added).
The judges at the Grapevine argument focused on this question – in particular pressing government counsel on the contours of the government’s position. Counsel tried to walk a fine line, hoping to significantly marginalize the role of legislative history at Step 1 without blatantly disregarding the language of Chevron. He stated that legislative history is relevant at Step 1 only for the very limited purpose of determining the meaning of a “term” in the statute, but not for determining the general purpose of the statute and using that as an aid to statutory construction. (This approach is more nuanced that the position advanced in the government’s brief, which appeared to argue that legislative history can never be examined at Chevron Step 1.) The court questioned both whether this line could truly be drawn and whether in any event it would aid the government’s position in this case where the Colony Court had used legislative history to construe the statutory phrase “omission from gross income.” Judge Prost specifically asked government counsel whether he was arguing that Brand X had overruled Chevron. In response, he characterized Brand X as “narrowing” the broad language of Chevron and later acknowledged that he believed that Brand X is “not completely consistent” with footnote 9 of Chevron. With respect to the question whether his argument failed in any event because Colony had construed a statutory term, government counsel argued that Colony had construed the 1939 Code and therefore was not authoritative on the meaning of the same language in the 1954 Code.
Taxpayer’s counsel got a similar grilling from the panel when he took the podium and tried to argue that the court should simply follow Chevron footnote 9 and not worry about any possible retrenchment from that position found in Brand X. Judge Bryson observed that there is only a “tiny sliver” left of Chevron deference if one applies footnote 9 aggressively – that is, by allowing a determination of general congressional intent through legislative history to play a significant role at Step 1. Taxpayer’s counsel looked to Mayo for help, observing that Mayo had cited approvingly to pp. 842-43 of Chevron, the very pages that included footnote 9. Judge Bryson, however, quickly retorted that the Mayo citation did not mention footnote 9.
Taxpayer’s counsel spent some of his argument time seeking affirmance on narrower grounds, such as that the new regulations could not apply to Grapevine’s case either because they were promulgated after the trial court issued its final judgment or because, as the Tax Court majority held, the new regulations by their terms did not apply to cases outside the three-year statute of limitations. But the Federal Circuit showed little sympathy for these arguments. Instead, it appears likely that the Federal Circuit’s decision will wade into the question of how Chevron and Brand X apply to the new regulations. The court did not tip its hand, although to this observer it appeared more likely to conclude that the taxpayer should prevail – because Colony was a sufficiently definitive interpretation of the statutory text under Chevron Step 1 that Brand X does not leave room for it to be overruled by regulation.
One interesting aspect of the argument was the failure of anyone to discuss the point made by Justice Stevens in his one-paragraph concurring opinion in Brand X. Justice Stevens noted that he fully joined the majority opinion, “which correctly explains why a court of appeals’ interpretation of an ambiguous provision in a regulatory statute does not foreclose a contrary reading by the agency.” 545 U.S. at 1003 (emphasis added). Justice Stevens added, however, that “[t]hat explanation would not necessarily be applicable to a decision by this Court that would presumably remove any pre-existing ambiguity.” Id. Justice Stevens’ suggested distinction between court of appeals decisions and Supreme Court decisions makes Grapevine an easy case. If Colony is understood to remove any ambiguity in the statutory text, then there is no room for Chevron deference to the new regulations and no need to get into the morass of determining whether Brand X modified Chevron. Taxpayer’s counsel did not raise this point, however, and none of the judges asked about it. (We note that the Tenth Circuit has addressed and rejected Justice Stevens’ suggested distinction between courts of appeals and the Supreme Court in applying Brand X. Hernandez-Carrera v. Carlson, 547 F.3d 1237, 1246-48 (10th Cir. 2008).).
A decision from the Federal Circuit would ordinarily be expected sometime in the spring. Judge Prost did ask government counsel about the status of the other Intermountain cases, and he responded that Grapevine marked the fifth case to be argued, with argument scheduled in the D.C. Circuit in April. But the Federal Circuit did not give the impression that it planned to sit tight and let other circuits sort out these issues. As we report elsewhere, the Seventh Circuit got the ball rolling today by deciding the Beard case – ruling for the government on statutory grounds without relying on the regulations. That decision should not have much impact on the Federal Circuit, which has already rejected the Seventh Circuit’s reasoning in Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009). If the Federal Circuit determines to rule for the government, it will have to rely on the regulations.