The government has filed its opening brief in MassMutual contesting the Court of Federal Claims’ conclusion that the taxpayer could accrue the amount of certain policyholder dividends in the year before they were paid. See our prior post on this case and the New York Life case here. The government’s brief raises three distinct objections to the decision.
The primary argument is that the liability to pay the dividends was not “fixed” under the all-events test. The government contends that no individual obligation was fixed at the close of the year, even if all the premiums had been paid, because the dividend would not be paid unless the policy remained in force on the anniversary date. This is the same argument that was accepted by the Second Circuit in New York Life, and the government’s brief here argues that the cases are indistinguishable (asserting that the Second Circuit’s effort to distinguish them was based on a misperception of the facts in MassMutual).
The brief argues that the case “clearly fits the General Dynamics fact pattern,” which it describes as one where the “potential obligee has taken some action that renders him preliminarily eligible to receive the payment, subject only to some other condition that is within his exclusive control” – here, “forgoing the right to surrender the policy for its cash value prior to the next anniversary date.” It rejects the proposition argued by the taxpayer that this alleged final condition is not a genuine “event,” but rather just a continuation of the status quo. The government points to a comment in the Restatement (Second) of Contracts stating that “a duty may be conditioned upon the failure of something to happen . . ., and in that case its failure to happen is the event” that constitutes a condition precedent. And it rejects the contrary suggestion in Burnham Corp. v. Commissioner, 878 F.2d 86 (2d Cir. 1989), as misguided. Finally, the brief argues that the taxpayer’s all-events-test interpretation proves too much because its logical implication is that the amount of the dividend could be accrued even if the company had not passed a board resolution in the taxable year guaranteeing an aggregate dividend – a position that the taxpayer has not argued.
Second, the government argues that the dividend guarantees did not even give rise to an obligation, fixed or otherwise, because they were not communicated to the persons who were to benefit from them. Thus, the government argues, the taxpayer could have walked away from the guarantees at any time. In addition, the government argues, the guarantees were not a meaningful “substantive undertaking” because, based on the historical data, the guaranteed payments were “already virtually certain to occur in the ordinary course of the companies’ business operations, independent of any ‘guarantee’ to that effect.” There is some degree of irony in this argument; on its face, certainty that the amounts will be paid would appear to be an argument in favor of accrual, not against it. But the certainty of which the government speaks refers to the aggregate amount of payment; it is not a concession with respect to an individual obligation being fixed.
Third, the government contests the Court of Federal Claims’ holding that the dividends fell within the “recurring item” exception. The government’s primary point here is that this determination turns on the meaning of “rebate, refund, or similar payment” in Treas. Reg. § 1.461-4(g)(3), and therefore the court should have deferred to the IRS’s interpretation of that regulation – even if that interpretation did not conclusively emerge until this litigation and is at odds with some earlier internal guidance on the regulation’s meaning. The general principle of so-called Auer or Seminole Rock deference to an agency’s interpretation of its own regulations has come under fire recently, with Justice Scalia stating that it should be abandoned and Chief Justice Roberts and Justice Alito indicating that they are at least open to reconsidering it. See Decker v. Northwest Environmental Defense Center, No. 11-338 (Mar. 20, 2013). So it will be interesting to see how the Federal Circuit responds to this argument, which presents a relatively weak case for deference because the claimed agency interpretation is just based on its litigation position.
The taxpayer’s brief is due April 4.
Yesterday, the D.C. Circuit unanimously held in Loving v. IRS, that the IRS lacks statutory authority to regulate tax-return preparers. See our previous coverage here. In its February 11 decision, the court characterized the IRS’s interpretation as “atextual and ahistorical,” and, more humorously, as a large elephant trying to emerge from a small mousehole.
In 2011, the IRS for the first time attempted to regulate tax-return preparers, issuing regulations requiring that paid tax-return preparers pass an initial certification, pay annual fees, and complete at least 15 hours of continuing education courses each year. The IRS estimated that the regulations would apply to between 600,000 and 700,000 tax-return preparers. Before 2011, the IRS had never taken the position that it had the authority to regulate tax-return preparers. According to the D.C. Circuit panel (Kavanaugh, Sentelle, and Williams): “In light of the text, history, structure, and context of the statute, it becomes apparent that the IRS never before adopted its current interpretation for a reason: It is incorrect.”
The IRS claimed that 31 U.S.C. § 330 provided statutory authority for the regulations. That statute authorizes the IRS to “regulate the practice of representatives of persons before the Department of Treasury.” 31 U.S.C. § 330(a)(1). The D.C. Circuit cited the familiar two-step Chevron standard of review: (1) is the statute ambiguous, and (2) if so, is the agency’s interpretation reasonable. The court of appeals concluded that the “IRS’s interpretation fails at Chevron step 1 because it is foreclosed by the statute,” and, in any event, “would also fail at Chevron step 2 because it is unreasonable in light of the statute’s text, history, structure, and context.” The court of appeals cited six reasons foreclosing the IRS’s interpretation of the statute:
First, the D.C. Circuit concluded that the term “representative” generally is understood to refer to an agent with authority to bind others. “Put simply, tax-return preparers are not agents. They do not possess legal authority to act on the taxpayer’s behalf.” Second, the preparation of a tax return does not constitute “practice . . . before the Department of the Treasury.” “Practice before” an agency generally implies an investigation, adversarial hearing, or other adjudicative proceeding. Moreover, a related section of the statute allows the Secretary of the Treasury to require that a representative admitted to practice before the agency demonstrate four qualities, one of which is “competency to advise and assist persons in presenting their cases.” 31 U.S.C. § 330(a)(2). Filing a tax return is not understood in ordinary usage to be “presenting a case.” Third, the original version of the statute, enacted in 1884, referred to “agents, attorneys, or other persons representing claimants before [the] Department.” The court of appeals concluded that this original language clearly would not encompass tax return preparers. When the statute was recodified in 1982, the phrase, “agents, attorneys, or other persons representing claimants” was simplified to “representatives of persons,” but the language change expressly was not intended to effect a substantive change. Fourth, the IRS’s interpretation is inconsistent with the “broader statutory framework,” in which Congress has enacted a number of statutes specifically directed at tax-return preparers and imposing civil penalties. Those statutes would not have been necessary, the court reasoned, if the IRS had authority to regulate tax-return prepares. Fifth, if Congress had intended to confer such broad regulatory authority upon the IRS, allowing it to regulate “hundreds of thousands of individuals in the multi-billion dollar tax-preparation industry,” the statute would have been clearer. Referring to the statutory language, the court of appeals concluded: “we are confident that the enacting Congress did not intend to grow such a large elephant in such a small mousehole.” Sixth, the court noted that the IRS in the past had made statements and issued guidance indicating that it did not believe it had authority to regulate tax-return preparers. The court found it “rather telling that the IRS had never before maintained that it possessed this authority.”
The decision ends with the court of appeals noting that new legislation would be needed to allow the IRS to regulate tax-return preparers.
Given that the membership of the D.C. Circuit has recently expanded to include three additional judges, the government might believe that it is worthwhile to seek rehearing en banc before the full court. A petition for rehearing would be due on March 28. If the government does not seek rehearing, a petition for certiorari would be due on May 12. Whether it pursues the litigation further or not, the government can be expected to seek new legislation that would give the IRS the regulatory authority that the court of appeals refused to find.
The D.C. Circuit heard oral argument on September 24 in the government’s appeal in Loving from the district court decision enjoining the IRS from enforcing its new registration regime for paid tax return preparers. The panel consisted of Judges Sentelle, Williams, and Kavanaugh. The court was active, jumping in with questions in the first minute of the government’s opening presentation. The court asked several questions of the plaintiffs’ counsel as well, but those questions seemed to evince less skepticism of the advocate’s position. While it is always hazardous to predict the outcome based on the oral argument, the court of appeals certainly seemed to be leaning towards affirming the district court.
As we have previously discussed, the government’s position relies heavily on Chevron deference to its new tax return preparer regulations. It argues that the statutory authority to regulate practice before Treasury is sufficiently broad to encompass tax return preparers — specifically, that the term “practice of representatives of persons before the Department of the Treasury” is ambiguous and could reasonably be construed by the regulations to include persons who prepare tax returns. The relevant language is currently codified at 31 U.S.C. § 330(a)(1), but it dates back to 1884, when Congress responded to complaints about misconduct by claims agents who represented soldiers with claims for lost horses or other military-related compensation from the Treasury.
Just 30 seconds after the argument began, Judge Sentelle stepped in to challenge the premise of government counsel Gil Rothenberg that the Treasury regulations were valid because the statute did not “foreclose” them. Judge Sentelle maintained that the question instead was whether the statute “empowered” Treasury to regulate in this area, and the case could not be analyzed by assuming that Treasury had unlimited power except to the extent that Congress had explicitly foreclosed it. Shortly thereafter, Judge Williams questioned the government’s failure, in his view, to provide any support for the notion that the ordinary use of the statutory terms, like “representative” or “practice,” could encompass a tax return preparer who merely helps a taxpayer “fill out a form” that he is obliged to file with the IRS. Mr. Rothenberg responded that, although there were no cases on point, return preparers do more than “fill out a form” and that the statutory term “representative” cannot be limited to an agency relationship because the term was intended to retain the same meaning as the original 1884 statute, which applied to “agents, attorneys, or other persons representing claimants.”
Judge Sentelle then suggested that the fact that Treasury had not claimed any authority to regulate tax return preparers until now, even though the statute had been on the books for more than a century, cast some doubt on the existence of that authority. Judge Kavanaugh added that Congress’s enactment of legislation regulating tax return preparers during that period also suggested that Congress did not think that it had delegated that authority to the Treasury Department. Mr. Rothenberg responded that the administrative process is an “evolving process,” and Treasury was free to “choose” not to regulate for many years and then later to invoke its latent authority to regulate. Later, he added that the need to regulate the competence of tax return preparers is greater today than it was decades ago when taxpayers could more easily avail themselves of direct assistance from the IRS in filling out their return. With respect to the legislation, Mr. Rothenberg distinguished laws that impose after-the-fact sanctions on return preparers from the Treasury initiative to impose up-front “admission” requirements. Judge Sentelle questioned why the regulations are limited to paid return preparers, but do not cover persons who prepare tax returns for free. Mr. Rothenberg responded that Treasury was tackling the problem one step at a time and reasonably believed that the biggest problem was with unqualified persons marketing their ability to prepare returns.
Judge Kavanaugh then zeroed in on the statutory text, pointing out that section 330 (a)(2)(D) states that Treasury “may . . . require” that “representatives” demonstrate their “competency to advise and assist persons in presenting their cases.” That language indicates that Congress understood that the “representatives” who could be regulated were persons who would assist in “presenting cases,” not just filling out returns. Mr. Rothenberg disagreed, arguing that Treasury was not compelled to impose all of the requirements set forth in subsection (a)(2) and that the other three requirements could apply to tax return preparers. Judge Sentelle expressed some doubt whether that position was consistent with the statutory use of the conjunctive “and” in joining the four subsections of (a)(2). Judge Williams then suggested that these were four different characteristics of representatives, but that the language of (a)(2)(D) in that case still bore some relevance to interpreting the term “representatives” in (a)(1). Mr. Rothenberg again disagreed, stating that the discussion was now focused on what he believed to be the fundamental error of the district court — namely, treating all four characteristics of section (a)(2) as mandatory, because that would exclude otherwise able practitioners from representing taxpayers before Treasury simply because they lacked advocacy skills. He also noted the position taken in the amicus brief of former IRS Commissioners that the “presenting a case” language could encompass preparing a tax return, but Judge Sentelle retorted that this would be an “awfully strange” use of the language.
Mr. Rothenberg then closed his argument by reiterating the government’s position that the district court erred in reading (a)(2) as limiting the language of (a)(1) and that (a)(1) itself did not foreclose Treasury from regulating tax return preparers. Therefore, Chevron deference is owed to those regulations.
Counsel for the plaintiffs, Dan Alban, began his argument by maintaining that there was no statutory authorization for the regulation. He described the statute as clearly focused on Treasury’s controversy and adjudicative functions, such as examination of returns and appeals before the agency, and not on what he described as “compliance” functions like filing a tax return. He also pointed to the “presenting their cases” language in subsection (a)(2), stating that no “case” exists until there is a dispute over the taxpayer’s return. Judge Williams asked about evidence that the scope of the original 1884 statute was limited to claims that were being resisted by the government — that is, controversies. Mr. Alban replied that it was clear that the statute was addressing claims that the claimants chose to bring, rather than a mandatory function like filing a tax return. In addition, he noted, the legislative history indicates that these were “contested” claims and that the representatives were standing in the shoes of the claimants. Here, by contrast, tax return preparers are not “representatives” before the agency. Judge Kavanaugh then asked who the preparers are representing. Mr. Alban replied that they are not representatives of anyone; they are just performing a service in assisting preparation of the return, but the taxpayer himself has to sign it. He noted in that connection that tax return preparers are not required to obtain a power of attorney, unlike taxpayer representatives in agency proceedings.
The court challenged Mr. Alban when he argued that the “level of policy decision” here warranted caution in allowing an agency, rather than Congress, to implement this new regulatory regime. Judge Sentelle noted that counsel couldn’t get much “traction” with that argument when the D.C. Circuit frequently deals with “sweeping regulations” that create major changes in the regulatory landscape. Judge Kavanaugh observed that, even if counsel was merely stating that the significance of the change ought to color the court’s approach to finding ambiguity, the suggestion was unworkable because it is hard for a court to decide what is “major.”
Finally, Judge Sentelle asked about the impact of the Supreme Court’s recent decision in City of Arlington holding that Chevron deference is owed to an agency’s determination of the scope of its jurisdiction. Mr. Alban stated that the decision was not directly applicable, but in any case the Supreme Court had made clear in that case the importance of seriously applying the limitations on Chevron deference. Here, because the statute was not ambiguous, Mr. Alban stated, the government’s position fails at Chevron Step 1, and therefore no deference is owed. Putting aside the discussion of broader administrative law principles, it was not apparent that any of the judges on the panel disagreed with the plaintiffs on that basic point regarding section 330(a).
Mr. Rothenberg began his rebuttal with a general discussion of Chevron principles, stating that all the prior cases in which the D.C. Circuit had invalidated regulations at Chevron Step 1 were situations where the agency action was more clearly foreclosed by a specific Congressional determination found in the statutory text, but he was met with considerable resistance. The judges observed that his list did not appear to be “exhaustive.” In particular, Judge Sentelle suggested that this case was perhaps analogous to the American Bar Ass’n case, which he described as invalidating FTC regulations directed at the legal profession on the ground that Congress had not empowered the FTC to regulate that profession. When Mr. Rothenberg answered in part that Chevron Step 1 sets a “low bar,” Judge Kavanaugh disagreed, stating that a court is to use all the tools of interpretation at Step 1 and that City of Arlington did not reflect a “low bar.”
Finally, Judge Kavanaugh asked Mr. Rothenberg to respond to Mr. Alban’s point that the IRS does not require tax return preparers to obtain a power of attorney. He replied that the power of attorney is required for “agents,” and tax return preparers are not agents. Mr. Rothenberg then repeated the point made in his opening remarks that the original 1884 statute covered “agents,” but other persons as well. Judge Williams interjected that the government appeared to be placing too much weight on the statutory reference to “other persons,” because canons of statutory construction provide that the scope of broad language like that is limited by the specific terms that precede it — here, “agents” and “attorneys.” Mr. Rothenberg noted that he disagreed, but his time expired before he could elaborate.
The case was heard on an expedited schedule, and therefore it is reasonable to expect that a decision will issue in the next couple of months.
Attached below is the plaintiffs’ response brief and the government’s reply brief, which were not previously posted on the blog. The government’s opening brief and two amicus briefs in support of the government were previously posted here and here.
[Note: Miller & Chevalier member and former Commissioner of Internal Revenue Lawrence B. Gibbs is among the five former Commissioners who filed an amicus brief in support of the Government in the Loving appeal.]
Five former IRS Commissioners filed an amicus brief in support of the Government’s appeal of the district court decision invalidating the IRS’s registration regime for paid tax return preparers. The former Commissioners “take no position regarding whether the manner in which the Treasury has chosen to regulate tax return preparers is advisable, but they strongly disagree with the District Court’s view that Congress has not empowered Treasury to do so.” Under 31 U.S.C. § 330, the Treasury Department is authorized to “regulate the practice of representatives of persons before the Department of Treasury.” The district court held that, although the statute did not define “the practice of representatives,” the surrounding statutory text made clear that Congress used “practice” to refer to “advising and assisting persons in presenting their case,” not simply preparing returns. In their amicus brief, the former Commissioners argue that filing a tax return does, in fact, constitute presenting a case. The amicus brief explains that an increasingly wide variety of government assistance programs are administered through the federal income tax system, including a number of refundable tax credits (the earned income credit, health insurance cost credit, etc.). Accordingly, the tax return preparer is not simply calculating tax liability; he or she also is often representing the taxpayer in pursuing claims for federal assistance. Because disbursements of benefits under these government assistance programs is administered largely through self-reporting on a tax return, it is essential, the former Commissioners argue, that paid tax return preparers be regulated so that taxpayers can identify the credits and benefits to which they are entitled and so that both the government and taxpayers are protected against fraud.
The National Consumer Law Center and National Community Tax Coalition also filed a joint amicus brief arguing for reversal of the district court’s decision. That brief documents “rampant” fraud and incompetence in the paid preparation industry, especially on the part of fringe return preparers, such as payday loan stores.
Yesterday, in Loving v. IRS (the subject of a recent post), the Government filed its reply brief in support of its motion to stay the district court’s injunction of the new registration regime for paid tax-return preparers. With respect to its likelihood of success on the merits, the Government argued the ambiguity of the statute authorizing Treasury to “regulate the practice of representatives of persons before” it. With respect to the threat of irreparable harm, the Government argued that the injunction risked delaying the implementation of the regulatory regime until the 2015 return-preparation season and that the problem of unregulated return preparers represents a “major public concern.”
Government Seeks Appellate Stay of Order Enjoining Enforcement of New Registration Regime for Paid Tax Return Preparers
The Government has appealed to the D.C. Circuit from the district court decision enjoining the IRS from enforcing its new registration regime for paid tax return preparers. Loving v. IRS, D.C. Cir. No. 13-5061. The Government has also asked the court of appeals to stay the decision pending appeal, after the district court declined to grant a stay. The Government’s stay motion recites that, the appeal has not yet been authorized by the Solicitor General’s office, but that, if the appeal is authorized, the Government intends to file its opening brief in March and to move for an expedited oral argument.
To recap the district court’s decision: In 2011, the Treasury Department promulgated regulations that extended Circular 230 (the regulations that govern practice before the IRS) to non-attorney, non-CPA tax-return preparers who prepare and file tax returns for compensation. Under the new regulations, tax-return preparers must register before they can practice before the IRS, and they are deemed to practice before the IRS even if their only function is to prepare and submit tax returns. In order to register initially, tax return preparers must pass a qualification exam and pay a fee. To maintain their registration each year, they must pay a fee and take at least fifteen hours of continuing education courses. The IRS estimated that the new regulation sweeps in 600,000 to 700,000 new tax return preparers who were previously unregulated at the federal level.
Three tax return preparers who were not previously regulated by Circular 230 brought suit challenging the 2011 regulations and seeking declaratory and injunctive relief. In January 2013, the U.S. District Court for the District of Columbia (Boasberg, J.) granted the plaintiffs’ motion for summary judgment. The court recognized that, under Mayo Foundation, the two-step analysis of Chevron should be applied to determine the validity of the regulations. The court explained, however, that “the battle here will be fought and won on Chevron step one” because “Plaintiffs offer no independent argument for why, if the statute is ambiguous, the IRS’s interpretation would be ‘arbitrary or capricious . . .’ under Chevron step two.” Focusing in this way on the unambiguous statutory text, the court held that the Treasury Department lacked statutory authority to issue the regulations.
The court rejected the Government’s argument that the agency had inherent authority to regulate those who practice before it, because a statute (31 U.S.C. § 330) specifically defined the scope of the Treasury Department’s authority. Under that statute, the Treasury Department is authorized to “regulate the practice of representatives of persons before the Department of Treasury.” The district court held that, although the statute did not define “the practice of representatives,” the surrounding statutory text made clear that Congress used “practice” to refer to “advising and assisting persons in presenting their case,” not simply preparing returns. Turning to provisions in the Internal Revenue Code that regulate tax return preparers, the court reasoned that Congress could not have intended § 330 to be the authority for regulating tax return preparers because “statutes scattered across Title 26 of the U.S. Code create a careful, regimented schedule of penalties for misdeeds by tax-return preparers.” The court rejected the Government’s resort to policy arguments. “In the land of statutory interpretation, statutory text is king.” Holding that the new regulations were ultra vires, the court enjoined the IRS from enforcing the registration regime.
In the motion for a stay pending appeal filed with the district court, the Government argued that the injunction substantially disrupted the IRS’s tax administration and that shutting down the program would be costly and complex. The district court was not persuaded, concluding that “[t]hese harms, to the extent they exist are hardly irreparable, and some cannot even be traced to the injunction.”
The Government’s stay motion in the court of appeals, filed February 25, argues that “[f]ailure to grant the stay will work a substantial and irreparable harm to the Government and the taxpaying public, crippling the Government’s efforts to ensure that individuals who prepare tax returns for others are both competent and ethical.” According to the Government’s brief, the “IRS estimates that fraud, abuse, and errors cost the taxpaying public billions of dollars annually.” In their March 8 response, the Plaintiffs/Appellees argue that the Government failed to establish any imminent irreparable harm traceable to the injunction, noting that even the Government acknowledged that most of the alleged harms would not occur until 2014. The tax return preparers also emphasize that the injunction merely preserves the historical status quo.
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.
Home Concrete Decision Leaves Administrative Law Questions Unsettled While Excluding Overstatements of Basis from Six-Year Statute of Limitations
May 3, 2012 by Alan Horowitz
Filed under Beard, Burks, Grapevine, Home Concrete, Intermountain, Regulatory Deference, Salman Ranch, Statute of Limitations, Statutory Interpretation, Supreme Court, UTAM
[A shorter version of this blog post appears on SCOTUSblog.]
The Supreme Court last week ruled 5-4 in favor of the taxpayer in Home Concrete, thus putting an end to the long-running saga of the Intermountain litigation on which we have been reporting for the past 18 months. The opinion was authored by Justice Breyer and joined in full by three other Justices, but Justice Scalia joined only in part. The result is a definitive resolution of the specific tax issue – the six-year statute of limitations does not apply to an overstatement of basis. But the Court’s decision provides a much less definitive resolution of the broader administrative law issues implicated in the case.
As foreshadowed by the oral argument (see our previous report here), the tax issue turned on the continuing vitality of the Court’s decision in The Colony, Inc. v. Commissioner, 357 U.S. 28 (1958). To recap, the Court held in Colony that the “omits from gross income” language in the 1939 Code did not encompass situations where the return understates gross income because of an overstatement of basis, and hence the extended six-year statute of limitations did not apply in those situations. The government argued that Colony did not control the interpretation of the same language in current section 6501(e) of the 1954 Code, because changes elsewhere in that section suggested that Congress might have intended a different result in the 1954 Code.
The administrative law issues came into play because, after two courts of appeals had ruled that Colony controlled the interpretation of the 1954 Code, the government tried an end run around that precedent. Treasury issued regulations interpreting the “omits from gross income” language in the 1954 Code as including overstatements of basis, thus bringing those situations within the six-year statute of limitations. Under National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005), the government argued, an agency is empowered to issue regulations that define a statute differently than an existing court decision, so long as the court decision did not declare the statutory language unambiguous. Because the Colony opinion had indicated that the 1939 Code language standing alone was “not unambiguous,” the government argued that Treasury’s new regulations were entitled to Chevron deference, which would supplant any precedential effect that Colony would otherwise have on the interpretation of the 1954 Code provision.
The Court’s Opinion
Justice Breyer wrote the opinion for the Court, joined in full by Chief Justice Roberts and Justices Alito and Thomas. Justice Scalia joined Justice Breyer’s analysis of the statute, but departed from his analysis of the administrative law issues.
The opinion dealt straightforwardly with the basic tax issue. First, the Court emphasized that the critical “omits from gross income” language in the current statute is identical to the 1939 Code language construed in Colony, and it recounted the Colony Court’s reasoning that led it to conclude that the language does not encompass overstatements of basis. Colony is determinative, the Court held, because it “would be difficult, perhaps impossible, to give the same language here a different interpretation without effectively overruling Colony, a course of action that basic principles of stare decisis wisely counsel us not to take.” With respect to the statutory changes made elsewhere in section 6501(e), the Court concluded that “these points are too fragile to bear the significant argumentative weight the Government seeks to place upon them.” The Court addressed each of these changes and concluded that none called for a different interpretation of the key language (and that one of the government’s arguments was “like hoping that a new batboy will change the outcome of the World Series”).
The Court then turned to the administrative law issues, reciting the government’s position that, under Brand X, the new regulations were owed deference despite the Court’s prior construction of the language in Colony. The opinion first responded to that position with a two-sentence subsection: “We do not accept this argument. In our view, Colony has already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency.”
Standing alone, that was not much of a response to the government’s Brand X argument, because Brand X said that the agency can adopt a construction different from that provided in a prior court decision so long as the statute was ambiguous. These two sentences were enough for Justice Scalia, however, and he ended his agreement with Justice Breyer’s opinion at this point. In a separate concurring opinion, Justice Scalia explained that he is adhering to the view expressed in his dissent in Brand X that an agency cannot issue regulations reinterpreting statutory language that has been definitively construed by a court.
With the other Justices in the majority not feeling free to ignore Brand X, Justice Breyer’s opinion (now a plurality opinion) then proceeded to explain why Brand X did not require a ruling for the government. According to the plurality, Brand X should be given a more nuanced reading than that urged by the government, one that looks to whether a prior judicial decision found a statute to be “unambiguous” in the sense that the court concluded that Congress intended to leave “‘no gap for the agency to fill’ and thus ‘no room for agency discretion.’” Under Chevron jurisprudence, the opinion continued, unambiguous statutory language provides a “clear sign” that Congress did not delegate gap-filling authority to an agency, while ambiguous language provides “a presumptive indication that Congress did delegate that gap-filling authority.” That presumption is not conclusive, however, and thus this reading of Brand X leaves room for a court to conclude that a judicial interpretation of ambiguous statutory language can foreclose an agency from issuing a contrary regulatory interpretation. In support of that proposition, the plurality quoted footnote 9 of Chevron, which states that “[i]f a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law and must be given effect.”
The plurality then ruled that the Court in Colony had concluded that Congress had definitively resolved the legal issue and left no gap to be filled by a regulatory interpretation. Given its analysis of the scope of Brand X, the plurality explained that the Colony Court’s statement (26 years before Chevron) that the statutory language was not “unambiguous” did not necessarily leave room for the agency to act. Rather, the Colony Court’s opinion as a whole – notably, its view that the taxpayer had the better interpretation of the statutory language and had additional support from the legislative history – showed that the Court believed that Congress had not “left a gap to fill.” Therefore, “the Government’s gap-filling regulation cannot change Colony’s interpretation of the statute,” and the Court today is obliged by stare decisis to follow it.
The Concurring and Dissenting Opinions
Justice Kennedy’s dissent, joined by Justices Ginsburg, Sotomayor, and Kagan, reached a different conclusion on the basic tax dispute. The dissent looked at the statutory changes made in the 1954 Code and concluded that they are “meaningful” and “strongly favor” the conclusion that the “omits from gross income” language in the 1954 Code should not be read the way the Colony Court read that same language in the 1939 Code. Given that view, the administrative law issue – and the resolution of the case – became easy. The dissent stated that the Treasury regulations are operating on a blank slate, construing a statute different from the one construed in Colony, and therefore they are owed Chevron deference without the need to rely on Brand X at all.
Justice Scalia’s concurring opinion declared a pox on both houses. He was extremely critical of the plurality’s approach, accusing it of “revising yet again the meaning of Chevron . . . in a direction that will create confusion and uncertainty.” He also criticized the dissent for praising the idea of a “continuing dialogue among the three branches of Government on questions of statutory interpretation,” when the right approach should be to say that “Congress prescribes and we obey.” Justice Scalia concluded: “Rather than making our judicial-review jurisprudence curiouser and curiouser, the Court should abandon the opinion that produces these contortions, Brand X. I join the judgment announced by the Court because it is indisputable that Colony resolved the construction of the statutory language at issue here, and that construction must therefore control.”
What Does It Mean?
The Home Concrete decision provides a clear resolution of the specific tax issue. The six-year statute of limitations does not apply to overstatements of basis. The multitude of cases pending administratively and in the courts that involve this issue will now be dismissed as untimely, leaving the IRS unable to recover what it estimated as close to $1 billion in unpaid taxes.
Indeed, in a series of orders issued on April 30, the Court has already cleared its docket of the other Intermountain-type cases that had been decided in the courts of appeals and kept alive by filing petitions for certiorari. In Burks and the other Fifth Circuit cases in which the taxpayers had prevailed, the Court simply denied certiorari, making the taxpayers’ victory final. For the certiorari petitions filed from courts of appeals that had sided with the government, such as Grapevine (Federal Circuit), Beard (Seventh Circuit), Salman Ranch (Tenth Circuit), and Intermountain and UTAM (D.C. Circuit), the Court granted the petitions and immediately vacated the court of appeals decisions and remanded the cases to the courts of appeals for reconsideration. Now constrained by Home Concrete, those courts will enter judgments in favor of the taxpayers in due course.
Notably, although the retroactive nature of the Treasury regulations was a significant point of contention in the litigation, retroactivity did not play a role in the final resolution. The Court held that Colony is controlling and leaves no room for the agency to construe the “omits from gross income” language differently. Thus, Treasury does not have the ability to use its regulatory authority to extend the six-year statute to overstatements of basis even prospectively. Any such extension will have to come from Congress.
The effect of the decision on administrative law generally is considerably more muddled. First, a couple of observations on what the Court did not do. It did not signal any retreat from Mayo. Treasury regulations addressed to tax issues will continue to be judged under the same Chevron deference principles that apply to regulations issued by other agencies. Furthermore, as noted above, the Court did not rely on the retroactive aspect of the regulations. Thus, the decision does not provide guidance one way or another on the extent to which Treasury is constrained in its ability to apply regulations to earlier tax years.
What the Court did do, however, is to weaken the authority of Brand X. Under the reasoning of Justice Breyer’s plurality opinion, courts are now free to decline to defer to a regulatory interpretation that construes ambiguous statutory language – if the court concludes that a prior court decision, using “traditional tools of statutory construction” that go beyond the text, determined that Congress intended to resolve the issue rather than leave a gap for the agency to fill. Although there were only four votes for that proposition, Justice Scalia’s approach would lead him to agree with such a result just as he did in Home Concrete, so lower courts may treat the plurality opinion as controlling. There is, however, room for debate about the impact of the Home Concrete approach. Justice Breyer’s opinion emphasizes the fact that Colony was decided long before Chevron, and lower courts may disagree regarding its impact when the court decision at issue is post-Chevron and, in particular, post-Brand X. At a minimum, the Home Concrete decision should make agencies less confident in their ability to use regulations to overturn judicial interpretations of statutes and should give taxpayers more ammunition to challenge such regulations if necessary.
Interestingly, Justice Breyer’s approach, and in particular his invocation of Chevron’s footnote 9 reference to “traditional tools of statutory construction,” was previewed in the argument in the Federal Circuit in the Grapevine case. As we reported at the time, that argument involved considerable discussion of whether the determination of “ambiguous” at Chevron step 1 must be based entirely on the statutory text, as Brand X suggests, or can be based on other “traditional tools of statutory construction,” as Chevron footnote 9 declares. In its decision, the Federal Circuit stuck to the statutory text and ruled for the government.
Justice Breyer’s opinion, however, supports the proposition that Chevron step 1 analysis can look beyond the statutory text. If that portion of Justice Breyer’s opinion had commanded a majority, it would be extremely significant because it would justify looking beyond the statutory text not only in assessing the impact of Brand X when there is a court decision on the books, but also in considering a Chevron deference argument in the first instance. A court could decide, under the approach suggested by Justice Breyer, that a statute whose text standing alone is ambiguous nonetheless leaves no room for agency interpretation – if other tools of statutory construction show that Congress intended to resolve the issue rather than leaving a gap for the agency. On this point, however, the plurality opinion cannot be treated as controlling because Justice Scalia would surely look askance at a decision that used legislative history to find a lack of ambiguity at Chevron Step 1. By the same token, the dissenters had no occasion to address this point, so we do not know if any of them would have agreed with Justice Breyer’s approach. For now, it is fair to say that Justice Breyer has heightened the visibility and potential importance of Chevron footnote 9, but that Home Concrete alone probably will not yield a significant change in how courts approach Chevron step 1.
In sum, Home Concrete may be a bit of a disappointment to those observers who thought that the decision would bring great clarity to the administrative law issues presented. In that respect, it joins a long list of administrative law cases that reach the Supreme Court and seem to yield as many questions as answers. But for the taxpayers with millions of dollars riding on the difference between a three-year and six-year statute of limitations, the decision is not disappointing at all. It is a huge victory.
The Supreme Court heard oral argument in the Home Concrete case on January 17, with the Justices vigourously questioning both sides on both the statutory and administrative deference issues. The Court will issue its decision by the end of June. The following is a recap of the argument that is also published at SCOTUSblog. A full transcript of the oral argument can be found here.
Home Concrete involves the scope of the extended six-year statute of limitations applicable when a taxpayer “omits from gross income an amount properly includible therein.” The case presents two main issues: (1) whether that statutory language covers overstatements of tax basis, even though the Supreme Court construed the same phrase in a predecessor statute not to do so; and, (2) if the Court does not accept the government’s statutory argument, whether it must defer to a recent Treasury regulation that adopts the government’s proffered interpretation. The argument was lively, with all Justices save Justice Thomas asking questions at some point. It was also somewhat disjointed, as the discussion jumped from topic to topic without any obvious agreement among the Justices concerning which issue would be the ground for resolving the case.
Arguing on behalf of the United States, Deputy Solicitor General Malcolm Stewart began by making a determined effort to persuade the Court that it should prevail on a standard statutory analysis without the need to resort to Chevron deference. In response to questions from the Chief Justice and Justice Scalia suggesting that the Court’s decision in The Colony, Inc. v. Commissioner derails that argument from the start, Stewart argued that Colony did not purport to give a definitive definition of the “omits from gross income” language wherever it appears in the Code. Rather, it just interpreted the language for the 1939 Code, and the 1954 Code should be read differently because of the additional subsections that were added.
Several Justices (the Chief Justice, Justice Scalia, and Justice Sotomayor) expressed skepticism that Congress would have used such an obscure mechanism to change the interpretation of the “omits from gross income” phrase. Stewart responded that he would agree if Colony had been on the books when the 1954 Code was enacted. But in fact Colony was not decided until 1958, and Congress was acting against the backdrop of the existing circuit conflict on the meaning of the 1939 Code. Justices Kennedy and Scalia immediately questioned that response, stating that it is “very strange” to say that the same language would have a different meaning depending upon when Colony was decided. Justice Scalia then elaborated on his skepticism over the government’s attempts to prevail on the statute alone, stating that “we’re not writing on a blank slate here.” “I think Colony may well have been wrong, but there it is. It’s the law. And it said that that language meant a certain thing.”
At that point, Justice Kagan sought to rescue Stewart by interjecting that the government has two arguments and the second one – that Treasury had the power to reinterpret the statute in regulations – was independent of Colony’s interpretation of the statutory language. Although Stewart first tried to steer the Court back to the statute, Justice Kagan persisted, and the Chief Justice then entered the fray to question the linchpin of the government’s deference argument – namely, that Colony had found the statute to be “ambiguous.” The Chief Justice pointed out that Justice Harlan, in using that word in 1958, “was writing very much in a pre-Chevron world” and likely was using the word not as “a term of art,” but rather in an attempt to be gracious to the lawyers and courts that had taken the opposite position. Justice Ginsburg, however, pointed out that the Court had characterized the new subsection in the 1954 Code as “unambiguous” and therefore should be taken at its word that the 1939 Code was ambiguous.
Another line of questioning explored the extent to which there was ever a well-entrenched view that Colony controlled the meaning of the 1954 Code. Stewart rejected the taxpayer’s position that everyone understood Colony as controlling prior to the Son-of-BOSS litigation, stating that there was a “surprising dearth of law” on the point, but the only arguably relevant case was a 1968 Fifth Circuit decision that suggested that Colony was not controlling. The taxpayer and the Fifth Circuit dispute that reading of the case. (No one observed that the likely reason there was no case law on this issue was because the IRS accepted Colony as controlling and therefore never attempted to invoke the six-year statute for overstatements of basis.) Justice Breyer asked about a 2000 IRS guidance document that appeared to adopt the taxpayer’s view of Colony, but government counsel dismissed it as merely the view of a single District Counsel. That prompted the Chief Justice to ask acerbically “at what level of the IRS bureaucracy can you feel comfortable that the advice you are getting is correct?”
When Gregory Garre took the podium on behalf of the taxpayer, Justice Kagan asked why Congress had added the new subsection addressing a trade or business. Garre argued that it was designed to resolve the Colony issue favorably to the taxpayer, noting that there was nothing problematic about the fact that the new subsection addressed the specific problem of cost of goods sold instead of explicitly sweeping more broadly. That answer triggered a more extensive discussion of why Congress acted as it did and whether it was drawing a distinction between sales of goods and services (addressed in the new subsection) and sales of real estate (at issue in Colony).
The key administrative law precedent at issue on the deference argument is National Cable & Telecommunications. Ass’n v. Brand X Internet Services, in which the Court accorded deference to a regulation that overturned existing court of appeals precedent. The Court did not show any interest in backing away from Brand X, but it did suggest that it might read the case somewhat more narrowly than the government would like. In Brand X, Justice Stevens wrote a short concurring opinion stating that the holding would not apply to a Supreme Court opinion because at that point no ambiguity would be left. At the beginning of the argument, Justice Scalia echoed that view when he objected to Stewart’s reliance on the statement in Colony that the statute was “not unambiguous” by observing: “Yes, but once we resolve an ambiguity in the statute, that’s the law and the agency cannot issue a regulation that changes the law just because going in the language was ambiguous.” The Chief Justice returned to this point at the argument’s close. He asked the only questions during the government’s rebuttal argument, seeking to confirm that the Court has never applied Brand X to one of its own decisions – that is, that “we’ve never said an agency can change what we’ve said the law means.”
The more open-ended issue concerning the scope of Brand X is what exactly was meant in that case by the statement that the judicial construction can trump a later regulation “only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.” The Court’s exploration of this point began with a lighthearted comment by Justice Scalia that the question in the case boils down to whether indeed Colony meant “ambiguous” when it used that term. Justice Alito followed up, however, pointing out that every statutory interpretation question in the Supreme Court “involve[s] some degree of ambiguity . . ., [s]o what degree of ambiguity is Brand X referring to?”
Garre’s response to this question was to go back to the original Chevron decision, which “looks to whether Congress has addressed the specific question presented.” Under that approach, Colony should be regarded as having found the degree of clarity necessary to insulate it from being overturned by regulation, because the Court concluded that Congress had addressed this specific question. Justice Kagan, later seconded by Justice Ginsburg, questioned that approach, commenting that the relevant question is “how clearly did Congress speak to that specific situation?” Because the Colony Court stated that the text was ambiguous and had to do a lot of “tap dancing” through the legislative history to resolve the case, she stated that Colony must be read as indicating “a lot of ambiguity.” Justice Breyer then jumped in to express agreement with the taxpayer’s argument that the Colony Court’s resort to legislative history was just a standard mode of statutory construction that did not require treating that case as finding an ambiguity under Brand X. Instead, Justice Breyer stated, “[t]here are many different kinds of ambiguity and the question is, is this of the kind where the agency later would come and use its expertise”?
The argument devoted relatively little attention to the retroactivity question. The Chief Justice observed that, in light of Brand X, a taxpayer could never feel confident about a tax precedent because the IRS can change the rule and apply it retroactively. This observation, however, did not obviously elicit much concern from the other Justices, with the notable exception of Justice Breyer who had stated early on that it was “unfair” for the IRS to promulgate “a regulation which tries to reach back and capture people who filed their return nine years before.” Later, Justice Breyer acknowledged that merely tagging the retroactivity as unfair “is not enough” and asked Garre an incredibly long question designed to explore possible justifications for avoiding the retroactive application of the regulations even if the Court were to defer to them on a prospective basis. These ideas, however, did not appear to gain any traction with the other Justices.
Predicting the outcome on the basis of this oral argument is dicey. Justice Kagan appeared sympathetic to the government’s position, while Justice Breyer was very troubled by the unfairness of it. Justices Ginsburg and Sotomayor seemed to tilt towards the government. But most of the Justices expressed enough difficulty with both sides that their votes cannot reasonably be forecast. Overall, however, it did appear that the Court is more likely heading towards a relatively narrow decision than towards one that would break new ground in administrative law. The Court’s approach to Colony will likely be critical. If the Court treats Colony as precedential with respect to the 1954 Code, as it was generally regarded for fifty years, then it would not be difficult to rule for the taxpayer. Brand X might be distinguished because Colony is a Supreme Court decision, or perhaps on the ground that the case should not be treated as finding an “ambiguity” in Chevron terms. Conversely, if the Court views Colony as inapplicable to the 1954 Code, then, notwithstanding Justice Scalia’s observation to the contrary, the Court will essentially be writing on a blank slate. If so, Brand X would likely lead to a ruling for the government.
The long journey of the Intermountain cases toward a definitive resolution enters its final phase on Tuesday morning when the Supreme Court hears oral argument in the Home Concrete case. (The final brief, the government’s reply brief, was filed last week.) Each side will have 30 minutes for its argument, with the government going first and having the opportunity for rebuttal (using whatever portion of the 30 minutes that remains after its opening argument). Deputy Solicitor General Malcolm Stewart (the Deputy SG in charge of tax cases) will argue for the government. Gregory Garre, who served as Solicitor General during the last few months of the Bush administration in 2008-09, will argue for the taxpayer. Both counsel have many Supreme Court arguments under their belts.
Regular readers of the blog know that we have covered these issues extensively since the Tax Court issued its decision in Intermountain. The following is a preview of the argument that summarizes the issues for those who have not been following it so closely (or perhaps have gotten tired reading about it and want a refresher course). A shorter version of this argument preview appears at SCOTUSblog.
We will return later in the week with a report on the argument.
Depending on how the Court resolves a threshold statutory construction issue, Home Concrete could yield a decision of broad importance or one of interest only to tax lawyers. The ultimate issue concerns the scope of an extended statute of limitations applicable only to tax cases. The first possible ground for decision is purely a matter of interpreting the language of the tax statutes. But the government faces significant hurdles on that ground, notably the Court’s 1958 decision in The Colony, Inc. v. Commissioner, which interpreted the same words in a predecessor statute in the 1939 Code in accordance with the taxpayer’s position. If the Court rejects the government’s position that the statutory language alone is dispositive, the case will move to the second issue presented – whether the Court must adopt the government’s statutory construction because Chevron requires it to defer to recently promulgated Treasury regulations. A decision on that issue could be a significant administrative-deference precedent that would have broad ramifications outside the tax context as well.
Generally, the IRS has three years from the date a tax return is filed to assess additional tax on the ground that a taxpayer underreported its tax liability. Under 26 U.S.C. § 6501(e)(1)(A), however, there is an extended six-year statute of limitations if the taxpayer “omits from gross income” a significant amount that it should have included. A similar provision governing partnership tax returns is found at 26 U.S.C. § 6229(c)(2). The question presented in Home Concrete is whether that “omits from gross income” language includes a situation where a taxpayer overstates its basis.
The textual question at the heart of this case goes back almost 70 years. The 1939 Internal Revenue Code, which was later superseded by the 1954 Code, contained a provision with language identical to that of current section 6501(e)(1)(A). Taxpayers argued that the extended statute of limitations applied only when there was a literal omission of gross income – that is, a failure to list an item of gross income on the return. The government argued that the extended statute also applied when there was an overstatement of basis, because that leads to an understatement of gross income. The issue generated a circuit conflict and eventually made it to the Supreme Court in the Colony case.
In the meantime, Congress enacted the 1954 Code, which largely carried forward the previous statute. Congress did not change the “omits from gross income” language and did not directly address the then-existing dispute about its scope. Congress did add a new subsection that specifically defined “gross income” in the case of a trade or business, and it defined that term so that an overstatement of basis could not possibly be an omission of “gross income.”
Thereafter, the Colony case arrived in the Supreme Court. Construing the 1939 Code, the Court ruled for the taxpayer, holding that “the statute is limited to situations in which specific receipts or accruals of income are left out of the computation of gross income” and therefore it did not apply to overstatements of basis. Little did the Court know that 50 years later litigants would be parsing its reasoning to see how the case fits into the framework of Chevron – specifically, whether the Colony Court should be understood to have found the statutory language before it unambiguous. Two statements by the Colony Court are particularly relevant. First, the Court stated that, although the statutory text “lends itself more plausibly to the taxpayer’s interpretation, it cannot be said that the language is unambiguous.” The Court then looked to the legislative history, where it found persuasive support for the taxpayer, and also concluded that the government’s interpretation would apply the statute more broadly than necessary to achieve Congress’s purpose. Second, having been urged by the parties to consider whether the new legislation shed any light on the meaning of the 1939 Code, the Court stated that its conclusion was “in harmony with the unambiguous language” of the 1954 Code.
Fast forward 50 years. The issue has lain dormant, as everyone assumed that Colony controlled the interpretation of the identical language in the 1954 Code. The IRS learned that many taxpayers had engaged in a series of securities transactions that came to be known as a Son-of-BOSS transaction. The IRS views this transaction as a tax avoidance scheme that manipulates certain tax rules to produce an artificially inflated basis for an asset that is then sold, producing either a noneconomic paper loss or a smaller gain than it should. The IRS has successfully challenged these transactions, with the courts generally concluding that they lack “economic substance” and therefore the taxpayers cannot take advantage of the apparent tax benefits. But in many cases, the IRS discovered that more than three years had elapsed before it could challenge the tax treatment, and therefore the standard statute of limitations had expired.
Seeking to recover what it estimated as almost $1 billion in unpaid taxes, the IRS began to argue that the extended six-year statute of limitations applied to these transactions because they involved an overstatement of basis. It contended that Colony was not controlling because the Court’s decision should be limited to the 1939 Code and that a different result should obtain in the Son-of-BOSS cases (which arise outside the “trade or business” context and hence are not encompassed within the new subsection added in 1954). This argument initially fell flat in the courts, as the Tax Court and the Ninth and Federal Circuits held that Colony controls the interpretation of the “omits from gross income” language of the 1954 Code.
The government then moved on to Plan B. The Treasury Department issued temporary regulations interpreting the “omits from gross income” language to include overstatements of basis. (These regulations have since been issued without material change as final regulations after a notice-and-comment period.) The government then filed a motion for reconsideration in the Intermountain case, arguing that the Tax Court should reverse its decision because of an “intervening change in the law” requiring it to accord Chevron deference to the new regulatory interpretation. The Tax Court was unimpressed, voting 13-0 (in three different opinions giving three different grounds) against the government.
Unfazed, the government filed appeals in several cases heading to different circuits, and the tide began to turn. First, the Seventh Circuit became the only court thus far to agree with the government’s statutory argument. The Fourth and Fifth Circuits quickly rejected that view and also rejected the government’s Chevron argument, holding that after Colony there was no ambiguity for the Treasury Department to interpret. Three other court of appeals decisions followed in short order, however, and all three circuits ruled for the government on Chevron deference grounds. Of particular note on that point is the Federal Circuit’s decision, since the Federal Circuit had already rejected the government’s pre-regulation statutory interpretation. The Federal Circuit explained that it still believed that the taxpayer had the best reading of the statute, but that it was required to defer to the regulation because it could not say that the regulation’s interpretation was unreasonable. The Court granted certiorari in Home Concrete, the Fourth Circuit case, to resolve the conflict.
With respect to the meaning of the statute, the taxpayer rests primarily on Colony, characterizing the IRS as having “overruled” that decision. The taxpayer argues that its reliance on stare decisis is buttressed by the fact that Congress reenacted the same statutory language in later years against the background of Colony, thereby putting a legislative stamp on the Court’s determination that the words “omits from gross income” should be interpreted not to include overstatements of basis.
The government in turn argues that Colony is irrelevant because it involved a different statute, which was materially changed in 1954 when Congress added a subsection making clear that there is no extended statute of limitations for overstatements of basis by a trade or business. Implicit in Congress’s decision to make that addition was its understanding that overstatements of basis would be covered outside of the trade or business context; otherwise, the new provision would be superfluous. The taxpayer responds that the new subsection is not superfluous and that it is absurd to conclude that the 1954 Code cut back on taxpayers’ statute of limitations protections when the only changes made to the statute favored taxpayers.
In addition to the Colony-related arguments, both sides argue that their position reflects the best reading of the statutory text and purpose. The taxpayer argues that “omits” means leaving something out, while the government emphasizes that overstatements of basis inevitably cause an understatement (that is, an “omission” of a portion) of gross income.
The taxpayer makes a couple of other narrow arguments that could theoretically divert the Court from reaching the deference issue: (1) that the regulations were procedurally defective; and (2) that by their terms, the regulations do not apply to cases like this one, where the three-year statute had already expired before the regulations were promulgated. These arguments did not prevail in any court of appeals, and the Court is unlikely to adopt them. That will lead the Court to a deference issue of potentially broad doctrinal significance.
Back in 1971, the Second Circuit thought it obvious that the Treasury Department did not have the power to affect pending litigation that the government claims here, stating that “the Commissioner may not take advantage of his power to promulgate retroactive regulations during the course of litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations.” But the D.C. Circuit, in reversing the Tax Court’s reviewed Intermountain decision, said that the Second Circuit’s statement has been “superseded” by Supreme Court precedent. The Home Concrete case is well positioned to determine who is right.
Basically, the government argues that the Court’s Chevron jurisprudence has already crossed all the lines that are necessary to get to its desired end result here. In Smiley v. Citibank, N.A., the Court afforded deference to a regulation in a case that was already pending when the regulation was issued, stating that it was irrelevant whether the regulation was prompted by litigation. In National Cable & Telecomms. Ass’n v. Brand X Internet Servs., the Court afforded deference to a regulation that overturned existing court of appeals precedent, holding that a “court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.” Put those two together, the government argues, and there is no justification for failing to defer to Treasury’s interpretation because Colony had described the 1939 statute as not “unambiguous.”
Not so fast, says the taxpayer, arguing that, after Colony, the law was settled and there was no ambiguity that could permissibly be “clarified” by regulation. Smiley is different, because the regulation there did not overturn a previously settled interpretation. Brand X is not applicable because Colony is properly read as having held that Congress did unambiguously express its intent not to include overstatements of basis. More generally, the taxpayer contends that the retroactive effect of the government’s position is a bridge too far that is not authorized by these precedents. Among the several amicus briefs filed in support of the taxpayer, one filed by the American College of Tax Counsel focuses exclusively on the retroactivity question, asserting that “retroactive fighting regulations” designed to change the outcome of pending litigation “are inconsistent with the highest traditions of the rule of law” and should not be afforded Chevron deference.
At the end of the day, the deference issue may turn on the Court’s comfort level with the amount of authority the government is asking courts to concede to agencies – particularly an agency frequently in a position to advance its fiscal interest through regulations that will affect its own litigation. That general topic has been flagged in the court of appeals opinions. In the Federal Circuit decision holding that the new regulation trumped that court’s precedent, the court observed that the case “highlights the extent of the Treasury Department’s authority over the Tax Code” because “Congress has the power to give regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.” Conversely, Judge Wilkinson cautioned in his concurring opinion in Home Concrete that “agencies are not a law unto themselves,” but must “operate in a system in which the last words in law belong to Congress and the Supreme Court.” In his view, the government’s invocation of Chevron deference in this case wrongly “pass[es] the point where the beneficial application of agency expertise gives way to a lack of accountability and risk of arbitrariness.”
In recent years, the Court has not evinced much concern over the amount of power that its Chevron jurisprudence has given to agencies. But this case could induce it to look more closely at the big picture. Justice Scalia’s position will be of particular interest. Justice Scalia was an early force in the development of Chevron deference, dating back to his time on the D.C. Circuit shortly after Chevron was decided. But recently, he has expressed some uneasiness that the way in which the doctrine has developed had given agencies too much power. He dissented in Brand X, commenting that the decision was creating a “breathtaking novelty: judicial decisions subject to reversal by executive officers.” And just last June, he noted in a concurring opinion in Talk America, Inc. v. Michigan Bell Telephone Co., that he would be open to reconsidering Auer v. Robbins (a decision that he authored in 1997) because its rule of extreme deference to an agency’s interpretations of its own regulations “encourages the agency to enact vague rules which give it the power, in future adjudications, to do what it pleases.” Justice Scalia’s questions at oral argument, and the reaction of other Justices to them, will be worth watching.