Supreme Court Denies Cert in Altera

Despite the glut of high-powered amicus briefs in support of the taxpayer’s petition for certiorari and last week’s landmark APA decision on DACA (the relevance of which to the issues in Altera we covered here), the Supreme Court declined to review the Ninth Circuit’s decision in Altera this morning.

Supreme Court’s DACA Decision May Affect Altera

Altera’s petition for certiorari is pending at the Supreme Court. With the support of several amici, Altera has asked the Court to review the Ninth Circuit’s decision (see our prior coverage here) to uphold the validity of Treasury’s transfer-pricing regulation (Treas. Reg. § 1.482-7A(d)(2)) requiring taxpayers to include employee-stock-option costs in the pool of costs that parties to cost-sharing arrangements must share. Two APA arguments loom large in Altera’s petition. Today’s Supreme Court decision on Deferred Action for Childhood Arrivals (DACA) and the APA in Department of Homeland Security v. Regents of the University of California, No. 18-587, may change the complexion of both arguments and provide the Court with an alternative route for the Court in handling Altera’s petition.

In today’s decision, the Court struck down efforts by the Department of Homeland Security (DHS) to terminate DACA because the initial action by the Acting Secretary of DHS failed to comply with the APA. DHS promulgated DACA in 2012. And in 2014, DHS sought to expand DACA by removing an age cap and creating a new program for parents (DAPA). That expansion was mired in litigation for several years and enjoined by the Fifth Circuit on the grounds that the expansion was more than a mere agency decision to not enforce particular immigration laws.

In 2017, the new administration sought not only to undo that expansion but altogether to rescind DACA, with DHS issuing a memorandum relying on little more than a citation to the Fifth Circuit’s decision (which addressed only the 2014 expansion) and reference to a letter from the Attorney General. The Fifth Circuit decision, however, had been limited to the aspects of the DACA expansion that related to eligibility for some public benefits (and not to the animating policy of forbearing deportations); the Attorney General’s letter reiterated only that the Fifth Circuit decision was correct. The NAACP (among others) challenged the administration’s attempt to rescind DACA based on this DHS memorandum. And in that suit, the D.C. District Court found that DHS’s “conclusory statements [in the memorandum] were insufficient to explain the change in [DHS’s] view of DACA’s lawfulness,” giving DHS a chance to explain itself more fully.

The new DHS Secretary offered up a second memorandum in which she stated that she “decline[d] to disturb” the first memorandum’s DACA rescission. That second memorandum had other conclusory statements and several prudential and policy reasons that were not in the first DHS memorandum. The D.C. District Court found the new explanations insufficient. That case and other related cases were appealed, and the Supreme Court ultimately granted certiorari in the California case in which it issued a decision today. The Supreme Court addressed, among other things, “whether the [DHS] rescission [of DACA] was arbitrary and capricious in violation of the APA.”

The Court held that it was. There are two elements to that decision, both of which may bear on Altera’s arguments in its petition for certiorari. First, the Court held that “[d]eciding whether agency action was adequately explained requires, first, knowing where to look for the agency’s explanation.” And the Court held that it would look only to the first, conclusory DHS memorandum because “[i]t is a ‘foundational principle of administrative law’ that judicial review of agency action is limited to ‘the grounds that the agency invoked when it took the action.’” This means that DHS could have either (1) issued a new memorandum that better explained the reasoning behind the first memorandum (thus propping up the agency action embodied in the first memorandum) or (2) taken altogether new agency action with a distinct explanation (which new explanation would be subject to a distinct APA review). DHS did not take new action but sought instead to explain its earlier action. In doing so, however, DHS did not offer a better explanation of previously identified reasons, but rather offered reasons that were not in the first memorandum at all. (In the Court’s words, the “reasoning [of the second DHS secretary in the second memorandum] bears little relationship to that of her predecessor.”) The Court elaborated on the reasons why administrative law principles bar agencies from introducing new justifications for agency action after the fact, not the least of which is that “[c]onsidering only contemporaneous explanations for agency action … instills confidence that the reasons given are not simply ‘convenient litigating position[s].’” Therefore, the Court held, “[a]n agency must defend its actions based on the reasons it gave when it acted.”

This element of the Court’s decision goes to the heart of one of Altera’s leading arguments for certiorari. Altera observed that the government pivoted from arguing (in the regulatory preamble and before the Tax Court) that its cost-sharing regulation was consistent with the arm’s-length standard to arguing (in its briefs before the Ninth Circuit) that the addition of the “commensurate-with-income” language to section 482 permitted Treasury to adopt a rule under which a “comparability analysis plays no role in determining” the costs that taxpayers must share. Altera argued that by invoking one rationale in its rulemaking and then invoking a different rationale in litigation, Treasury violated the Chenery rule, which “ensures that an agency cannot say one thing in a rule-making proceeding, and then change its mind as soon as the rule is challenged in court.”

Today’s decision provides some reason to think the Ninth Circuit was incorrect in looking to the rationale that the government offered in litigation to decide whether to uphold the cost-sharing regulation. As Altera has argued extensively, the rationale that the government has offered in litigation bears little resemblance to the reasons offered in the regulatory preamble. And because they offer such different characterizations of how the arm’s-length standard operates, it is difficult to reconcile the former with the latter. If the Ninth Circuit was incorrect in entertaining the government’s rationale offered in litigation, then there are significant problems with the Ninth Circuit’s conclusion.

The second element of today’s decision that may be germane to Altera is the Court’s decision that DHS’s action to rescind DACA was “arbitrary and capricious” under the APA. The Court observed that the first DHS memorandum relied almost entirely on the Fifth Circuit’s decision (since the Attorney General letter cited in that memorandum also relied on the Fifth Circuit’s decision). But that Fifth Circuit decision pertained only to the benefit-eligibility features of the DACA expansion and did not address what the Court called the “defining feature” of DACA—“the decision to defer removal (and to notify the affected alien of that decision).” And on that front, the first DHS memorandum “offers no reason for terminating forbearance.” In fact, the Court held, the DHS memorandum “contains no discussion of forbearance or the option of retaining forbearance without benefits” and therefore “‘entirely failed to consider [that] important aspect of the problem’” in violation of the reasoned decision-making standard in the Court’s State Farm decision. In particular, the Court here observed that in taking any action with respect to the forbearance aspects of the DACA rescission, DHS had to consider the consequences of rescission on aliens’ obvious reliance interests.

This second element may affect the outcome with respect to another one of Altera’s APA arguments. Altera argued that the regulation was the result of arbitrary and capricious agency decision-making. Treasury “purported to apply the arm’s-length standard” and “stated that whether that standard is satisfied depends on an empirical and factual analysis of real-world behavior of unrelated parties.” But then, Altera argued, when confronted with “extensive evidence demonstrating that unrelated parties would not share stock-based compensation,” Treasury “ignored or dismissed that evidence because it was inconvenient” and enacted the regulation. There is no dispute that Treasury was aware of that evidence when it finalized the disputed cost-sharing regulation, but Altera has argued that neither Treasury’s regulatory preamble nor the government’s subsequent litigating position adequately address that evidence. Just as DHS’s failure to consider obvious reliance interests in its attempt to rescind DACA created a fatal APA problem, so too, the taxpayer might argue, does Treasury’s failure to consider obvious evidence that runs counter to its cost-sharing regulation when enacting that regulation.

Although the Court’s decision on DACA is directly relevant to issues in Altera, it may not ultimately result in the Supreme Court hearing the case. But the DACA decision gives the Court an opportunity to deal with the Altera decision in a much less labor-intensive way. The Court can issue a “GVR” (grant, vacate, and remand) order, which is a one-paragraph order in which the Court grants certiorari, immediately vacates the judgment below, and remands the case to the court of appeals for “further consideration in light of” a new development not previously considered—usually an intervening Supreme Court decision.

In many cases in which the Court issues such orders, the remanded case is on all fours with the new Supreme Court decision, and the circuit court’s decision on remand is a formality. That would not be true in Altera. Even so, if the Court were to issue such a GVR, it would send a clear message about what the Ninth Circuit would need to do on such a remand. Invoking the GVR procedure would allow the Court to vacate the Ninth Circuit’s Altera decision without having to entertain full briefing and argument. The Court often issues numerous GVR orders on the last day of its Term before breaking for the summer recess. That is usually at the end of June, though the timing could get extended somewhat this year because of the delays in the Court’s spring argument schedule caused by the coronavirus. But some resolution of the pending Altera petition should be expected within the next few weeks.

Supreme Court Opinion – DHS v. Regents of Univ. of Cal

Ninth Circuit Denies Petition for Rehearing

On Tuesday, the Ninth Circuit denied Altera’s petition for rehearing en banc (which petition we discussed in our recent post here). The order issuing that denial includes a strong, 22-page dissent written by Judge Smith and joined by Judges Callahan and Bade. (Ten judges recused themselves, meaning that the vote was 10-3 against rehearing.) The dissent made several arguments for why the petition should have been granted, taking aim at the panel’s reasoning in upholding the regulation and warning about the decision’s broader effects.

Quoting State Farm, the dissent stated that it would have invalidated the regulations because Treasury’s “‘explanation for its decision [ran] counter to the evidence before’ it.” When it promulgated the regulations, Treasury asserted that it was applying the traditional arm’s-length standard, stating that “‘unrelated parties entering into [cost-sharing arrangements] would generally share stock-based compensation costs.’” But the evidence showed that “unrelated entities do not share stock-based compensation costs.”

Although the dissent stated that “[t]his should be the end of our analysis,” it went on to explain why the panel’s decision violates the Chenery rule that courts cannot provide “‘a [purportedly] reasoned basis for the agency’s action that the agency itself has not given.’” The dissent observed that despite Treasury’s clear statement in the preamble that its cost-sharing rule was “based on a traditional arm’s length analysis employing (unsubstantiated) comparable transactions,” the panel upheld “Treasury’s convenient litigating position on appeal that it permissibly jettisoned the traditional arm’s length standard altogether.” That mismatch undermines the regulation’s validity under APA notice-and-comment principles because Treasury cannot offer one rationale in its preamble, dismiss public comments on that rationale, “and then defend its rule in litigation using reasoning the public never had notice of.” Compounding this notice problem, the panel accepted Treasury’s argument that it could jettison a traditional arm’s length analysis because of the addition of the “commensurate-with-income” sentence to section 482 in 1986. But Treasury had stated in the 1988 White Paper that the addition of that sentence did not amount to a “departure from the arm’s length standard.” So not only did the panel uphold the regulation based on a rationale that Treasury did not offer in its preamble, it also upheld the regulation based on a rationale that Treasury itself had previously disclaimed.

The dissent also took up a cause that we’ve explored here before. By its own terms, the commensurate-with-income provision in section 482 applies only to “transfers of intangible property.” The panel concluded that provision was implicated here because there were “future distribution rights” transferred in Altera’s cost-sharing arrangement. The dissent disagreed because (1) cost-sharing agreements contemplate the “development” of intangibles, which implies that not every intangible subject to the arrangement must have been transferred to the arrangement, and (2) the intangibles enumerated in the pertinent regulation do not include future intangibles because they are all “property types that currently exist.” The dissent therefore concluded that the commensurate-with-income language “simply does not apply to” cost-sharing arrangements.

Finally, the dissent detailed three “particularly deleterious” consequences of the panel’s decision. First, the decision will “likely upset the uniform application of the challenged regulation” because the Tax Court’s decision invalidating the regulation still applies to taxpayers outside of the Ninth Circuit. Second, the decision “tramples on the longstanding reliance interests of American businesses,” many of whom relied not just on the Tax Court unanimously invalidating the regulation but also on Treasury reaffirming the primacy of the arm’s-length standard in the 1988 White Paper and the 2003 regulatory preamble. The dissent observed that these reliance interests are far-reaching because at least 56 major companies have noted the Altera issue in annual reports. Third, the decision threatens international tax law uniformity insofar as the arm’s-length standard (setting aside GILTI and the latest from the OECD) has been the method for allocating taxable income among major developed nations.

At a minimum, the dissent should strengthen the Tax Court’s resolve to invalidate the regulation again for taxpayers from other circuits—the dissent remarked on the “uncommon unanimity and severity of censure” in the Tax Court’s decision. And the dissent can be read as encouragement for Altera to seek certiorari—the dissent stated that the panel’s reversal of a Tax Court decision that would have applied nationwide produces “a situation akin to a circuit split.” Unless extended, the time for Altera to file a petition for certiorari will expire on February 10.

Thanks to Colin Handzo for his help with this post.

Altera – Ninth Circuit Rehearing Denial

Reflections on the Ninth Circuit’s Decision in Amazon.com

Although some time has passed (and we’ve fallen short of our hope here to get something up “soon”), we nevertheless wanted to post some thoughts on the Ninth Circuit’s unanimous affirmance of the taxpayer’s victory in the Tax Court in Amazon.com while also revisiting some of the topics that we covered here after oral argument. The panel’s opinion is brief, but it touched on several important aspects of the law under section 482.

Finding Ambiguity in the Regulatory Definition of “Intangible”

As you’ll recall, the primary dispute on appeal was whether the regulatory definition of “intangible” under Treas. Reg. § 1.482-4(b) included residual business assets like goodwill, going concern, and the amorphous notions of “growth options” and “culture of continuous innovation” that the government theorized the taxpayer made available in its cost-sharing agreement.

The taxpayer argued that the definition excluded such residual business assets because it did not expressly list them in any of the six subparagraphs of the definition. And the taxpayer argued that the 28 specified items in the regulation all “can be sold independently” from the business while the residual business assets cannot, invoking the statutory-interpretation canon of ejusdem generis to reason that the regulation therefore excludes residual business assets (which cannot be sold without a sale of the entire business).

The government argued that those residual business assets fell under the sixth subparagraph of Treas. Reg. § 1.482-4(b), which provides that “intangible” includes “other similar items” and that “an item is considered similar … if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” Since residual business assets do not derive their value from physical attributes but from other intangible properties, the government reasoned, they must be included here. And the government went on to argue that residual business assets must be compensable because otherwise, taxpayers could have transferred assets of value to a cost-sharing arrangement without compensation, which the government asserts would have violated the arm’s-length principle that undergirds section 482 and its regulations.

The panel held that although the taxpayer’s “focus on the commonality of the 28 specified items has some force,” that argument did not carry the day. The panel drew this conclusion from the plain language in the sixth subparagraph: that paragraph does not state that the commonality is that each item “can be sold independently” but rather states that each item “derives its value … from its intellectual content or other intangible properties.” The panel reasoned that the regulation therefore “leaves open the possibility of a non-listed item being included in the definition even if it doesn’t share the attribute of being separately transferable.” The panel thus echoed the concern that Judge Fletcher raised at oral argument—that while the 28 specified items share the commonality of being independently transferable, that commonality is “not the one the text [describing what constitutes a ‘similar item’ under the regulation] gives me.”

Resolving the Ambiguity by Looking to the Drafting History of the Regulation

After concluding that the regulatory definition “is susceptible to, but does not compel, an interpretation that embraces residual-business assets,” the panel looked to the overall regulatory scheme but held that to be inconclusive. The panel then turned to the drafting history of Treas. Reg. § 1.482-4(b) and found it to show that Treasury’s 1994 final regulations (which amended the sixth subparagraph of Treas. Reg. § 1.482-4(b)) both (1) exclude residual business assets from the definition of intangible and (2) provide reason to think that the definition of “intangible” includes only independently transferable assets.

The panel described how when Treasury issued temporary and proposed regulations in 1993, it asked “whether the definition of intangible property … should be expanded to include … goodwill or going concern value.” The panel concluded that since Treasury asked whether the definition should be “expanded” to include residual business assets, those assets were not included in the then-existing definition. And when Treasury issued final regulations in 1994 without expressly enumerating goodwill or going concern value in that definition, Treasury stated that its final rule “merely ‘clarified’ when an item would be deemed similar to the 28 items listed in the definition.” The panel concluded that by its own admission, Treasury would have needed to “expand” the definition to include residual business assets but instead opted to merely “clarif[y]” its definition, and therefore Treasury did not intend for the 1994 final regulations to include residual business assets.

Moreover, Treasury’s 1993 regulations limited the universe of compensable intangibles to “any commercially transferable interest.” But when it issued final regulations in 1994, Treasury dropped the “commercially transferable interest” language because “it was superfluous: if the property was not commercially transferable, then it could not have been transferred in a controlled transaction.” The panel concluded that the transfer-pricing regulations thus “contemplate a situation in which particular assets are transferred from one entity to another.” Since Treasury stated that it would have been “superfluous” to expressly state that the definition of “intangible” includes only commercially transferable assets, the panel held that the regulatory history “strongly supports Amazon’s position that Treasury limited the definition of ‘intangible’ to independently transferable assets.”

That the panel found this history dispositive comes as no surprise. We observed in our prior post that both Judge Callahan and Judge Christen recounted the regulatory history, with Judge Callahan questioning government counsel about whether Treasury ever expressed an intent to expand the definition to include residual business assets.

What Is the Rationale for Including Only Independently Transferable Assets in the Definition of Intangible?

Although the panel’s explanation for how it concluded that the definition of intangibles includes only independently transferable assets is explicit, the rationale for why Treasury would include only independently transferable assets is markedly subtler. It’s possible, however, to cobble together an explanation from other statements in the decision.

The first clue is when the panel looked to the genesis of the cost-sharing regulations, where Treasury identified “intangibles as being the product of R&D efforts.” In that sense, the panel reasoned, the “regulations seem to exclude” residual business assets, “which ‘are generated by earning income, not by incurring deductions.’” This distinction is clear enough—businesses incur expenses in undertaking R&D efforts, while goodwill and going concern value are byproducts of a well-run and successful business.

Why does this distinction matter? One answer lies in the legislative history and policy underpinnings for the statutory definition of “intangibles.” As the panel observed in a footnote, the “Senate Report states that the Committee viewed the bill as combatting the practice of transferring intangibles ‘created, developed or acquired in the United States’ to foreign entities to generate income tax free.” Which is to say that one animating concern in defining intangibles was to prevent U.S. entities from developing intangibles domestically but then transferring those intangibles to foreign affiliates whose income is not subject to U.S. tax.

And the reason why this is a concern for intangibles that result from R&D and other independently transferrable assets but not goodwill or going-concern value should be apparent: while the former involve expenditures that are deductible against U.S. income (but where the asset transfer will prevent the income from being taxed in the U.S.), the latter involve assets that exist only if the taxpayer has generated business income in the U.S. in the first place. In other words, the definition of “intangible” was initially meant to prevent taxpayers from incurring expenses to create intangibles in the U.S. and deducting those expenses against U.S. income, but then turning around and transferring those intangibles to foreign affiliates that may not owe U.S. tax on the income resulting from those intangibles.

Distinguishing the Definition of “Intangibles” from the Value of Those Intangibles

On brief and at oral argument, the government repeatedly cited deposition testimony by one of the taxpayer’s experts in which that expert admitted that parties at arm’s length would pay for residual business assets. The government tried to leverage that admission to argue that the arm’s-length standard itself means that residual business assets are compensable because “it is undisputed that a company entering into the same transaction under the same circumstances with an unrelated party would have required compensation.”

The panel addressed that argument in a footnote, holding that the government’s argument “misses the mark.” The panel explained that while the arm’s-length standard “governs the valuation of intangibles; it doesn’t answer whether an item is an intangible.” This is a decisive response to the government’s arguments; it cannot be the case that any value associated with a business falls under the definition of “intangible.”

Putting Footnote 1 in Context

One aspect of the panel’s decision that is certain to receive attention in future transfer-pricing disputes is the discussion in the first footnote. In that footnote, the panel described the 2009 changes to the cost-sharing regulations as “broadening the scope of contributions for which compensation must be made” and explained that the TCJA “amended the definition of ‘intangible property’” in section 936(h)(3)(b). The footnote then stated that “[i]f this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the Commissioner’s position would be correct.”

There are a few things worth noting about this footnote, the first of which is arguably the most important: It’s dicta. The question of whether residual assets are compensable under the 2009 cost-sharing regulations or the 2017 statutory amendment was not before the court. And since the panel says nearly nothing in the footnote about the language in those 2009 regulations or the TCJA amendment, there is no reason to think that the panel gave material consideration to whether the outcome in the case would have been different under either.

Second, given some of the panel’s other statements, it is not so clear that “there is no doubt the Commissioner’s position would be correct” for years after the 2009 changes to the regulations. Recall that the government’s case was predicated on charging a higher buy-in for the purported transfer of “growth options” and a “culture of continuous innovation” to the cost-sharing arrangement. Although the 2009 regulatory amendments changed the cost-sharing regulations and TCJA amended the statutory definition for “intangibles,” there was no change to the definition under Treas. Reg. § 1.482-4(b). That regulation provides that an item not otherwise specified is an intangible only if it “has substantial value independent of the services of any individual.” The panel itself expressed serious doubt about whether the purported intangibles in this case met that requirement, stating that “residual business assets, such as ‘growth options’ and a ‘culture of innovation,’ are amorphous, and it’s not self-evident whether such assets have ‘substantial value independent of the services of any individual.’”

Finally, the TCJA amendments would affect the result in the case only if the purported “growth options” and “culture of continuous innovation” are items of property that fall under the new statutory category of “goodwill, going concern value, or workforce in place” or constitute an item “the value or potential value of which is not attributable to … the services of any individual.” But there is reason to think that the government is itself unconvinced that “growth options” and “culture of continuous innovation” fall under that new statutory category. At oral argument, the panel asked government counsel why, if Treasury meant to expand the definition of “intangible” with its 1994 changes, Treasury didn’t just add “goodwill and going concern” to the list. In response, government counsel argued that merely adding “goodwill and going concern” to the list would not have solved anything because then taxpayers would just fight about whether particular assets fell under those additions to the list. The government cannot coherently maintain both that (1) Treasury could not have achieved the Commissioner’s desired result in this case by expanding the regulatory list to include goodwill and going concern in 1994 and (2) Congress’s addition of goodwill and going concern to the list in TCJA would change the result in this case. Even though Congress meant to change the result in cases like this, government counsel’s argument suggests an absence of faith that expanding the list succeeds in changing the result.

Whether the Commissioner’s Litigating Position Warrants Auer Deference

The government also argued that under Auer, the Tax Court should have deferred to the Commissioner’s interpretation of Treas. Reg. § 1.482-4(b) as including residual business assets. The panel rejected this argument for two reasons.

First, the panel found that pursuant to the Supreme Court’s decision in Kisor, the Commissioner’s interpretation warrants Auer deference only if the regulation is “genuinely ambiguous.” The panel states that Auer thus implicates a higher standard for ambiguity. Under that standard, a regulation is “genuinely ambiguous” for Auer purposes only if ambiguity remains once the court has exhausted the traditional tools of construction, which requires it to consider “the text, structure, history, and purpose of a regulation.” The panel concluded that the text of Treas. Reg. § 1.482-4(b), its place in the transfer-pricing regulations, and its rulemaking history “leave little room for the Commissioner’s proffered meaning.” The panel’s holding is therefore that the definition of “intangible” under Treas. Reg. § 1.482-4(b) is ambiguous but not genuinely ambiguous.

Second, the panel also rejected the government’s deference argument because the government first advanced an interpretation of Treas. Reg. § 1.482-4(b) in the litigation that had never appeared in the drafting history of the regulations or anywhere else. As we remarked earlier, reliance concerns loomed large at oral argument, and especially in Judge Callahan’s questions. The panel’s conclusion that “Amazon and other taxpayers were not given fair warning of the Commissioner’s current interpretation of the regulatory definition of an ‘intangible’” was thus foreseeable from oral argument.

Whether the Cost-Sharing Regulations Provide a Safe Harbor

As we observed in our prior post, at oral argument the government disavowed the notion that the Treasury Regulations create a safe-harbor for cost-sharing arrangements. We surmised that whether the Ninth Circuit agreed with the government on this point might be pivotal in the outcome.

While the extent to which that issue factored into the panel’s decision is not evident, the panel’s decision is entirely consistent with the notion that cost sharing operates as a safe harbor. First, the panel described cost sharing as “an alternative to licensing … under which [the parties to the cost-sharing arrangement] become co-owners of intangibles as a result of the entities’ joint R&D efforts.” If the cost-sharing arrangement qualifies, then it “provides the taxpayer the benefit of certainty because … new intangibles need not be valued as they are developed.” But the panel explained that the certainty comes at a price—the R&D payments by the foreign cost-sharing participants “serve to reduce the deductions the [domestic] taxpayer can take for the R&D costs (thereby increasing tax liability).” What the panel thus described operates like a safe harbor—taxpayers that ensure that their cost-sharing arrangements qualify and sacrifice some deductions for intangible development costs can gain certainty that their intangibles need not be re-valued. The panel’s decision will hamper any future IRS arguments that cost-sharing does not operate like a safe harbor.

Procedural Status

The government did not file a petition for rehearing in the case; the mandate issued on October 8. There is still time for the government to file a petition for certiorari; it is due November 14.

Ninth Circuit Affirms Tax Court in Amazon.com

In a unanimous opinion issued today, the Ninth Circuit affirmed the taxpayer’s victory in the Tax Court in Amazon.com. We previously covered the case and oral argument here. We will take some time to digest the opinion and post on its finer points soon. In the meantime, one key sentence in the opinion is worth noting because it appears to capture the thrust of the Ninth Circuit’s decision about the disputed scope of the relevant regulatory definition for the term “intangible”: “Although the language of the definition is ambiguous, the drafting history of the regulations shows that ‘intangible’ was understood to be limited to independently transferable assets.”

Amazon.com Ninth Circuit Opinion

Petition for Rehearing En Banc Filed in Altera

As most expected, Altera filed a petition for rehearing en banc after the reconstituted three-judge panel decided to reverse the Tax Court’s invalidation of Treasury’s cost-sharing regulations. (A link to the petition is below.) As we explained previously, those regulations have been the subject of much controversy over the last two decades, and the success that Xilinx had with its petition for rehearing several years ago made it likely that Altera would ask for rehearing.

The petition picks up on one of the themes we discussed in our most recent post here. The taxpayer takes aim at the majority’s conclusion that the “commensurate with income” language added to section 482 in 1986 is relevant in the cost-sharing context. The taxpayer argues that language was aimed at addressing a different issue from the one before the court here—“how to value transfers of existing intangible property from one related entity to another” and not “intangible property yet to be created.”

The taxpayer makes four or five (the petition combines arguments (3) and (4) below) arguments for why its petition should be granted:

(1) The decision upsets settled principles about the application of the arm’s-length standard because the majority permitted Treasury to “cast aside the settled arm’s-length standard” for “a new standard” that is “purely internal.”

(2) The decision “validates bad rulemaking” because, contrary to the majority’s account of the regulation’s history, “[n]o one involved in the rulemaking thought the IRS was interpreting ‘commensurate with income’ to justify a new standard that did not depend on empirical evidence.” And under the law in Chenery, the court must assess the “‘propriety of [the agency’s] action solely by the grounds invoked by the [agency]’ in the administrative record.”

(3) The decision is irreconcilable with the Ninth Circuit’s decision in Xilinx, which held that parties would not share in employee stock option costs at arm’s length.

(4) The decision “threatens the uniform application of the tax law” because, under the Golsen rule, the Tax Court will continue to apply its unanimous decision declaring the regulation invalid to cases arising anywhere outside the Ninth Circuit.

(5) As evidenced by the glut of amicus briefs, the treatment of employee stock options in cost-sharing arrangements is “exceptionally important.”

It is likely that additional amicus briefs will be filed in support of the rehearing petition. And given the prominence of the issue, we anticipate that the court will order the government to file a response to the petition. We will report on further developments as warranted.

Altera Petition for Rehearing En Banc July 2019

Observations on Changes in the Ninth Circuit’s Second Altera Decision

As we posted earlier here (with a link to the new decision), the Ninth Circuit issued a new decision in Altera after replacing the late Judge Reinhardt with Judge Graber on the panel. But the result was the same as the withdrawn July 2018 decision—the Ninth Circuit upheld the validity of Treasury’s cost-sharing regulation that requires taxpayers to include the cost of employee stock options under qualifying cost sharing arrangements (QCSAs). Today, we present some observations after comparing the majority and dissent in the new decision with those in the Ninth Circuit’s withdrawn decision.

In the new decision, Judge Thomas recycled much of the language and logic from his withdrawn opinion, and Judge O’Malley reused much of her original dissent. Although they are few, some changes in the two opinions are interesting and notable. Overall, the changes serve to sharpen the disagreements between the parties (and the disagreements between the majority and dissent) in ways that will focus the discussion in the likely event of a rehearing en banc petition (or possible petition for certiorari). We focus here on two aspects of the changes.

Was There a Transfer of Intangibles that Implicated the Commensurate-With-Income Language in the Second Sentence of Section 482?

The majority did not address this issue in its withdrawn opinion, so some background is in order. When Treasury proposed cost-sharing regulations that explicitly required related parties to include employee-stock-option costs in the pool of shared costs, commenters put forward evidence that unrelated parties do not share employee-stock-option costs. But Treasury did not heed those comments and ultimately determined that the arm’s-length standard would be met if the regulations required taxpayers in QCSAs to include the cost of employee stock options in the pool of shared costs, regardless of what a comparability analysis might show about whether unrelated parties share those costs. So in order to uphold the Treasury Regulations, the majority had to conclude that the arm’s-length standard under section 482 does not mandate the use of comparable transactions.

In reaching that conclusion, the majority relied on the history of section 482 and especially on the addition of the second sentence of section 482. That second sentence provides that “[i]n the case of any transfer (or license) of intangible property…, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” The majority held that the Congressional intent behind the addition of that language in 1986 is what made it reasonable for Treasury to conclude that it was permitted “to dispense with a comparable transaction analysis in the absence of actual comparable transactions.”

Was there a “transfer (or license) of intangible property” such that Treasury could invoke the commensurate-with-income language to justify dispensing with a comparable-transaction analysis? There was indeed a transfer of intangibles at the outset of the QCSA in this case; Altera transferred intangible property to its QCSA with its foreign subsidiary. But that initial transfer is unrelated to the disputed employee-stock-option costs. Those stock-option costs relate to subsequently developed intangibles, not to the value of the pre-existing intangibles that Altera initially contributed. Then-applicable Treasury Regulation § 1.482-7A(g)(2) required a buy-in payment only for “pre-existing intangibles.”

It is, then, wholly unclear how those employee-stock-option costs for as-yet undeveloped intangibles constitute a “transfer (or license) of intangible property” such that the commensurate-with-income language is implicated at all. The taxpayer argued—both in its initial and supplemental briefing—that by its own terms, the commensurate-with-income language is not implicated once a QCSA is in place and therefore that language is irrelevant to the dispute. The taxpayer reasoned that “no ‘transfer (or license)’ occurs when entities develop intangibles jointly” because jointly developed intangibles “are not transferred or licensed between the parties, but rather are owned upon their creation by each participant.”

The majority said little about this issue in its withdrawn opinion and did not address the taxpayer’s argument. In its new opinion, the majority addressed the argument and declared itself “unpersuaded.” It held that “[w]hen parties enter into a QCSA, they are transferring future distribution rights to intangibles, albeit intangibles that are yet to be developed.” The majority does not, however, explain how “intangibles that are yet to be developed” are “pre-existing intangible property” under Treas. Reg. § 1.482-7A(g)(2) or, perhaps more importantly, how such undeveloped future intangibles can constitute intangible assets at all under the words of the statute. Instead, the majority leaned on the language in the second sentence of section 482 providing that the commensurate-with-income standard applies to “any” transfer of intangible property, holding that “that phrasing is as broad as possible, and it cannot reasonably be read to exclude the transfers of expected intangible property.”

The dissent seized on whether there was any transfer of intangibles that implicated the commensurate-with-income language. The dissent stated that “[t]he plain text of the statute limits the application of the commensurate with income standard to only transfers or licenses of intangible property.” And it observed that there is a contradiction between the majority’s conclusion that QCSAs “constitute transfers of already existing property” and Treasury’s own characterization (in the very preamble of the disputed regulations) of QCSAs “as arrangements ‘for the development of high-profit intangibles,’” inferring that parties cannot transfer something that is not yet developed. The dissent concluded that Treasury’s failure to make “a finding that QCSAs constitute transfers of intangible property” should be, as a matter of review under the APA, fatal to Treasury’s cost-sharing regulations.

Has the Arm’s-Length Standard Historically Required a Comparable-Transaction Analysis?

The majority made several changes from its withdrawn opinion in its account of the history of the arm’s-length standard under section 482. The changes appear to be aimed at bolstering the majority’s conclusion that Treasury was justified in concluding that the arm’s-length standard does not necessitate a comparable-transaction analysis. These changes take a couple of forms.

First, the changes add justifications for the proposition that the arm’s-length standard has not always mandated a comparable-transaction analysis in all cases. The withdrawn opinion included some evidence for this historical account, recounting the Tax Court’s Seminole Flavor decision from 1945 (where the Tax Court “rejected a strict application of the arm’s length standard in favor of an inquiry into whether the allocation…was ‘fair and reasonable’”). In its new opinion, the majority added the observation that Treasury provided for an unspecified fourth method for pricing intangibles in its 1968 regulations. And the majority refined its discussion of the Ninth Circuit’s 1962 decision in Frank, still quoting the language from that opinion denying that “‘arm’s length bargaining’ is the sole criterion for applying” section 482 (as it did in the withdrawn opinion) but then adding the new assertion that the “central point” of Frank is that “the arm’s length standard based on comparable transactions was not the sole basis” for reallocating costs and income under section 482. (As the dissent pointed out, a later Ninth Circuit decision limited the holding in Frank to the complex circumstances in that case and noted that the parties in Frank had stipulated to apply a standard other than the arm’s-length standard.)

Second, the majority made changes to add a series of new and more sweeping assertions that under section 482, Treasury has always had the leeway to dispense with comparable-transaction analyses in deriving the correct arm’s-length price. For instance, as a rejoinder to the taxpayer’s argument that the arm’s-length standard requires a comparable-transaction analysis, the majority wrote that “historically the definition of the arm’s length standard has been a more fluid one” and that “courts for more than half a century have held that a comparable transaction analysis was not the exclusive methodology to be employed under the statute.” It added similarly broad historical statements elsewhere in the new opinion, all in service of concluding that Treasury acted reasonably in dispensing with a comparable-transaction analysis in its cost-sharing regulations: “[a]s demonstrated by nearly a century of interpreting § 482 and its precursor, the arm’s length standard is not necessarily confined to one methodology” (p. 33); “the arm’s length standard has historically been understood as more fluid than Altera suggests” (p. 41); and “[g]iven the long history of the application of other methods…Treasury’s understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable” (p. 49).

In one of the subtler but more interesting changes from the withdrawn opinion, the majority’s new opinion removed a single word. In its withdrawn opinion, the majority said that Treasury’s 1988 White Paper “signaled a dramatic shift in the interpretation of the arm’s length standard” by advancing the “basic arm’s length return method…that would apply only in the absence of comparable transactions….” (emphasis added). But consistent with its conclusion in the new opinion that “for most of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology,” the majority appears to have concluded that shift in the White Paper was not so “dramatic,” dropping that word altogether in its new opinion. (In this vein, the majority also removed its assertion in the withdrawn opinion that “[t]he novelty of the 1968 regulations was their focus on comparability.”)

The new dissenting opinion disputed the majority’s historical account, stating that the first sentence of section 482 “has always been viewed as requiring an arm’s length standard” and that before the 1986 amendment, the Ninth Circuit “believed that an arm’s length standard based on comparable transactions was the sole basis for allocating costs and income under the statute in all but the narrow circumstances outlined in Frank.” And the dissent observed that even with the 1986 addition of the commensurate-with-income language, “Congress left the first sentence of § 482—the sentence that undisputedly incorporates the arm’s length standard—intact,” thus requiring a comparable-transaction analysis everywhere that comparable transactions can be found. The dissent pointed out that the White Paper clarified that this was true “even in the context of transfers or licenses of intangible property,” quoting Treasury’s own statement in the White Paper that in that context the “‘intangible income must be allocated on the basis of comparable transactions if comparables exist.’”

Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera

The Ninth Circuit issued a new opinion in Altera today after having withdrawn its July 2018 opinion. But today’s opinion does not change the result—by a 2-1 vote, the Ninth Circuit upheld the validity of the Treasury Regulation under section 482 that requires taxpayers to include the cost of employee stock options in the pool of costs that must be shared in qualifying cost sharing arrangements. Judge Thomas again wrote the panel’s opinion, Judge O’Malley again dissented, and Judge Graber—who was added to the panel to replace the late Judge Reinhardt—voted with Judge Thomas.

Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison.

The taxpayer may seek a rehearing of the decision by the full Ninth Circuit (which is likely after the success that another taxpayer had in the Ninth Circuit’s rehearing of a similar issue in Xilinx). A petition for rehearing would be due July 22.

Altera Ninth Circuit Opinion June 2019

Briefing Complete in Kisor

The petitioner has now filed his reply brief in Kisor, and the case is fully briefed in preparation for the oral argument later this week on March 27.  Given the government’s partial retreat from defending Auer deference (see our prior post here), which the petitioner describes as a “sharp retreat,” the reply brief responds to two different briefs.  First, it responds directly to an amicus brief by a group of law professors (linked in our prior post) that put forth a full-throated defense of Auer deference.  Second, it acknowledges that the government’s “Auer-light” position is “preferable to existing Auer deference,” but it still rejects that position and argues that complete overruling of Auer is the correct approach.  The reply brief concludes that the existing principles of Skidmore deference satisfactorily address the policy goals described in the government’s brief without improperly permitting “an agency to exert its expertise in binding fashion without any participation by the regulated public.”

Kisor – Petitioner Reply Brief

 

Treasury and IRS Issue Joint Policy Statement on the Tax Regulatory Process

Earlier this week, the Treasury Department issued a policy statement on the tax regulatory process.  A significant section of the statement describes the approach that will be taken in Tax Court litigation to arguments based on judicial deference to regulations.  Treasury states that it will not claim Auer deference in such litigation to interpretations set forth in subregulatory guidance, such as revenue rulings, nor will it claim Chevron deference to such interpretations.  That apparent abandonment of Auer deference arguments goes beyond the position the Justice Department has taken in the Supreme Court in the Kisor case, where the government has argued for a significant narrowing of Auer but stops short of stating that it should be overruled.  See our reports on Kisor here.  Note that the Treasury Department statement by its terms applies only to Tax Court litigation, which is handled by the IRS, not to refund suits where the Justice Department handles the litigation.

The Treasury Department statement also addresses topics other than judicial deference, including: when to issue subregulatory guidance; legislative vs. interpretative regulations; and temporary regulations.  For a fuller analysis of the Treasury Department statement, please read this Miller & Chevalier Tax Alert.

Government Brief Filed in Kisor

The government was faced with something of a dilemma in filing its response brief in the Kisor case addressing the level of deference owed to an agency’s interpretation of its own regulation. See our prior reports here. On the one hand, the government was defending the agency action in this case and the decision below, which rested on paying Auer deference to the agency’s interpretation. On the other hand, conservative legal theorists have long been critical of Auer deference, following Justice Scalia’s lead, and the views of the political appointees in this administration about Auer likely range from unenthused to hostile. But on the third hand, the government’s institutional interests would generally be better served by a strong principle of Auer deference, since that would make challenges to agency action more difficult.

The government’s brief attempts to juggle these conflicting imperatives, and the result is a bit schizophrenic. The bottom line is that the government argues that Auer should not be overruled, but that its applicability should be substantially narrowed. In the end, the government does not rely on Auer to defend the agency action in this case, but instead argues that the regulation is clear on its face without the need to consider the agency interpretation at all.  (Although outgunned by the cascade of amicus briefs filed in support of the petitioner, two amicus briefs were filed on the government’s side, including one by a group of administrative law professors (linked below) who argue that Auer “is sound and should be maintained.”)

The first, and longest, section of the government’s brief is a full-fledged assault on the doctrine of Auer deference. The government contends that the doctrine: (1) is not well grounded historically; (2) is not supported by any consistent rationale; (3) is in tension with the APA’s distinction between interpretive and legislative rules; and (4) can have harmful practical consequences by discouraging agency resort to notice-and-comment rulemaking. Notably, the government states that the reasons that support Chevron deference do not apply to Auer, and thus the brief does not signal that the current administration will argue against Chevron deference in a future case.

The government argues, however, that Auer should not be overruled because of stare decisis considerations, including that doing so “would upset significant private reliance interests” because it allegedly “could call into question” earlier decisions that rested on Auer deference. In contrast to the opening part of its brief, this section praises Auer deference where it is limited to “its core applications,” such as “when the agency announces its interpretation in advance in a widely available guidance document.” The government states that the task of choosing among reasonable interpretations is more appropriately performed by administrators than by judges, that Auer deference would promote national uniformity, that it recognizes the technical expertise of agencies, and that it fosters regulatory certainty and predictability—in contrast to a system “in which the meaning of a regulation must be determined de novo in every judicial proceeding.” In addition, the government disagrees with the petitioner’s argument that Auer deference poses a separation-of-powers problem, stating that an agency’s actions in making rules and conducting adjudications are both exercises of “executive power.”

Accordingly, the government proposes “significant limits” on the doctrine that will thread the needle, neither overruling Auer nor further entrenching it. First, the government states that deference should not be paid to an agency interpretation that is “unreasonable,” describing this seemingly benign limitation as a “rigorous predicate.” If the agency interpretation is judged to be within the range of reasonable readings of the regulation, then the government argues that deference is appropriate “only if the interpretation was issued with fair notice to regulated parties; is not inconsistent with the agency’s prior views; rests on the agency’s expertise; and represents the agency’s considered view, as distinct from the views of mere field officials or other low-level employees.”

It is hard to say at this point what the Court will do with the various permutations that have been presented to it for moving forward, but it appears that Auer deference in its current form stands on very shaky ground.

Oral argument is scheduled for March 27.

Kisor – Government Response Brief

Kisor – Amicus Brief by Administrative Law Scholars in Support of Auer

Briefing Underway in Kisor

The opening salvo has been filed in the Supreme Court challenge to the continuing vitality of what is usually called either Seminole Rock or Auer deference – the rule that a court owes deference to an agency’s interpretation of its own regulations. See our prior report here. The petitioner, a Vietnam veteran seeking disability benefits, has filed his opening brief, supported by 25 different amicus briefs.

The petitioner argues that Auer deference is unjustified for three principal reasons. First, petitioner contends that it is incompatible with the Administrative Procedure Act (APA) because it allows an agency to exercise lawmaking authority through administrative interpretation without adhering to the APA’s procedural safeguards of public participation and agency accountability through notice-and-comment rulemaking.

Second, petitioner argues that Auer is a judge-made rule that destabilizes administrative law because it allows an agency to receive deference to what may not be the best interpretation of a regulation, even if it is “reasonable.” That can unfairly confound an individual who can only try to conform his or her conduct to what appears to be the best interpretation of the regulation. Petitioner adds that Auer deference is “especially suspect . . . where the agency has an economic interest in the outcome,” such as when the interpretive issue relates to a monetary claim against the government.

Third, petitioner contends that Auer is incompatible with separation-of-powers principles because it “renders an agency simultaneously a law’s maker and its expositor.” That is in contrast to Chevron deference, which respects Congress’s power because it “rests on agency compliance with the APA.”

The petitioner adds that principles of stare decisis should not deter the Court from overruling Auer. He notes that this is a purely judge-made rule and that the seminal 1945 decision in Seminole Rock provided no reasoning for the doctrine. The petitioner also argues that “no private reliance interests rest on Auer’s continuing vitality” and that reexamination is warranted because of the substantial expansion of the role of administrative agencies in our government since Seminole Rock was decided.

Linked below is the petitioner’s brief and the amicus brief of Professor Thomas Merrill, a leading academic expert on administrative law, who argues that Auer should be overruled and that instead agency interpretations of regulations should be afforded the much more modest recognition of so-called Skidmore deference, which gives weight to an agency interpretation to the extent it has the “power to persuade.” Professor Merrill argues that “the persuasiveness standard would require reviewing courts to engage with and give respectful consideration to the agency’s experience in implementing the statutory regime and familiarity with its own regulations, respect that de novo review would not require.” Like the petitioner, Professor Merrill states that Chevron deference is consistent with the APA, and he does not suggest that the Court should retreat from Chevron. The other 24 amicus briefs can be found on the Supreme Court’s website.

The government’s response brief is due February 25. Oral argument has been scheduled for March 27.

Kisor – Petitioner’s Opening Brief

Kisor – Amicus Brief of Professor Merrill

Supreme Court to Reconsider Important Administrative Law Precedent

The Supreme Court granted certiorari this morning in a non-tax case that should be of considerable interest to tax litigators because of the important administrative law principle that will be decided.  In Kisor v. Shulkin, the Federal Circuit applied the government’s interpretation of the governing regulation in ruling against a veteran’s claim for disability benefits.  The court found that the regulation was ambiguous, and therefore it ruled that it should defer to the government’s interpretation under the longstanding Supreme Court precedents of Bowles v. Seminole Rock & Sand Co., 325 U.S. 410 (1945), and Auer v. Robbins, 519 U.S. 452 (1997).  The court denied rehearing en banc, although three judges joined an opinion dissenting from that denial.  The Supreme Court has now granted certiorari specifically to address the question “[w]hether the Court should overrule Auer and Seminole Rock.”

Auer deference has played an increasingly prominent role in tax cases since the Supreme Court’s decision in Mayo Foundation made tax cases subject to general administrative law principles.  Revenue Rulings and other lower level administrative interpretations of Treasury regulations are pervasive in the tax area and are subject to being relied upon by courts under Auer deference principles.  And the government has even argued for Auer deference to interpretations stated in its briefs, with the Second Circuit agreeing with that argument.  See, e.g., our prior coverage of the MassMutual and Union Carbide cases here and here.  If Auer is overruled, taxpayers will likely benefit in future litigation involving conflicting views of the meaning of a Treasury regulation.

In recent years, several individual Justices have expressed concern about the wisdom of Auer or Seminole Rock deference, pointing out that it potentially allows an end run around the notice-and-comment procedure for issuing regulations and arguably violates separation-of-powers principles.  Instead of noticing clear regulations that can reasonably be commented upon, Auer enables agencies to promulgate ambiguous regulations and then later to provide administrative interpretations of those regulations (outside the notice-and-comment framework) that create a rule to which courts must defer.  Justice Scalia (who ironically was the author of Auer) was the first to suggest publicly back in 2011 that the Court should reconsider the Auer deference doctrine.  See Talk Am., Inc. v. Michigan Bell Tel. Co., 564 U.S. 50 (2011) (Scalia, J., concurring). In Decker v. Northwest Envtl. Def. Center, 568 U.S. 597, 615 (2013), Chief Justice Roberts and Justice Alito remarked that Justice Scalia had raised “serious questions” about the doctrine.  More recently, in Perez v. Mortgage Bankers, 135 S. Ct. 1199 (2015), Justice Scalia stated flatly that Auer should be “abandoned,” and Justice Thomas wrote a long concurring opinion explaining his view that Auer deference was “constitutionally suspect.”  Justice Alito added that those two Justices had “offered substantial reasons why the Seminole Rock doctrine may be incorrect.”  And just this past March, Justice Gorsuch joined an opinion of Justice Thomas dissenting from the Court’s denial of certiorari in which the latter again described Auer as “constitutionally suspect.”  Garco Construction, Inc. v. Speer, No. 17-225 (Mar. 19, 2018).  Thus, even with Justice Scalia no longer on the Court, four sitting Justices have indicated great skepticism, to put it mildly, about the continuing vitality of Auer deference.  In addition, in a keynote address at a 2016 conference at the Antonin Scalia (George Mason) Law School, Justice Kavanaugh spoke approvingly of Justice Scalia’s criticism of Auer deference and predicted that Justice Scalia’s view would become the law.  Things can change when cases are fully briefed and argued in the Supreme Court, but for now the future of Auer/Seminole Rock deference looks bleak.

The petitioner’s opening brief is due January 31, and the case should be argued in the spring and decided by June 2019. 

Kisor – Petition for Certiorari

Altera Decision Now Ripe for Appeal

We reported earlier on the Tax Court’s important decision in Altera, which invalidated a transfer-pricing regulation for failure to satisfy the “reasoned decisionmaking” standard for rulemaking under the Administrative Procedure Act.  At the time, there were outstanding issues that prevented the Tax Court from entering a final decision.  The parties have now submitted agreed-upon computations, and on December 1 the Tax Court entered a final decision.  The government has 90 days to file a notice of appeal from that decision.

As we noted previously, the government will be motivated to appeal this decision both because of its specific impact on the regulation of cost-sharing agreements and, more broadly, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules.  On the other hand, the government could make a judgment that this particular case is not an ideal vehicle for litigating the broader APA issue, in part because an appeal would go to the Ninth Circuit where the Xilinx precedent on cost-sharing is on the books (see here for a report on Xilinx).  It might then make the tactical choice to forego appeal in this case and await a stronger setting in which to litigate the APA issue for the first time in an appellate court.  The Department of Justice will be weighing these competing considerations, and its conclusion should be evident when the 90-day period expires next March.

Divided Ninth Circuit Reverses Tax Court in Sophy on Question of Mortgage Interest Deduction Limits for Unmarried Taxpayers

We previously reported (see here and here) on the Ninth Circuit’s consideration of an appeal involving the mortgage interest deduction – specifically, whether the statutory limits on that deduction apply on a per-taxpayer or per-residence basis. The unmarried taxpayers here (Charles Sophy and Bruce Voss) argued that they were each entitled to take a deduction up to the $1.1 million limit for the residence that they co-owned, and thereby receive double the tax benefit that a similarly situated married couple would receive, but the Tax Court disagreed. The briefing in this case was completed in April 2013, but the Ninth Circuit did not schedule oral argument until almost two years later. The court has finally issued its decision, reversing the Tax Court by a 2-1 vote. (Although we have referred to the case as Sophy based on the Tax Court’s caption, the Ninth Circuit opinion reverses the order of the two taxpayers in its caption, and therefore the case may come to be referred to as Voss in the future.)

The majority opinion (authored by Judge Bybee and joined by 8th Circuit Senior Judge Melloy, sitting by designation) recognized that neither the statute nor the regulations directly address this question and then engaged in a detailed textual analysis of various provisions of Code section 163. The majority found the strongest evidence of the correct answer in the statute’s treatment of married taxpayers who file separately. In order to put them in the same position as married taxpayers who file jointly, the statute provides in a parenthetical that married taxpayers filing separately are each entitled to a $550,000 deduction. Because that approach reflects a per-taxpayer rather than per-residence treatment, the majority concluded that the same per-taxpayer approach should be applied to unmarried taxpayers, even though it arguably gives them a windfall double deduction.

The majority rejected the Tax Court’s argument that other provisions of Code section 163 reveal a “focus” on the residence, and it also rejected the Tax Court’s explanation that the approach to married-filing-separately taxpayers was meant to address only the proper allocation of a deduction that is already limited to $1.1 million per residence. Finally, the majority acknowledged that its holding results in a “marriage penalty,” but surmised that “Congress may very well have good reasons for allowing that result” and added that, even if Congress didn’t, the court was bound by the text of a statute that singles out married taxpayers (who file separately) for specific treatment that is not explicitly provided for unmarried co-owners.

Judge Ikuta dissented, arguing primarily that the court should defer to the IRS’s administrative interpretation of the statute set forth in a 2009 Chief Counsel Advice memorandum. She maintained that this informal guidance is entitled to “Skidmore deference,” which the Supreme Court has described as a measure of deference equivalent to the interpretation’s “power to persuade.” The majority found that this level of deference was negligible because the CCA contained only a fairly cursory analysis of the statute, which carried little power to persuade. Judge Ikuta reasoned, however, that the CCA is “more persuasive” than the taxpayer’s interpretation, “which would result in a windfall to unmarried taxpayers.” As to the majority opinion, Judge Ikuta characterized as “the thinnest of reeds” its reliance on the treatment of married taxpayers filing separately.

The government has until November 3 to seek certiorari, but there is no reason to expect that the government would seriously consider seeking Supreme Court review in this case.

Sophy – Ninth Circuit opinion

 

 

 

Tax Court Relies on APA to Invalidate the Cost-Sharing Regulation Governing Stock-Based Compensation

We present here a guest post from our colleagues Patricia Sweeney and Andrew Howlett. A longer version of this post is published here.

In Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), the Tax Court put the IRS and Treasury on notice that, when promulgating regulations premised on “an empirical determination,” the factual premises underlying those regulations must be based on evidence or known transactions, not on assumptions or theories. Otherwise, the regulations do not comply with the requirements of the Administrative Procedure Act (“APA”), 5 U.S.C. § 551 et seq. Applying the arm’s-length standard of Code section 482, the Altera decision provides another example of transfer-pricing litigation being decided on the basis of evidence of actual arm’s-length dealings rather than economic theories. Looking more broadly beyond the section 482 context, the decision is an important reminder to the IRS and Treasury that, in the wake of the Supreme Court’s decision in Mayo Foundation (562 U.S. 44 (2011), see our prior reports on the decision and oral argument in that case here and here), tax regulations are subject to the same APA procedures as regulations issued by other federal agencies. As a result, Treasury cannot ignore the evidence and comments submitted during the rulemaking process. If it is to reject that evidence, Treasury must engage in its own factfinding, and it must explain the rationale for its decision based upon the factual evidence.

Because of its specific impact on the regulation of cost-sharing agreements and, more generally, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules, the government will strongly consider an appeal of this decision to the Ninth Circuit. A notice of appeal will be due 90 days after the Tax Court enters its final decision, but there is not yet a final, appealable order in Altera.

The Context for the Dispute. Code section 482 authorizes the Commissioner to allocate income and expenses among related parties to ensure that transactions between them clearly reflect income. Treas. Reg. § 1.482-1(b)(1) provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” In 1986, Congress amended section 482 to provide that, “in the case of any transfer (or license) of intangible property . . ., the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” As noted by the Tax Court, Congress enacted this amendment to section 482 in response to concerns regarding the lack of comparable arm’s-length transactions, particularly in the context of high-profit-potential intangibles. Congress did not intend, however, to preclude the use of bona fide cost-sharing arrangements under which related parties that share the cost of developing intangibles in proportion to expected benefits have the right to separately exploit such intangibles free of any royalty obligation. See H.R. Conf. Rep. No. 99-841 (Vol. II), at II-637 to II-638 (1986).

In 1995, Treasury issued detailed new cost-sharing regulations that generally authorized the IRS “to make each controlled participant’s share of the costs . . . of intangible development under the qualified cost sharing arrangement equal to its share of reasonably anticipated benefits attributable to such development.” In Xilinx, Inc. v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010), the Ninth Circuit affirmed the Tax Court’s holding that the regulations did not require the taxpayer to include employee stock options (“ESOs”) granted to employees engaged in development activities in the pool of costs shared under the cost-sharing arrangement. The court reasoned that the term “costs” in the regulation did not include ESOs because that would not comport with the “dominant purpose” of the transfer pricing regulations as a whole, which is to put commonly controlled taxpayers at “tax parity” with uncontrolled taxpayers. Because of the overwhelming evidence that unrelated parties dealing at arm’s length in fact do not share ESOs in similar co-development arrangements, the court concluded that such tax parity is best furthered by a holding that the ESOs need not be shared. (For a more detailed examination of Xilinx, see our contemporaneous analysis here.)

In 2003 (prior to the Xilinx decision), Treasury had amended the transfer pricing regulations that were applicable to the years at issue in Xilinx. The amended regulations explicitly address the interaction between the arm’s-length standard and the cost-sharing rules, as well as the treatment of ESOs. Treas. Reg. § 1.482-1(b)(2)(i) now states that “Treas. Reg. § 1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement . . . produces results consistent with an arm’s length result.” Contrary to Xilinx, Treas. Reg. § 1.482-7(d)(2), as amended, specifically identifies stock-based compensation as a cost that must be shared.

Altera did not include ESOs or other stock-based compensation in the cost pool under the cost-sharing agreement it entered into with a Cayman Islands subsidiary. In accordance with the 2003 regulations, the IRS asserted that those costs should be included in the pool, and that, as a result, Altera’s income should be increased by approximately $80 million in the aggregate.

The Tax Court’s Analysis. Ruling on cross motions for summary judgment, the Tax Court, in a 14-0 decision reviewed by the full court, agreed with the taxpayer that the 2003 amendments to the cost-sharing regulations were invalid under the APA because Treasury did not adequately consider the evidence presented by commentators during the rulemaking process that stock-based compensation costs are not shared in actual third-party transactions.

The Tax Court first addressed the threshold issue of whether the 2003 regulations were governed by the rulemaking requirements of section 553 of the APA. To that end, it analyzed whether the regulations were “legislative” (regulations that have the force of law promulgated by an administrative agency as the result of statutory delegation) or “interpretive” (mere explanations of preexisting law). (This legislative/interpretive distinction under the APA is different from the distinction between legislative and interpretive Treasury regulations that was applied for many years in tax cases, but rendered largely obsolete by the Supreme Court’s Mayo decision.) Relying on Hemp Indus. Ass’n v. DEA, 333 F.3d 1082 (9th Cir. 2003), the Tax Court found that the 2003 cost-sharing regulations were legislative because there would be no basis for the IRS’s position that the cost of stock-based compensation must be shared under section 482 absent the regulation and because Treasury invoked its general legislative rulemaking authority under Code section 7805(a) with respect to the regulation.

APA section 553 generally requires the administrative agency to publish a notice of proposed rulemaking in the Federal Register, to provide interested persons an opportunity to participate in the rulemaking through written comments, and to incorporate in the adopted rules a concise general statement of their basis and purpose. APA section 706(2)(A) empowers courts to invalidate regulations if they are “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” The Tax Court cited Motor Vehicles Mfrs. Ass’n v. State Farm, 463 U.S. 29 (1983), as holding that this standard requires “reasoned decisionmaking” and that a regulation may be invalidated as arbitrary or capricious if it is not based on consideration of the relevant factors and involves a clear error of judgment.

The Tax Court found that the stock-based compensation rule did not comply with the reasoned decisionmaking standard because the rule lacked a factual basis and was contrary to evidence presented to Treasury during the rulemaking process. The Tax Court stated that, although the preamble to the 2003 rule stated that unrelated parties entering into cost-sharing agreements typically would share ESO costs (thereby relating the regulation to the arm’s-length requirement of section 482), Treasury had no factual basis for this assertion. Commentators had provided substantial evidence that stock-based compensation costs were not shared in actual third-party agreements, which the Tax Court itself had found (and which the government conceded) in Xilinx. Treasury could draw no support from any of the submitted comments nor did it engage in any of its own factfinding to support its position. Absent such factfinding or other evidence, the Tax Court concluded that “Treasury’s conclusion that the final rule is consistent with the arm’s-length standard is contrary to all of the evidence before it.”

The Tax Court also stated that Treasury’s failure to respond to any of the comments submitted was evidence that the regulation did not satisfy the State Farm standard, stating “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is [because m]eaningful judicial review and fair treatment of affected persons require an exchange of views, information and criticism between interested persons and the agencies.” As a result, the final rule failed to satisfy State Farm’s reasoned decisionmaking standard.

Challenges for Treasury. The Altera decision highlights the limitations of the Treasury Department’s rulemaking authority when the regulation is based on a factual determination. In that situation, the deference normally given to Treasury because of its expertise as an administrative agency carries little weight unless it is supported by specific factfinding Treasury has done with respect to the rule at issue. In other words, Treasury cannot expect tax regulations that seek to implement a fact-based standard to be upheld simply because Treasury believes that they reach the right theoretical result. Instead, Treasury must explicitly cite the evidence and explain how that evidence provides a rational basis for the regulation.

The Altera decision should motivate Treasury to incorporate responses to submitted comments in its descriptions of final regulations. By specifically citing Treasury’s failure (1) to respond to comments or (2) to engage in independent factfinding as being important components of judicial review under the APA, the Tax Court’s decision effectively directs Treasury to spend more resources during the rulemaking process.

More broadly, the Altera decision underscores the constraints placed on Treasury and other administrative agencies under the APA. Although Mayo announced that Chevron deference principles would apply to Treasury regulations in the future, that was not a radical shift in the law because Treasury regulations had always been subjected to a deference analysis that bore considerable similarity to Chevron. By contrast, as the Tax Court noted, Treasury regulations have not traditionally been measured by APA standards, and Treasury’s notice-and-comment procedures have not been analyzed under State Farm. The Tax Court’s unanimous decision in Altera shows that judicial review under the State Farm standard is more than a mere paper tiger; where Treasury does not demonstrate that it adequately considered the relevant factors, including submitted comments, its regulation is at risk of being overturned. Although Altera as of now is binding authority only in Tax Court cases, challenges to Treasury regulations in other forums likely will cite its reasoning with respect to what constitutes reasoned decisionmaking for purposes of judicial review under the APA.

Considerations for Taxpayers. Absent reversal on appeal, Altera will have an impact on all related-party cost-sharing agreements. Although cost-sharing agreements governed by the 2003 regulations typically have provided for a sharing of stock-based compensation, they often have provided for a retroactive adjustment back to the start of the agreement if there is any relevant change in law. Taxpayers with cost-sharing agreements should carefully review their agreements and tax positions to determine whether their agreement provides for an adjustment mechanism or whether if claims for refund for open years are appropriate based on the Altera holding.

In addition, taxpayers should consider whether Altera has opened the door for additional regulatory challenges, both in the transfer pricing arena and elsewhere, in contexts where the regulations were premised on factual or theoretical assumptions by Treasury that lack sufficient evidentiary support. The Altera case already has been brought to the attention of the district court handling the Microsoft summons litigation in the Western District of Washington as relevant to determining whether the Treasury regulations at issue there are valid, and the case will likely also be cited in cases involving the validity of other transfer pricing regulations, such as the regulations currently under review by the Tax Court in 3M Co. et al. v. Commissioner; No. 005816-13. In addition, the transfer pricing regulations governing services transactions, which were developed following the regulations at issue in Altera, also define the term “cost” to include stock-based compensation and therefore may be vulnerable to reasoning similar to that in Altera.

Finally, taxpayers and other commentators should consider the Tax Court’s reasoning in Altera in developing comments to proposed regulations. Altera demonstrates that such comments can be important in laying a foundation for future judicial challenge even if the commentators are not successful in persuading Treasury to adopt their position.

Altera – Tax Court opinion

Taxpayer Brief Filed in MassMutual

The taxpayer has filed its response brief in the Federal Circuit in the MassMutual case. See our previous coverage here. With respect to the primary issue of whether its policyholder dividend guarantee was a “fixed liability” within the meaning of the “all events test,” the taxpayer relies heavily on Washington Post Co. v. United States, 405 F.2d 1279 (Ct. Cl. 1969). (The Court of Claims was the predecessor court to the Federal Circuit and its pre-1982 decisions are binding precedent in the Federal Circuit.) According to the taxpayer, Washington Post establishes that “a company can fix a liability to an existing class of beneficiaries, even though the class composition may change before the liability is ultimately satisfied.” In contrast to the government’s brief, the taxpayer does not dwell at length on the Supreme Court’s decisions in Hughes Properties and General Dynamics, but argues that both of those cases are fully consistent with the more-directly-on-point decision in Washington Post.

The brief also addresses the Second Circuit’s decision in New York Life, arguing that the cases are distinguishable. (The Second Circuit had suggested a distinction, but without great conviction, suggesting that it believed the Court of Federal Claims was wrong in MassMutual.) The critical difference, according to the taxpayer, is that “New York Life addressed thousands of separate liabilities to individual policyholders, any one of which could cease to be a policyholder at any time,” whereas MassMutual involves a guarantee to “a class of policyholders” that “does not depend on identifying individual policyholder liability.”  Finally, the taxpayer rejects the government’s argument that the dividend guarantees were “illusory,” stating that the trial court correctly ruled that “Board resolutions can fix liability.”

With respect to the second issue of whether the liability fell within the “recurring item exception,” the taxpayer argues that its position comports with “the only sound interpretation of the regulation.” It further argues that the government’s administrative deference argument is waived for failure to raise it below and, in any event, fails because the government is seeking deference to what is no more “than a convenient litigating position” that has not been shown to have been approved at any level by IRS or Treasury.

The taxpayer’s brief is linked below. Also linked below is the government’s brief in opposition to the petition for certiorari filed by the taxpayer in New York Life. That petition was denied by the Supreme Court on April 28.

MassMutual – Taxpayer Response Brief

New York Life – Brief in Opposition

 

 

 

Government Brief Filed in MassMutual

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.

MassMutual – Gov’t Opening Brief

D.C. Circuit Holds in Loving that IRS Lacks Authority to Regulate Tax-Return Preparers

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.

Loving – Court of Appeals Opinion

Government Faces Sharp Questioning from D.C. Circuit in Loving

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.

Loving – Plaintiffs’ Response Brief

Loving – Government Reply Brief

 

 

Government Files Opening Brief in Loving; Seeks Expedited Appeal

Two days after the D.C. Circuit denied its motion for stay pending appeal, the Government moved for an expedited appeal and concurrently filed its opening brief.  The Government seeks an expedited resolution of its appeal of the decision of the U.S. District Court for the District of Columbia (Judge James E. Boasberg) invalidating a licensing regime for paid federal tax return preparers.  Under the Government’s proposed briefing schedule, briefing would be complete by May 31, 2013.  The Appellees have consented to the Government’s proposed briefing schedule.

In its opening brief, the Government argues that the tax return preparer regulations are a reasonable interpretation of an ambiguous statutory grant of authority to regulate the “practice of representatives before the Department of Treasury.”  The district court had held that the Treasury Department was not entitled to any Chevron deference because the statute, 31 U.S.C. 330(a)(1) unambiguously did not authorize the regulation of individuals whose only role is the preparation of the return.  The Government argues that “neither the actual language nor the overall context of 31 U.S.C. 330(a) unambiguously forecloses the Secretary’s interpretation that the term ‘ practice of representatives before the Department of the Treasury’ includes the practice of tax-return preparers.”  The Government pointed to the absence of a definition — either in the Code or in ordinary meaning — of “practice” that would exclude mere return preparation.  The Government also seizes on language in 31 U.S.C. 330(a)(2) authorizing the Secretary of the Treasury to require that representatives who practice before it demonstrate “necessary qualifications to enable the representative to provide to persons valuable service.”  The Government reasons that, because tax return preparers provide a “valuable service,” they should be deemed to “practice” before the Treasury Department.   Acknowledging that the statute authorizes the Treasury Department to require a representative to demonstrate “competency to advise and assist persons in presenting their cases,” the Government contends that Congress did not intend by that language to limit the Treasury Department’s authority to regulate tax-return preparers whose representation ends with preparing the tax return.

Loving – Government’s Opening Brief

Loving- Government’s Motion to Expedite Appeal

Reply Brief Filed on Stay Motion in Loving

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.”

Loving – USG Reply Brief re Motion for Stay

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.

Loving – District Court Opinion Granting Injunction

Loving – District Court order denying stay and modifying injunction

Loving – Government Motion for Stay

Loving – Appellees’ Response to Motion for Stay

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.

Dominion Resources – Federal Circuit Decision

Dominion Resources – Court of Federal Claims Decision

Home Concrete Decision Leaves Administrative Law Questions Unsettled While Excluding Overstatements of Basis from Six-Year Statute of Limitations

[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.

Supreme Court opinion in Home Concrete

Lively Oral Argument in Home Concrete Leaves Outcome in Doubt

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.

Home Concrete Argument Preview

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.

Introduction

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.

Background

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.

Arguments

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.

Analysis

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. 

 

Taxpayer and Supporting Amicus Briefs Filed in Home Concrete

The taxpayer has filed its brief in Home Concrete.  The brief argues forcefully that the case is controlled by Colony, characterizing the underlying statutory issue as “settled by stare decisis.”   The brief disputes the government’s arguments that the changes made by Congress in the 1954 Code had the effect of extending the six-year statute to overstatements of basis outside the trade or business context, observing that the 1954 Code changes were all designed to favor taxpayers. 

With respect to the regulations, the taxpayer first argues that Colony should be understood as having held that the statutory language was unambiguous, thus foreclosing Treasury from issuing regulations that would require a different statutory interpretation.   (As we previously reported, this particular point was the focus of oral argument before the Federal Circuit in Grapevine, with the court ultimately resolving that point in favor of the government and deferring to the regulation.)  Second, the brief argues that the regulation would in any event be invalid because of its retroactive effect on pending litigation.  In addition, the brief makes some narrower arguments about this particular regulation, maintaining that by its terms the regulation does not cover cases like Home Concrete and that the regulation is procedurally defective.

At least eight amicus briefs were filed in support of the taxpayer.  A brief filed by the American College of Tax Counsel focuses on the retroactive application of the regulations, elaborating on the taxpayer’s arguments in asserting that “retroactive fighting regulations” that are 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.  The brief invokes general principles against retroactive legislation and also argues that Code section 7805(b)’s prohibition on retroactive regulations applies.  The government argues that section 7805(b) does not apply to regulations interpreting statutes enacted before 1996, a position that was not heavily disputed by taxpayers in the court of appeals litigation of these cases.

Four other amicus briefs were filed by taxpayers who litigated the Home Concrete issues in other circuits and whose cases will be controlled by the outcome — one filed by Grapevine Imports (Federal Circuit), one filed by UTAM, Ltd. (D.C. Circuit), one filed jointly by Daniel Burks (5th Circuit) and Reynolds Properties (case pending in the 9th Circuit), and one filed by Bausch & Lomb (cases pending in the Second Circuit).   The latter brief emphasizes that Bausch & Lomb’s case does not involve a son-of-BOSS tax shelter, but rather a more standard business transaction, and also that it involves only section 6229, which does not contain the statutory changes from the 1939 Code found in section 6501 and on which the government heavily relies to distinguish Colony.  Amicus briefs were also filed by the Government of the U.S. Virgin Islands, the National Association of Home Builders, and the National Federation of Independent Business, Small Business Legal Center.  Copies of the taxpayer’s brief and some of the amicus briefs are attached.

The oral argument in Home Concrete is scheduled for January 17.   The government’s reply brief is due on January 10.

Home Concrete – Taxpayer’s Supreme Court brief

Home Concrete – Amicus Brief of American College of Tax Counsel

Home Concrete – Grapevine Amicus Brief

Home Concrete – Amicus Brief of Burks and Reynolds Properties

Home Concete – Amicus Merits Brief of Bausch & Lomb

Supreme Court Briefing Underway and Argument Date Set in Home Concrete

The Supreme Court has set January 17 as the date for the oral argument in Home Concrete, the case in which it will decide the “Intermountain” issues concerning the applicability of the six-year statute of limitations to overstatements of basis, on which we have reported extensively many times before.  (See here and here for a sample.)  In the meantime, the briefing has commenced with the filing of the government’s opening brief (linked below).

The brief covers what is mostly familiar ground at this point, but it does further develop some of the arguments that have emerged in the course of the court of appeals litigation, with particular reliance on the D.C. Circuit’s decision in Intermountain.  The government divides its argument into three sections.  The first analyzes the statutory text, structure, and purpose, emphasizing a broad definition of the word “omission” and arguing that its position is supported by other subsections within section 6501(e).  Second, the government argues for deference to the final regulations.  Finally, the third section argues that the Supreme Court’s Colony decision is not controlling.

With respect to the administrative deference point that is of the broadest significance in this case, the government not surprisingly offers up arguments that will enable the Court to rule in its favor without exploring the outer limits of the power that the Court’s recent precedents arguably confer on the Treasury Department.  But the government does not shirk from pushing those limits in case its other arguments are unpersuasive. 

For example, although the government argues that the Colony decision is inapplicable because it involved a 1939 Code provision that has since changed in some ways, the government maintains that it should still prevail even if no changes had been made to the statute in the 1954 Code.  “Under Brand X,” the government states, “the new Treasury Department regulation would be entitled to Chevron deference even if that rule construed precisely the same statutory provision that was before the Court in Colony.”  Thus, the government is not bashful about claiming an extraordinary amount of power for the Treasury Department.  Congress can pass a law establishing a particular rule, and the Supreme Court can construe that law, but the Treasury Department can turn it all upside down as long as the Court did not declare the statutory language unambiguous. 

The government’s brief also addresses the additional objection that the regulations operate retroactively.  The government argues that they are not truly retroactive, because they supposedly “clarified rather than changed existing law” (notwithstanding Colony and two court of appeals decisions that were unquestionably on point) and addressed “procedures,” rather than the legality of the conduct.  In the end, however, the government maintains that “the rule would be valid even if it had retroactive effect.” Thus, the government fully embraces an expansion of the Treasury Department’s power beyond that recognized in Mayo — arguing that an agency not only has the power to promulgate rules that overturn settled judicial precedents, but also has the power to apply those new rules to prior years.  Given that even Congress is usually constrained in adopting retroactive legislation, it will be interesting to see if the Court balks at conferring this kind of power on unelected officials.

The taxpayer’s brief is due December 15.

Home Concrete – U.S. Supreme Court opening brief

Supreme Court Agrees to Hear Home Concrete Case to Address Six-Year Statute Issues

The Court this morning granted certiorari in the Home Concrete case from the Fourth Circuit, thus paving the way for a definitive, nationwide resolution of the issues presented in the Intermountain cases.  We had previously indicated that it was more likely that the Court would hear the Beard case, since the petition in that case was filed first.  It is ironic that the Court chose to hear the Home Concrete case, since that is the one case that neither party urged the Court to take.  (The government asked the Court to grant Beard and hold the Home Concrete case, and the taxpayer asked the Court to deny certiorari. See our previous report here.)  Perhaps the Court thought that Home Concrete was the preferable vehicle because the court of appeals had addressed the applicability of the regulations; perhaps the Court was just being ornery and wanted to resist the government’s efforts to manipulate the docket by contriving to have the Beard case jump ahead of the earlier-decided Home Concrete case.  See our previous report here.

In the long term, it does not appear to make much difference which case the Court agreed to review.  The Court can be expected to resolve the six-year statute question in this case, likely addressing the effect of the regulation.  In the short term, the Court’s choice does affect the briefing schedule.  Since the government is the petitioner in Home Concrete, its brief will be due first, and it will have the opportunity to file a reply brief.  This schedule gives taxpayers interested in filing an amicus brief a bit more time to prepare one than they would have had if Beard were the lead case, as such a brief would be due seven days after the taxpayer’s brief, which will now not be due until mid-December.

The Court took no action on the petitions in Beard and Grapevine.  The petitions in these cases will likely be held and acted upon only after the Home Concrete case is decided.

The government’s opening brief in Home Concrete is due November 14.  The case will likely be argued in January, or possibly February, and the Court will issue its decision before the end of June 2012.

Update on Intermountain Cases

Although our blog coverage might reasonably be accused of hibernating over the summer, court calendars inexorably marched on, and there were several developments in the various Intermountain cases.  If the Supreme Court grants cert in Beard on September 26, as we have predicted, these developments will not be of much moment, since all of the cases will likely be governed by the Supreme Court’s decision in Beard.  The one possible exception is the Federal Circuit’s decision in Grapevine, where the taxpayer’s cert petition has been fully briefed and is ready for consideration by the Supreme Court on September 26 together with Beard.  In any event, for those keeping score, here is an update, along with a selection of the filings, which are somewhat duplicative.

Federal Circuit:  The Federal Circuit denied rehearing in Grapevine on June 6.  The taxpayer petitioned for certiorari, docketed as No. 11-163, and the government responded by asking the Court to hold the petition and dispose of it as appropriate in light of its decision in Beard.  The government filed its response early, thus allowing the Court to consider the petition in tandem with Beard on September 26.  Thus, the Court could conceivably agree to hear both cases, or agree to hear Grapevine alone (because the regulatory deference issue is fleshed out in the court of appeals opinion in that case).  The government, however, does not urge either of those approaches.  Instead, it asks the Court to grant cert in Beard alone, following its usual practice of hearing the earliest-filed case when two petitions raise the same issue.

D.C. Circuit:  The taxpayers in both Intermountain and UTAM filed petitions for rehearing.  The court denied the petition in Intermountain on August 18 and denied the petition in UTAM earlier today on September 15.  In both cases, the court slightly amended its opinion to provide what it believed to be a better response to certain relatively narrow arguments made by the taxpayers.

Fourth Circuit:  The government filed a petition for certiorari in Home Concrete, asking the Court to hold the case for Beard.  The taxpayer filed a brief in opposition asking the Court to deny certiorari on the grounds that the Fourth Circuit got it right and that Congress has closed the son-of-BOSS loophole for future years.  Good luck with that.  The Home Concrete petition will also be considered at the Court’s September 26 conference.  If the Court grants cert in Beard or Grapevine, it will surely hold the Home Concrete petition pending consideration of those cases.

Fifth Circuit:  The government filed a cert petition in Burks, docketed as No. 11-178, and asking that that case also be held pending the disposition of Beard.  The taxpayer did not file an early response, and that case will not be ready for consideration at the Court’s September 26 conference.

Ninth Circuit:  The Ninth Circuit’s Reynolds Properties case lagged behind those in the other circuits because the briefing schedule was delayed for some time by the mediation process.  Undeterred for now by the prospect that the Supreme Court will resolve the issue, the Ninth Circuit is marching ahead.  The case is now fully briefed and is scheduled for oral argument on October 13, 2011.

Tenth Circuit:  The court denied rehearing in Salman Ranch on August 9.  The taxpayer obtained a stay of the mandate so that it can file a petition for certiorari, which will surely be held if the Court grants cert in one of the other cases.

We will be back soon with a report on what, if anything, the Court does at its September 26 conference.

Grapevine – U.S. response

UTAM Order Denying Rehearing and Amending Opinion

Intermountain Order Denying Rehearing and Amending Opinion

Home Concrete – Cert petition

Home Concrete – Brief in Opposition

Government Acquiesces in Beard Petition for Certiorari

The government has now filed its response to the taxpayer’s petition for certiorari in Beard, the first of the Intermountain cases to reach the Supreme Court.  As expected, the government filed an “acquiescence,” meaning that it told the Court that the Seventh Circuit had correctly ruled against the taxpayer, but the government agreed that it is appropriate for the Supreme Court to hear the case in order to resolve the conflict in the circuits.   In the words of the response, “[a]lthough the decision below is correct, . . . [i]n light of the square circuit conflict, and the importance of the uniform administration of federal tax law, the petition for a writ of certiorari should be granted.”

It is very likely that the Supreme Court will agree to hear the case in light of the government’s acquiescence.  The Court does not issue orders on certiorari petitions over its summer recess, but will sometimes issue them during the week before the Court’s formal return on the first Monday in October.  Look for an order granting certiorari to issue on September 26 or soon thereafter.

Beard – Government Response to Petition for Cert

Taxpayer Seeks Rehearing in Salman Ranch

While we wait to see what the government will say to the Supreme Court on the Intermountain issue, litigation continues in the courts of appeals.  (The government’s response to the certiorari petition in Beard is currently due on July 27.)   The taxpayer has filed a petition for rehearing en banc in Salman Ranch.  It is hard to imagine that the Tenth Circuit will head down that road when it appears that the Supreme Court will address the issue.  Salman Ranch, however, does present one wrinkle not present in the other cases — namely, whether the government was precluded by collateral estoppel from relitigating the issue against this taxpayer because Salman Ranch had prevailed in the Federal Circuit on the same issue in another tax year.  The Tenth Circuit panel ruled that collateral estoppel did not apply because, in light of the issuance of the regulations, it was not true that the “applicable legal rules remain unchanged.” 

The petition for rehearing, as well as the other briefs in this case, are linked below.

Salman Ranch – Taxpayer Petition for Rehearing

Salman Ranch – Government Opening Brief

Salman Ranch – Taxpayer Response Brief

Salman Ranch – Government Reply Brief

Beard Becomes First Intermountain Case to Reach the Supreme Court

We have been noting for the past few months that the Intermountain issue would be heading to the Supreme Court soon, with the government’s petition in the Home Concrete case due on July 5.  The taxpayers in Beard have jumped the line, however, by seeking certiorari ahead of the deadline, and that case is now docketed in the Supreme Court as No. 10-1553.  Meanwhile, the government has obtained a 30-day extension until August 3 to file its certiorari petition in Home Concrete.  Thus, unless the taxpayer in either Salman Ranch, Grapevine, or one of the D.C. Circuit cases sprints to the Court with its own cert petition well before the deadline, it looks like Beard will be at the head of the line by a good margin.

The petition does not add much to the arguments on the merits of the dispute.  The goal of a certiorari petition is to explain to the Court why it is important for it to hear the case.  If cert is granted, there is plenty of opportunity for the litigant to address the merits.  One of the best ways to convince the Court that it has to step in to a dispute is to demonstrate a conflict among the various courts of appeals, which will lead to different outcomes in similar cases unless the Court steps in.  Making that showing on the Intermountain issues is like shooting fish in a barrel.  The Beard petition sensibly focuses on discussing the circuit conflicts, both on the statutory interpretation issue (where the Seventh Circuit in Beard is the only court to have ruled that, even without the regulations, the statute should be construed as providing for a six-year statute of limitations (see here)), and on the question whether Chevron deference is owed to the regulations.

There are two items worth noting in the petition that relate to the merits.  The petition signals that the taxpayer will argue that Chevron is getting completely out of hand if deference is paid in the context of this case.  Specifically, the petition states that the government’s position that “the Treasury is empowered to reject and overrule longstanding precedent of this Court and other courts that it disfavors, simply through the issuance of temporary regulations without notice and public comment threatens obvious, far-reaching consequences.”  Second, the petition briefly responds to the argument that Colony should be read as applying only to cases involving a trade or business by pointing out that, although Colony itself did involve a trade or business, the Court was seeking there to establish a rule that would resolve a circuit conflict, and some of the conflicting cases did not involve a trade or business.

The next step is a response by the government, currently due on July 27.  In most cases, of course, the government’s response to a cert petition is to oppose the petition and argue that the Court should leave standing the court of appeals decision in favor of the government.  Sometimes, however, when there is a circuit conflict on an important issue, the government will “acquiesce” in the petition — meaning that it will tell the Court that the court of appeals decision was correct but that it agrees with the petition that the Supreme Court should hear the case so that it can pronounce a rule that will apply uniformly throughout the country. 

The government is virtually certain to agree that the Court should resolve the Intermountain dispute.  The only question would seem to be a tactical one:  will the government acquiesce in the Beard petition and have the dispute resolved in that case, where the government prevailed below?  Or will the government instead try to steer the Court towards a different case where perhaps it believes the facts are more favorable or where the taxpayer prevailed below.  The request for an extension in Home Concrete is a pretty good indication that the government is content to let the issue be resolved in Beard.

As far as timing, the government routinely secures extensions of time to respond to certiorari petitions.  (You may recall that the government got four extensions to respond to the Kawashima petition.  See here).  But if the government decides to acquiesce in Beard, that would be a very simple filing, and the government has had plenty of time already to decide what it wants to do in these cases.  Thus, it is possible that the government’s response will be filed on July 27.

The Beard petition is linked below.

Beard Petition for Certiorari

D.C. Circuit Gives the Government Another Victory in Intermountain

The D.C. Circuit yesterday reversed the Tax Court in Intermountain, handing the government more ammunition to use if, as appears increasingly likely, the Supreme Court considers the question of the applicability to overstatements of basis of the six-year statute of limitations found in Code sections 6229(c)(2) and 6501(e)(1)(A).  This now makes the score 4-2 for the government and represents the third straight court of appeals to adopt the government’s primary argument that courts owe Chevron deference to the relatively recent Treasury regulations interpreting the six-year statutes to apply to overstatements of basis.

The D.C. Circuit’s opinion is comprehensive, tracing the same ground as the Federal Circuit’s Grapevine decision, but also supplementing that court’s analysis.  In particular, the D.C. Circuit explores in detail the background of Colony and the legislative history of the 1954 Code in order to justify the conclusion that section 6501 does not unambiguously provide that overstatements of basis do not trigger the six-year statute — even though the same statutory term “omission from gross income” in the 1939 Code was construed in Colony not to include overstatements of basis.  Having reached that conclusion, the D.C. Circuit found that the Chevron step two analysis was “easy,” and there was no justification for suggesting that the Treasury regulation was an unreasonable interpretation of the statute.

One item of interest is the court’s refusal to address a couple of arguments made by Intermountain’s counsel because they were not raised in a timely fashion.  The court’s analysis distinguishing current law from the 1939 Code provision addressed in Colony relies heavily on the 1954 addition of section 6501(e)(1)(A)(i), which specifically addresses “gross income” in the case of a trade or business.  Intermountain contended at oral argument that this analysis ought to be irrelevant in a case that involved only section 6229, not section 6501.  The court, however, refused to consider that argument, stating that Intermountain had never before argued “that the two sections have different meanings outside the trade or business context.”  The court also refused to consider, as raised too late, Intermountain’s reliance on positions taken by the Commissioner on the meaning of Colony before the son-of-BOSS cases arose.  One might see these arguments raised and addressed in the Supreme Court down the road.

The Intermountain opinion also governs the companion UTAM case that was argued in tandem.  The D.C. Circuit did issue a separate opinion in UTAM addressing an issue unique to that case — whether a final partnership administrative adjustment (FPAA) tolls an individual partner’s limitations period under section 6501 in the same way section 6229(d) tolls the section 6229(a) “minimum period.”  The court ruled for the government on that issue as well, and we plan to address that opinion in another post.

Intermountain is likely the last that will be heard from the courts of appeals on the six-year statute issue before it moves to the Supreme Court.  (The Federal Circuit, as expected, denied rehearing in Grapevine on June 6.  Reynolds Properties v. Commissioner, No. 10-72406, has been fully briefed in the Ninth Circuit, but oral argument is not yet scheduled.)  The government’s recent successes in the courts of appeals give it a lot of momentum heading to the Court.  Of course, it is often said that momentum is only as good as the next day’s starting pitcher, and in the end the Supreme Court will make up its own mind without regard to the score in the courts of appeals.  The government’s anticipated petition for certiorari in Home Concrete is due July 5.

Intermountain opinion

UTAM opinion

Tenth Circuit Sides With Government on Intermountain Issue

The Tenth Circuit, after a long period of deliberation, has reversed the Tax Court in Salman Ranch.  (Opinion linked here.)  This now makes the score 3-2 in favor of the government in the series of appeals that have spread to most circuits.  See our original report here.

The Tenth Circuit’s opinion closely tracks the reasoning of the Federal Circuit in Grapevine.  The court first looked at the Supreme Court’s decision in Colony and concluded that it should not be read as holding that the statute unambiguously supports the taxpayer’s position.  (The Tenth Circuit did note its disagreement with the Seventh Circuit’s conclusion in Beard that the statute unambiguously resolves the issue in the government’s favor.)   Having found that Colony was not an obstacle to the issuance of valid Treasury regulations, the court proceeded to apply the Chevron test to the regulations and, like the Federal Circuit, ruled that the regulations surmounted the relatively low bar of being a reasonable interpretation of the statute.  The Tenth Circuit stated:  “Although we are not convinced the IRS’s interpretation is the only permissible one or even the one we would have adopted if addressing this question afresh, we are satisfied that it is a ‘permissible construction’ within the mandate of Chevron.” 

The Salman Ranch case presented one interesting wrinkle not found in the other Intermountain cases.  The Salman Ranch partnership had already prevailed on the identical issue in the Federal Circuit for a different tax year.  See Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009).  Ordinarily, that decision would have collateral estoppel effect in other litigation on the same issue between the same parties, and therefore it would have controlled the outcome in the Tenth Circuit.  The Tenth Circuit ruled, however, that there was no collateral estoppel effect because the “rules” had changed in the interim — because of the issuance of the new regulations.  The Federal Circuit had observed in Grapevine that the Chevron doctrine gives “regulatory agencies, not the courts, primary responsibility to interpret ambiguous statutory provisions.”  The Tenth Circuit’s decision goes that statement one better with respect to the power of agencies to make law, at least in this particular context.  It potentially gives regulatory agencies more power than even Congress to change the law, as Congress usually does not act retroactively when it enacts new legislation to overturn a court decision.  Without retroactive effect, new legislation would not destroy the collateral estoppel effect of a court decision.

If the taxpayer wishes to seek rehearing, the petition would be due on July 18.  By that time, the issues could be on their way to the Supreme Court because the government’s deadline for seeking certiorari in Home Concrete, the most advanced of these cases, is July 5.

Rehearing Denied in Burks

On April 15, the Fifth Circuit denied the government’s rehearing petition in Burks.  Not surprisingly, the courts of appeals are showing little interest in sitting en banc to address the Intermountain issue when they cannot eliminate the circuit conflict.  To recap, a rehearing petition is pending in the Federal Circuit, but the other three circuits to rule (the Fourth, Fifth, and Seventh) have denied rehearing, and the time is running to file petitions for certiorari in those cases.  The first deadline on the horizon is in the Home Concrete case from the Fourth Circuit, where the certiorari petition is due July 5.

Taxpayer Petitions for Rehearing in Grapevine

The taxpayer has filed a petition for rehearing en banc in the Federal Circuit in Grapevine.  Because Grapevine is the first appellate decision to rely on the new regulations (see here), the petition focuses part of its argument on criticizing the Federal Circuit’s decision to defer to those regulations, especially after the same court in Salman Ranch had rejected the statutory interpretation embodied in the regulations.  The petition also argues that applying the regulations to Grapevine is unlawful, even if the regulations could be controlling in future cases, because Grapevine had already obtained a favorable judgment from the Court of Federal Claims before the regulations were promulgated.

With the courts of appeals hopelessly conflicted already on the Intermountain six-year statute of limitations issue, it is a longshot to expect the Federal Circuit to want to wade into these issues en banc.  At this point, that court most likely will be inclined to sit back and see what the Supreme Court has to say.

Grapevine – Petition for Rehearing

Fourth Circuit Denies Rehearing in Home Concrete

On April 5, the Fourth Circuit denied rehearing in Home Concrete, one of the Intermountain-type cases that went for the taxpayer.  This now becomes the first of the cases for which there is no recourse left other than seeking Supreme Court review.  The government is very likely to pursue that course of action.  A petition for certiorari would be due on July 5.

D.C. Circuit Leans Toward Government at Intermountain Oral Argument

On April 5, the D.C. Circuit (Judges Sentelle, Randolph, and Tatel) heard oral argument in Intermountain and its companion case, UTAM.  The court’s questions generally indicated that the most likely outcome is a reversal of the Tax Court and another point for the government in the circuit court competition that is currently tied at 2-2.  (See our recent report on the Federal Circuit’s decision in Grapevine.)

Judge Randolph in particular was an advocate for the government’s position.  He dismissed the argument that Congress could be regarded as having adopted the Colony result under the doctrine of reenactment, and he expressed the view that Colony could not be controlling for an issue arising under the 1954 Code.  He also indicated his belief that an overstatement of basis is logically encompassed within the phrase “omission from gross income.”

Judges Sentelle’s questions were more evenhanded.  Both he and Judge Tatel indicated some skepticism about the government’s textual argument that a basis overstatement is an “omission” from gross income.  Judge Sentelle also pressed government counsel on the Supreme Court’s statement in Colony that the 1954 Code was unambiguous.  But he seemed satisfied with government counsel’s response that the Court’s statement must be read in light of the additions made to the 1954 Code that the Seventh Circuit relied upon in Beard. 

Judge Tatel followed up on this issue, pressing taxpayer’s counsel to explain why those additions did not defeat the taxpayer’s reliance on Colony.  Taxpayer’s counsel argued that these additions did not exist in the partnership statute, section 6229, and also directed the court to the Federal Circuit’s decision in Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009), for an explanation of why these additions were fully consistent with applying Colony to an individual under the 1954 Code.  But it was not apparent that these arguments were making headway.  Judge Tatel also jumped in to squash taxpayer counsel’s attempt to get mileage from the fact that the controversy was well underway before the temporary Treasury Regulations issued.

Overall, most of the argument was devoted to Colony and to parsing the statutory text and the differences between the 1939 and 1954 Code provisions.  All three judges appeared comfortable with the notion that, if they found Colony not to be controlling, then Brand X and the principle of Chevron deference to Treasury regulations would lead inexorably to a ruling for the government.  That is probably the most likely outcome, though, as we have noted previously, it is likely that the Supreme Court will have the last word.

One glimmer of light for the taxpayers was Judge Tatel’s exploration at the end of the argument of the question whether the taxpayers had made an adequate disclosure that would defeat the six-year statute of limitations.  Government counsel conceded that this issue remained open and that it should be addressed by the Tax Court on remand if the decision is reversed.

Government Rehearing Petition Filed in Burks

As promised, the government filed a petition for rehearing en banc in the Fifth Circuit in the Burks case.  The filing has one wrinkle that differs from the numerous other recent filings on this issue.  The petition claims an intracircuit conflict as a basis for rehearing en banc, arguing that the panel’s decision conflicts with Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), a case that the panel had found distinguishable.  See our previous report on the Burks decision here.

Burks – US petition for rehearing

New Government Filings Try to Unify Courts of Appeals Behind the Six-Year Statute for Overstatements of Basis

As we have reported extensively (e.g. here and here), the courts of appeals appear to be hopelessly split on the “Intermountain” issue of whether a six-year statute of limitations applies to overstatements of basis.  Nevertheless, the government has not given up on the possibility of winning this issue in all courts of appeals and thus eliminating the need for it to go to the Supreme Court.  To that end, it filed in two cases at the rehearing stage yesterday. 

In the Beard case in the Seventh Circuit, the government filed a response opposing the taxpayer’s petition for rehearing en banc.  It argued that the Seventh Circuit’s pro-government decision was correct and pointed out that the Seventh Circuit “cannot by itself resolve this conflict” in the circuits even if it grants rehearing, because there are multiple circuits that have ruled on both sides of the issue.

In the Home Concrete case in the Fourth Circuit, the government filed its own petition for rehearing en banc.  It argued that the Fourth Circuit erred and should instead adopt the reasoning of either the Seventh Circuit in Beard or the Federal Circuit in Grapevine.  Lawyers being what they are, the government’s own petition managed to avoid pointing out to the Fourth Circuit that it “cannot by itself resolve this conflict.”  The petition did state that the government also plans to seek rehearing in the next few days in the Burks case in Fifth Circuit — the other court of appeals that has rejected the government’s position even after the new regulations issued.

For now, these filings seem to put the Beard case back in the lead as the first case likely to be ready for Supreme Court review.  But that can change depending on the respective speed with which the different courts of appeals rule on the rehearing petitions.

Beard – US response to rehearing petition

Home Concrete – Petition for Rehearing

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.”

Federal Circuit opinion in Grapevine

Fifth Circuit Rules for Taxpayer on Intermountain Issue and Cautions on the Limits of Mayo

The Fifth Circuit announced today its ruling in favor of the taxpayer in the two consolidated cases pending before it on the Intermountain issue, Burks v. United States, and Commissioner v. MITA.  As we previously noted, the Fifth Circuit had decided what the government regarded as the most favorable precedent on this issue before the Son-of-BOSS cases, Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), but the court at oral argument appeared to be leaning towards finding that case distinguishable.  And so it did, creating the anomaly that the Seventh Circuit in Beard has given Phinney a much broader reading than the Fifth (see here).  In any event, the Fifth Circuit rejected the reasoning of Beard and concluded that Colony is controlling with respect to the meaning of the phrase “omits from gross income” in the 1954 Code.  The court addressed this argument in some detail, relying heavily on the “comprehensive analysis” of the Ninth Circuit in favor of the taxpayer’s position in Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009).

The court devoted comparatively little attention to the government’s reliance on the new regulations.  It concluded that the statute was unambiguous and therefore there was no basis for affording deference to the regulations.  In addition, the court stated that the new regulations by their terms were inapplicable because they should be read as reaching back no more than three years — an argument accepted by the Tax Court majority but that does not appear to be among the taxpayers’ strongest, especially after the final regulations were issued.

The most provocative discussion in the opinion is a long footnote 9 near the end, which points out some possible limitations on the impact of the Supreme Court’s recent Mayo Foundation decision (discussed here).  Although its conclusion that the statute is unambiguous made the regulations irrelevant, the court went on to state that it would not have deferred to the regulations under Chevron even if the statute were ambiguous.  On this point, the court emphasized an important difference between Mayo and the Intermountain cases — namely, the retroactive nature of the regulations at issue in the latter cases.  Noting that the Supreme Court has said that it is inappropriate to defer “to what appears to be nothing more than the agency’s convenient litigating position” (quoting Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 213 (1988)), the Fifth Circuit stated that the “Commissioner ‘may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations'” (quoting Chock Full O’Nuts Corp. v. United States, 453 F.2d 300, 303 (2d Cir. 1971)).  In addition, the court questioned the efficacy of the government’s request for deference to final regulations that were largely indistinguishable from the temporary regulations:  “That the government allowed for notice and comment after the final [perhaps should read “temporary”] Regulations were enacted is not an acceptable substitute for pre-promulgation notice and comment.  See U.S. Steel Corp. v. U.S. EPA, 595 F.2d 207, 214-15 (5th Cir. 1979).”

Thus, we have perfect symmetry between the conflicting decisions of the Fifth and Seventh Circuits.  The Seventh Circuit says that the statutory language supports the government, so there is no need to consider the regulations.  But if it did consider the regulations, it would defer.  The Fifth Circuit says that statutory language unambiguously supports the taxpayer, so there is no justification for considering the regulations.  But if it did consider the regulations, it would not defer.  The Supreme Court awaits, and it may well have something to say about the Fifth Circuit’s observations in footnote 9.

Fifth Circuit opinion in Burks

Fourth Circuit Rules for Taxpayer on Intermountain Issues

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.

Government Files Reply Brief in Intermountain

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.

Intermountain – US reply brief

Federal Circuit Plunges Deep Into the Weeds of Chevron Analysis in Grapevine Oral Argument

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.

Seventh Circuit Sets Up Likely Supreme Court Showdown By Reversing Tax Court on Intermountain Issue

The Seventh Circuit today became the first court of appeals to weigh in on the Intermountain issue subsequent to the issuance of the temporary regulations, and it handed the government a big victory.  Interestingly, the court did not rely on the regulations, instead ruling that the term “omission from gross income” is best read to include overstatements of basis – at least in “non-trade or business situations.”  The Court ruled that Colony did not control this issue because that case involved a construction of the 1939 Code, not the 1954 Code.  Describing it as a “close call,” the Seventh Circuit ruled that “a close reading of Colony” (which includes explaining away the Colony Court’s observation that the language in the 1954 Code is unambiguous) justifies the conclusion that “an overstatement of basis can be treated as an omission from gross income under the 1954 Code.”

The Seventh Circuit acknowledged that its decision directly conflicts with the two court of appeals decisions that prompted the Treasury Department to attack this issue by issuing temporary regulations, Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007).  The court explained that it disagreed with the reasoning in those decisions, and cited approvingly to Judge Newman’s dissenting opinion in Salman Ranch.  Thus, there is a clear conflict in the circuits, and the only way that conflict could disappear would be if the government prevails in every single circuit (including the Federal and Ninth Circuits) on its post-regulation appeals.  Such a clean sweep is unlikely.  With the government anxious to have this issue heard by the Supreme Court, and claiming that $1 billion is at stake, it appears almost inevitable that the Court will ultimately decide the Intermountain issue sometime in 2012.

As we noted in our original post on these cases, the Seventh Circuit panel was the most sympathetic to the government at oral argument and seemed particularly troubled by the bottom line outcome of allowing the taxpayers to retain massive tax benefits from what the court regarded as a tax shelter.  That attitude is reflected in the opinion as well, which goes out of its way to commend the government’s description of the transaction as an “abusive . . . tax shelter.”  Thus, the court’s reliance on a somewhat strained statutory interpretation might be understood as the least disruptive way to reach what it believed to be the “right result,” while avoiding having to make broad pronouncements on difficult issues of deference owed to temporary regulations.  The court indeed stated explicitly that, “[b]ecause we find that Colony is not controlling, we need not reach” the issue of deference to the regulations.

Curiously, though, the court then added two sentences stating in conclusory fashion that it “would have been inclined to grant the temporary regulation Chevron deference,” simply citing some cases in which the court had previously accorded deference to Treasury regulations.  Whatever the court’s motivation for adding this dictum, it does not address the difficult issues involved in deferring to these particular regulations.  Accordingly, the dictum is unlikely to carry much weight with other courts of appeals that do not agree that Colony is irrelevant to construing the statutory text and therefore are struggling with the question of the degree of deference owed to the regulations.

Seventh Circuit decision in Beard

Supreme Court Opts for Chevron Analysis of Treasury Regulations, Discarding the Traditional National Muffler Dealers Analysis

The Supreme Court this morning issued its opinion in the Mayo Foundation case, ruling unanimously that medical residents are not “students” exempt from FICA taxation.  As previously discussed several times on this blog (see here, here, and here), the Mayo case carried the potential for broad ramifications beyond its specific context because the parties had framed the question of whether deference to Treasury regulations is governed solely by general Chevron principles that supersede the deference analysis previously developed in tax cases like National Muffler Dealers.  The Court in fact addressed that question and has now endorsed use of the Chevron standard in tax cases, thereby providing the IRS with a big victory that will make it more difficult for taxpayers to prevail in court in the face of contrary regulations, even if they are “bootstrap” regulations designed primarily to influence the outcome of litigation.  And for good measure, the Court obliterated the long-held view by many in the tax world that “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under Code section 7805(a) are entitled to less deference than “legislative” regulations promulgated pursuant to more specific rulemaking authority.

The Court’s opinion was authored by the Chief Justice, who was the Justice who spoke out most forcefully during the oral argument in favor of the position that Chevron had superseded earlier decisions in tax cases, as noted in our previous post.  Thus, the opinion sought to be very clear on this point and to identify some of the familiar approaches to regulatory deference in tax cases that the Court was now consigning to the trash heap.  First, the Court pinpointed some of the key factors that had been identified as important under the National Muffler Dealers analysis, stating that under that analysis “a court might view an agency’s interpretation of a statute with heightened skepticism when it has not been consistent over time, when it was promulgated years after the relevant statute was enacted, or because of the way in which the regulation evolved.”  Slip op., at 8-9 (citing Muffler Dealers, 440 U.S. at 477).  The Court continued:  “Under Chevron, in contrast, deference to an agency’s interpretation of an ambiguous statute does not turn on such considerations.”  Id. at 9.

The Court amplified its rejection of the Muffler Dealers analysis by citing a series of non-tax decisions under Chevron that decline to attribute significance to these considerations.  Thus, the Court remarked that it had “repeatedly held that ‘[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the Chevron framework’” (quoting National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967, 981 (2005)); “that ‘neither antiquity nor contemporaneity with [a] statute is a condition of [a regulation’s] validity’” (quoting Smiley v. Citibank, N.A., 517 U.S. 735, 740 (1996)); and that it is “immaterial to our analysis that a ‘regulation was prompted by litigation’” (quoting Smiley, 517 U.S. at 741).  Trying to link these decisions to its tax law jurisprudence, the Court then observed that in United Dominion Industries, Inc. v. United States, 532 U.S. 822, 838 (2001) (which involved the calculation of product liability losses for affiliated entities under Code section 172(j)), it had “expressly invited the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of the case.”  Mayo slip op., at 9.  The Court emphasized that it saw no good reason “to carve out an approach to administrative review good for tax law only.”  Id.  Thus, the Court concluded:  “We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.”  Id. at 10.

Second, the Court moved to squash another area where it discerned a difference between Chevron principles and those developed in tax cases – even though the parties had not focused on that point.  Pointing to an amicus brief filed by Professor Carlton Smith arguing for reduced deference because the regulations in Mayo were “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under 26 U.S.C. § 7805(a), the Court acknowledged that there is pre-Chevron authority for the proposition that courts “‘owe the [Treasury Department’s] interpretation less deference’ when it is contained in a rule adopted under that ‘general authority’ than when it is ‘issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision’” (slip op., at 10-11 (quoting Rowan Cos. v. United States, 452 U.S. 247, 253 (1981)).  The Court tossed that precedent aside as well, ruling that the Rowan statement was not compatible with the current approach to administrative deference, which is unaffected by “whether Congress’s delegation of authority was general or specific.”  Slip op., at 11.

With the Chevron analytical framework in place, the Court made short work of the FICA issue before it.  It reasonably concluded that the statutory text did not unambiguously resolve whether medical residents qualify for the FICA student objection.  Hence, the Court moved to “Chevron stage two” – namely, whether the regulation was a “reasonable interpretation” of the statute.  Observing that “[r]egulation, like legislation, often requires drawing lines” (slip op., at 13), the Court held that it was reasonable for Treasury to establish a rule that anyone who works a 40-hour week, even a medical resident, is not a “student” for purposes of the FICA student exception.

In sum, the Court’s decision in Mayo resolves the deference issues that have recently divided the lower courts in a way that is extremely favorable to the government.  Treasury likely will be emboldened to issue regulations that seek directly to overturn cases that the government loses in court on statutory interpretation issues, or to issue regulations even earlier to sway the outcome of pending litigation before the courts interpret the statute in the first place.  Of course, we have seen that phenomenon already in the Mayo case itself, with respect to the statute of limitations issue litigated in Intermountain and a host of other cases (see here and here), and in other settings.  The Mayo decision will further encourage the Treasury Department to issue such regulations and will make it tougher for taxpayers to prevail in court in the face of those regulations.

 Mayo Foundation – Supreme Cout opinion

IRS Issues Final Regulations on Intermountain Six-Year Statute of Limitations Issue

As we have previously discussed, the IRS sought to buttress its reliance on the six-year statute of limitations in Son-of-BOSS cases by issuing temporary regulations that interpret the term “omission” of gross income in Code sections 6229 and 6501 to include understatements of gross income attributable to overstatements of basis.  Because that interpretation strains the language of the statute and flies in the face of the Supreme Court’s decision in Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958), the government has argued for application of Chevron deference to the temporary regulations.  The Tax Court has rejected that argument, and it is now pending in several courts of appeals.  Last week, the IRS issued final regulations that supplant the temporary regulations.  The final regulations have the same effective date as the temporary regulations (Sept. 14, 2009), and they are essentially the same, although they do clarify what the Tax Court majority in Intermountain found to be an ambiguity — making clear that the regulations are intended to apply to all cases for which the six-year statute of limitations remained open on the effective date.

The government is now submitting the final regulations as supplemental authority to the appellate courts considering the Intermountain issue.  (This is an example of the government’s supplemental submission, taken from the Fifth Circuit cases, with the final regulations attached.)  In the government’s view, the issuance of the final regulations strenghtens the argument for Chevron deference.  Taxpayers have objected that such deference was not owed to the temporary regulations because, among other reasons, they were temporary and issued without notice-and-comment.  Indeed, more than a quarter of the pages of argument in the government’s opening brief in Intermountain (here) were devoted to arguing that the temporary regulations were valid and entitled to deference notwithstanding the absence of notice-and-comment.  The final regulations arguably eliminate those objections, since the final regulations provided notice and opportunity for comment (even if the comments were disregarded).  Notice-and-comment aside, however, the government’s deference argument still faces the formidable obstacle of the contrary Supreme Court decision in Colony.

Briefing Underway in Intermountain

We recently surveyed the nationwide litigation addressing the government’s efforts to apply a six-year statute of limitations to Son-of-BOSS cases, including its efforts to have the courts defer to a late-issued temporary regulation.  The government has now filed its opening brief in the D.C. Circuit in Intermountain, the case in which the Tax Court addressed the issue.  Of note, the brief contains an extensive argument for applying Chevron deference to the temporary regulation, rather than “the differing standards of pre-Chevron jurisprudence” (an apparent reference to National Muffler Dealers, though the brief declines to acknowledge that case by name), and notwithstanding the lack of opportunity for notice and comment.  As we have discussed before here and here, the Supreme Court may shed some light in the next few months on the extent to which Chevron deference applies to Treasury regulations.

The taxpayer’s response brief is due January 5, 2011.

Intermountain – US opening brief

The Curious Non-Appeal of Veritas

Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial.  The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development.  Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property).  The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.

The Tax Court held for the taxpayer in substantial part.  Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever.  This is Gunnery Sergeant Hartman’s valuation method:

Marines die, that’s what we’re here for.  But the Marine Corps lives forever.  And that means you live forever.  Full Metal Jacket (1987).

Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.

The Tax Court is correct.  The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either.  The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts.  Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former.  Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates.  Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.

In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous.  However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim.  The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas.  The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.

This attempt by the IRS to use an AOD to continue to harass taxpayers should fail.  The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments.  And it did not exclude the possibility of future product value flowing from that original IP.  Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value.  The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity.  (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.)  IP does give competitive advantages that do not necessarily disappear in next generation product developments.  However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business.  Contra Litigating Treas. Reg. § 1.482-7T.

The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences.  The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers.  If it does not believe its position merits an appeal, the IRS should accept its loss.  Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them.  As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.”  The Veritas AOD is nothing but smoke.

Son-of-BOSS Statute of Limitations Issue Inundates the Courts of Appeals

The government has successfully challenged understatements of income attributable to stepped-up basis in so-called Son-of-BOSS tax shelters.  See, e.g., American Boat Co., LLC v. United States, 583 F.3d 471, 473 (7th Cir. 2009).  But it has been stymied in some cases by the three-year statute of limitations for issuing notices of deficiency.  Code section 6501(e)(1)(A) provides for a six-year statute “[i]f the taxpayer omits from gross income an amount” that exceeds the stated gross income by 25 percent.  Section 6229(c)(2) provides a similar six-year statute for cases governed by the TEFRA partnership rules.  The IRS has argued, unsuccessfully so far, that this section applies when there is a substantial understatement of income that is attributable not to a direct omission of income but rather to an overstatement of basis of sold assets.

The major obstacle to the government’s argument is that the Supreme Court long ago rejected essentially the same argument with respect to the predecessor of section 6501(e)(1)(A) (§ 275(c) of the 1939 Code).  The Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958).  The IRS argued there that the six-year statute applies “where a cost item is overstated” and thus causes an understatement of gross income.  Id. at 32.  The Court agreed with the taxpayer, however, that the six-year statute “is limited to situations in which specific receipts or accruals of income items are left out of the computation of gross income.”  Id. at 33.  The Court added that, although this was the best reading, it did not find the statutory language “unambiguous.”  Id.  Accordingly, the Court noted that its interpretation derived additional support from the legislative history and that it was “in harmony with the unambiguous language of [the newly enacted] section 6501(e)(1)(A).”  Id. at 37.  Based largely on the precedent of Colony, the Tax Court and two courts of appeals have already rejected the government’s attempts to invoke the six-year statute of limitations in Son-of-BOSS cases.  See Salman Ranch Ltd. v. Commissioner, 573 F.3d 1362 (Fed. Cir. 2009); Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009), aff’g, 128 T.C. 207 (2007).

Seeking to rescue numerous other cases that were still pending in the courts or administratively, the government responded by issuing temporary regulations on September 24, 2009, that purported to provide a regulatory interpretation of the statutory language to which the courts would afford Chevron deference.  The temporary regulations provide that “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income for purposes of [sections 6229(c)(2) and 6501(e)(1)(A)].”  Temp Regs. §§ 301.6229(c)(2) – 1T, 301.6501(e)-1T. 

The Tax Court was the first tribunal to consider the efficacy of this aggressive (one might say, desperate) effort to use the regulatory process to trump settled precedent, as the IRS moved the Tax Court to reconsider its adverse decision in Intermountain Ins. Service v. Commissioner, T.C. Memo. 2009-195, in the wake of the temporary regulations.  The reception was underwhelming.  The Tax Court denied the motion for reconsideration by a 13-0 vote, generating three different opinions.  The majority opinion, joined by seven judges, was the only one to base its ruling on rejecting the substance of the government’s argument that courts should defer to the regulations notwithstanding the Supreme Court’s Colony decision.  (Four judges stated simply that the new contention about the temporary regulations should not be entertained on a motion for reconsideration; two judges stated that the temporary regulations are procedurally invalid for failure to submit them for notice and comment.)

The government’s deference argument rests on Nat’l Cable and Telecommunications Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), which ruled 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.”  (In a concurring opinion, Justice Stevens stated his view that this rule would not apply to a Supreme Court decision, since that would automatically render the statute unambiguous, but that remains an open question.).  The Tax Court majority ruled that the Supreme Court’s statement in Colony that the statute was ambiguous “was only a preliminary conclusion,” but “[a]fter thoroughly reviewing the legislative history, the Supreme Court concluded that Congress’ intent was clear and that the statutory provision was unambiguous.”  Accordingly, the majority concluded that Brand X did not apply, and “the temporary regulations are invalid and are not entitled to deferential treatment.”  (The two judges who found the regulations procedurally invalid questioned the majority’s reasoning and suggested that the Court should not have reached the substantive issue).

The Tax Court’s decision in Intermountain is just the first skirmish in what will be an extended battle over the temporary regulations.  The Justice Department has asserted that there are currently 35-50 cases pending in the federal courts that raise the same issue, with approximately $1 billion at stake.  Accordingly, the government is pursuing an appeal to the D.C. Circuit in Intermountain, and it is arguing for deference to the temporary regulations in other cases pending on appeal in other circuits, even where those regulations were not considered by the trial court.  The government seems determined to litigate the issue in every possible court of appeals, presumably hoping that it can win somewhere and then persuade the Supreme Court to grant certiorari and reconsider Colony.  The current map looks like this:

D.C. Circuit:  Briefing schedules have been issued in Intermountain, No. 10-1204, and in an appeal from another Tax Court case, UTAM Ltd. v. Commissioner, No. 10-1262.  The government’s opening brief is due in Intermountain on December 6, 2010, and in UTAM on January 6, 2011.  The panel assigned to both cases is Judges Sentelle, Tatel, and Randolph.

Federal Circuit:  Grapevine Imports, Ltd. v. United States, No. 2008-5090, is fully briefed and scheduled for oral argument on January 12, 2011.  The Federal Circuit has already rejected the government’s invocation of the six-year statute in Salman Ranch, but the government is arguing in Grapevine that the Federal Circuit should reverse its position in light of the temporary regulations, which were not previously before the court.

Fourth Circuit:  Home Concrete & Supply, LLC v. United States, No. 09-2353, is fully briefed and was argued on October 27, 2010, before Judges Wilkinson, Gregory, and Wynn.  In that case, the district court had ruled for the government, distinguishing Colony as limited to situations in which the taxpayer is in a trade or business engaged in the sale of goods or services.  That was the rationale of the Court of Federal Claims in the Salman Ranch case, but that decision was reversed by the Federal Circuit.

Fifth Circuit:  Burks v. United States, No. 09-11061 (consolidated with Commissioner v. MITA, No. 09-60827) is fully briefed and was argued on November 1, 2010, before Judges DeMoss, Benavides, and Elrod.  In its briefs on this issue in various courts, the government has often invoked the Fifth Circuit’s decision in Phinney v. Chambers, 392 F.2d 680 (1968), the only court of appeals decision that has applied the six-year statute in the absence of a complete omission of gross income.  In Phinney, the taxpayer on her return had mislabeled proceeds from payment of an installment note as proceeds from a sale of stock with basis equivalent to the proceeds, reporting no income from that sale.  The Fifth Circuit accepted the government’s contention that the six-year statute applied, finding that it applies not only in the Colony situation where there is “a complete omission of an item of income of the requisite amount,” but also where there is a “misstating of the nature of an item of income which places the Commissioner . . . at a special disadvantage in detecting errors.”  392 F.2d at 685.  The government has argued that Phinney essentially involved an overstatement of basis, and therefore strongly supports its position in the Son-of-BOSS cases.  Indeed, the district court in Burks ruled for the government based on Phinney.  The government therefore likely viewed the Fifth Circuit as the most favorable appellate forum for the current dispute. 

At oral argument, however, the panel appeared sympathetic to the taxpayer’s position that Phinney involved a situation where the taxpayer had taken steps akin to a direct omission that would make it difficult for the IRS to discover the potential tax liability.  Therefore, the taxpayer maintains, Phinney is fully consistent with the position that the six-year statute does not generally apply to overstatements of basis. 

In addition, the discussion of the temporary regulation at oral argument specifically addressed the debate over whether deference to Treasury regulations is governed by Chevron principles or by ­­the less deferential National Muffler Dealers standard.  As we have discussed elsewhere, the Supreme Court may resolve that question in the next few months in the Mayo Foundation case.

Seventh Circuit:  Beard v. Commissioner, No. 09-3741 is fully briefed and was argued on September 27, 2010, before Judges Rovner, Evans, and Williams.  Although the panel, particularly Judge Rovner, expressed skepticism about some of the IRS’s legal arguments, Judges Williams and Evans appeared troubled by the prospect of allowing the taxpayer to escape scrutiny on statute of limitations grounds.  Judge Williams suggested that the taxpayer still ought to have the relevant records and that there was no apparent reason why a misstatement should be treated different from an omission.  Judge Evans emphasized that the taxpayer’s position with respect to tax liability was very weak and suggested that Colony might be distinguishable because it involved a return that was much easier for the IRS to decipher than the complex return involved in Beard.  Thus, to some extent, the government seemed to have found a sympathetic ear in the Seventh Circuit, though that will not necessarily translate into a reversal of the Tax Court.

Ninth Circuit:  Reynolds Properties, L.P. v. Commissioner, No. 10-72406.  The court of appeals vacated the briefing schedule to allow the parties to participate in the court’s appellate mediation program.  The government, however, has indicated that the case is not suitable for mediation, and therefore a new briefing schedule is likely to be issued soon.  The Ninth Circuit has already ruled in Bakersfield that the six-year statute does not apply to overstatements of basis.  Presumably, the government will ask the court to reverse itself in light of the temporary regulations, which were not previously before the court.

Tenth Circuit:  Salman Ranch Ltd. v. United States, No. 09-9015, is fully briefed and was argued on September 22, 2010, before Judges Tacha, Seymour, and Lucero.  This case comes from the Tax Court, but involves the same partnership that prevailed in front of the Federal Circuit. 

Attached below as a sampling are the briefs filed in the Fourth and Seventh Circuit cases.

Home Concrete – Taxpayer’s opening brief

Home Concrete – United States response brief

Home Concrete – Taxpayer’s reply brief

Beard – United States opening brief

Beard – Taxpayer’s response brief

Beard – United States reply brief

Mayo Foundation Oral Argument Tilts Towards the Government and Raises Doubts About the Continuing Vitality of National Muffler Dealers

At oral argument on November 8, several Supreme Court Justices expressed skepticism regarding the claim that medical residents fall within the “student exemption” from FICA taxation.  Although it is always hazardous to predict the outcome of a case from the questions asked at oral argument, it is difficult to envision the taxpayer getting the five votes needed to overturn the court of appeals’ rejection of the exemption.

The Justices’ objections to the taxpayer’s position came from a variety of angles.  Justice Sotomayor focused on the essence of what a medical resident does, suggesting that a person working unsupervised for more than 40 hours per week, and for significant remuneration, is “really not a student.”  Justice Ginsburg focused more on Congress’s intent, suggesting that the exemption seemed directed at “the typical work/study program in a college.”  Chief Justice Roberts observed that the line between student and worker is a difficult one to draw and suggested that it was therefore appropriate to let the IRS draw the line in a categorical way and then defer to the IRS’s interpretation.  Justice Breyer took a different tack, arguing that the IRS’s position was a valid interpretation of a requirement that had been in the regulations for a long time – namely, that the employment has to be “incident” to the study.  Full-time employment, he suggested, would not be “incident” to the study because it is “so big in comparison to the study.”

Justice Alito seemed the most sympathetic to the taxpayer.  He rose to the taxpayer’s defense by offering an alternative reading of word “incident.”  Later, he challenged the government’s counsel to explain why medical residents should not be eligible for the exemption when law students who write briefs are eligible, arguing that the medical residents should be treated as students if their primary motivation is to complete a course of study rather than to earn money.  Justice Ginsburg and the Chief Justice also questioned government counsel, though not as sharply as they had questioned the taxpayer’s counsel.  Justices Scalia and Kennedy were uncharacteristically silent during the argument.  In accordance with his usual practice, Justice Thomas did not speak.  Justice Kagan is recused in the case because of her prior involvement when she was Solicitor General.

In our prior posts on this case (see here, here, and here), we discussed the possibility that this case could be a vehicle for the Supreme Court to address the correct standard for deference to Treasury regulations – that is, whether the more generic Chevron analysis has superseded the more specific, and in some respects less deferential, approach set forth in National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979).  The Justices did not exhibit any independent interest in this issue, as their questions focused on the meaning of the statute, not on deference to the regulation.  At one point in his opening argument, taxpayer’s counsel noted that the new regulation was issued only after the government had repeatedly lost in court (a fact that would argue for less deference under the National Muffler Dealers approach), but that point did not elicit any reaction from the Justices.

Thus, the oral argument did not touch on the Chevron/National Muffler Dealers issue until the very end when taxpayer’s counsel affirmatively raised it during his few minutes of rebuttal time.  Counsel sought again to persuade the Court that the government’s position is suspect because it is a recent invention that seeks to overturn a series of adverse court decisions, and this time phrased the argument explicitly in terms of the standard for deferring to a regulation.  Taxpayer’s counsel argued that deference to the new Treasury Regulation is inappropriate under “[t]he National Muffler standards, which we understand still to be appropriate to evaluate deference given to an IRS regulation,” because the regulation “is not a contemporaneous regulation.”  Justice Sotomayor quickly objected, asserting that the Court has “said that agencies can clarify situations that have been litigated and positions that they have lost on.”  (She was referring here not to tax cases, but to decisions that apply the Chevron analysis.).  Shortly thereafter, Chief Justice Roberts zeroed in on the issue, asking:

Why are we talking about National Muffler?  I thought the whole point of Chevron was to get away from that kind of multifactor ad hoc balancing?

Taxpayer’s counsel tried to respond by arguing that the National Muffler Dealers factors were “sensible factors” that the Court should continue to apply in the case of a “regulation that pops up 65 years of the enactment of the statute, after the government has lost five cases.”  But the Chief Justice was dismissive, stating simply:  “If Chevron applies, those considerations are irrelevant, right?”

The outlook for the case therefore is that the Court will likely affirm the Eighth Circuit’s ruling that medical residents do not come within the student exemption from FICA.  Such a decision would not necessarily require a discussion of deference to Treasury regulations, but if there is such a discussion, the Court may well be ready to conduct the analysis explicitly in the Chevron framework and consign National Muffler Dealers to the dustbin of history.  As noted in our previous post, that would in some respects be an unfortunate outcome – giving too much deference to regulations that may well be unduly influenced by the IRS’s narrow interest in maximizing tax revenues rather than a neutral effort to implement the will of Congress.

Attached below are links to the taxpayer’s reply brief and to the transcript of the oral argument.  A decision is expected in the next few months.

Taxpayer Reply Brief in Mayo Foundation

Transcript of Oral Argument in Mayo Foundation

Government Argues for Abandoning the Muffler Dealers Test for Deference to IRS Regulations

In our initial post on the Mayo Foundation case pending in the Supreme Court, which concerns whether medical residents are exempt from FICA taxation, we noted that the case potentially raised a broad question that has surfaced in the courts of appeals and the Tax Court in recent years — namely, whether Chevron deference principles have supplanted the traditional Muffler Dealers approach to analyzing the deference owed to Treasury regulations.  Although that issue was not flagged by the parties at the certiorari stage, we later observed that the taxpayers’ opening merits brief served that ball into the government’s court by relying heavily on some of the Muffler Dealers factors that are not ordinarily part of the Chevron analysis.  The government has now responded by directly challenging the continuing vitality of Muffler Dealers.  (The government’s brief is attached below.)  As a result, there is a good chance that the Supreme Court will address the question and resolve the disagreement between the Tax Court and some courts of appeals on the proper analysis of deference to Treasury regulations.

The government’s brief does not mince words.  It states that Muffler Dealers “has been superseded by Chevron” and therefore “the considerations on which [taxpayers] rely are largely irrelevant.”  In particular, the government identifies three Muffler Dealers factors relied upon by the taxpayers that are allegedly irrelevant under Chevron:  (1) “the recency of [the] adoption” of the regulation; (2) that the new regulation “was enacted ‘to overturn judicial decisions’ interpreting the student exemption”; and (3) that “Treasury’s interpretation of the student exemption has purportedly been inconsistent.”

It is by no means a foregone conclusion that the Supreme Court will resolve the question of the proper deference standard, as there are many ways to resolve the ultimate question of the applicability of the FICA exemption without having to decide on a deference standard.  Nor is it as clear as the government would like that Chevron did or should supersede Muffler Dealers.  (If it were, the question probably would not still be open 26 years after Chevron was decided).  The IRS is often in an adversarial relationship with taxpayers; it has an inherent fiscal interest in interpreting the Internal Revenue Code in a way that maximizes tax revenues.  Therefore, there are good reasons for the courts to afford less deference to Treasury regulations that would determine the outcome of tax disputes than to regulations of more neutral agencies that are merely administering a federal statute.  Can the government really respond to an IRS defeat in court by promulgating a regulation to overturn the decision and then expect the courts to defer to that regulation without taking any account of how it came to pass?  Or can it reverse a regulatory interpretation simply because it determines that the reversal will benefit the public fisc, without paying some price in terms of judicial deference?  Perhaps the Supreme Court will answer those questions soon. 

Oral argument in the Mayo Foundation case is scheduled for November 8.

Mayo Foundation – United States Response Brief

Xilinx AOD Straightforward but Finds the IRS Still Intent on Redefining the Arm’s Length Standard

On July 28, 2010, the IRS released AOD 2010-33; 2010-33 IRB 1.  The AOD acquiesces in the result but not the reasoning of Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1196 (9th Cir. 2010) which held that stock option costs are not required to be shared as “costs” for purposes of cost sharing agreements under old Treas. Reg. §1.482-7.  For prior analysis of Xilinx see this.  The AOD in and of itself is relatively unsurprising.  New regulations (some might say “litigating regulations”) have been issued that explicitly address the issue, and those regulations will test the question of whether Treasury has the authority to require the inclusion of such costs.  The IRS surely realized that from an administrative perspective it was smart to let this one go.  The best move for most taxpayers is likely to grab a bucket of popcorn and watch the fireworks as a few brave souls test Treasury’s mettle by challenging the validity of the new regulations.  Including a provision in your cost sharing agreements that allow adjustments in the event of a future invalidation of the regulations might go well with the popcorn.

The only really interesting item in the AOD is the gratuitous bootstrap of the Cost Sharing Buy-In Regs “realistic alternatives principle.”  The still warm “realistic alternatives principle” – the IRS assertion that an uncontrolled taxpayer will not choose an alternative that is less economically rewarding than another available alternative – “applies not to restructure the actual transaction in which controlled taxpayers engage, but to adjust pricing to an arm’s length result.”  AOD, 2010 TNT 145-18, pp.4-5.  That assertion appears to ignore that “arm’s length” is not some obscure term of art cooked up by the IRS, but rather an established concept that lies at the heart of most countries’ approach to international taxation.

Still clinging to the withdrawn Ninth Circuit opinion, the AOD offers in support of this premise that “the Secretary of the Treasury is authorized to define terms adopted in regulations, especially when they are neither present nor compelled in statutory language (such as the arm’s length standard), that might differ from the definition others would place on those terms.”  Xilinx, Inc. v. Comm’r, 567 F.3d 482, 491 (9th Cir. 2009).

In short, the IRS appears to have dusted off the rule book of the King in Alice and Wonderland:

The King: “Rule Forty-two. All persons more than a mile high to leave the court.”

“I’m not a mile high,” said Alice.

“You are,” said the King.

“Nearly two miles high,” added the Queen.

“Well, I shan’t go, at any rate,” said Alice: “besides, that’s not a regular rule: you invented it just now.”

“It’s the oldest rule in the book,” said the King.

“Then it ought to be Number One,” said Alice.

Alice’s Adventures in Wonderland at 125 (Giunti Classics ed. 2002).  The IRS has often been disappointed with the real rule Number One (the arm’s length principle) when the results of real-world transactions do not coincide with the results the IRS desires.   Now the IRS looks to magically transform that rule into one that replaces those real-world transactions with the IRS’s revenue-maximizing vision.  Tax Wonderland is getting curiouser and curiouser.