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Another Altera May Be Waiting in the Wings of the D.C. Circuit

POSTED ON Jul. 12, 2018
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A case currently awaiting decision in the D.C. Circuit could provide rocket fuel to Administrative Procedure Act (APA) challenges to tax regs, and it has largely been ignored.

“If the opinion comes out in the way that the oral argument suggested, I think it’s going to be very, very significant. . . . It’s along the lines of Altera,” Patrick J. Smith of Ivins Phillips and Barker Chtd. said. If the D.C. Circuit, the court of appeals with the most expertise in administrative law, “were to come out with a decision that these regulations violated the arbitrary and capricious standard because they didn’t have an adequate explanation for what they were doing, that would be absolutely huge,” Smith said.

Practitioners may be forgiven if they haven’t followed the developments in Good Fortune Shipping v. Commissioner, No. 17-1160 (D.C. Cir.). The case is wonky, even by tax standards. It is on appeal from a taxpayer-adverse decision in which the Tax Court ruled on the validity of regs related to section 883. The rules relate to the preclusion of foreign corporations engaged in international shipping from using bearer shares to satisfy a qualified shareholder stock ownership test to claim eligibility for an income exemption. Given the difficulty in proving true ownership in bearer shares, the regs “set forth a sensible approach to effecting the intent of Congress in enacting section 883(c)(1),” to curb potential abuse, the Tax Court held in finding the regs valid under the two-part Chevron test.

But if oral arguments held in April are any indication, the D.C. Circuit may disagree. The case has the potential to significantly affect future litigation on numerous other regs already on the books.

Comparisons to Altera Corp. v. Commissioner, 145 T.C. 91 (2015), should catch any practitioner’s eye. The most noteworthy recent tax case pertaining to the reach of the APA, a unanimous Tax Court in Altera invalidated regs that require participants in qualified cost-sharing arrangements to share stock-based compensation costs, finding that they were arbitrary and capricious. The Ninth Circuit heard oral arguments in that case in October 2017 and may be nearing a decision. But the death of one of the judges on the panel may be resulting in procedural uncertainty, potentially leaving the fateful appellate decision temporarily in limbo.

Both the taxpayer’s initial and reply brief and the government’s brief in Good Fortune Shipping spend a significant portion of their arguments on step one of the regulatory analysis set forth in Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984) — examining the language of the statute to see whether Congress has spoken directly on the issue. A decision by the D.C. Circuit on such grounds would narrow the opinion’s application to other tax cases since it would be confined to the statute.

While neither party mentions the APA in its briefs, and neither refers to Altera, both give attention to Chevron step two and the arbitrary and capricious standard found there. The Supreme Court has acknowledged, in a footnote in Judulang v. Holder, 132 S. Ct. 476 (2011), that Chevron step two involves analysis similar to the APA arbitrary and capricious standard. The D.C. Circuit has weighed in as well, noting the overlap of the two standards in General Instrument Corp. v. FCC, 213 F.3d 724, 732 (D.C. Cir. 2000), and Shays v. FEC, 528 F.3d 914, 924 (D.C. Cir. 2008).

Under Chevron step two, if the statute is silent or ambiguous on an issue, the court looks to see whether the agency’s interpretation is a permissible construction of the statute and is not arbitrary and capricious.

Tell Me Why

The D.C. Circuit did not pay much heed to arguments pertaining to Chevron step one during oral arguments, instead concentrating its attention on the lack of explanation in the regs' preamble for why a shareholder cannot be a qualified shareholder through an interest in bearer shares. In response to comments objecting to the rule, the 2003 final regs (T.D. 9087) simply state that the rule from the 2000 proposed regs is retained because of “the difficulty of reliably demonstrating true ownership of bearer shares.”

Judge Sri Srinivasan seemed skeptical of the one-sentence conclusory explanation in the Federal Register. And Judge Merrick Garland asked whether it would have been permissible for the IRS to fail to provide an adequate explanation if it wanted to apply the same rule to ordinary shares. “We need to evaluate your explanation to determine whether it’s reasonable. . . . If you don’t have an explanation then it’s not reasonable,” Garland said.

When Richard Caldarone, arguing for the Justice Department, responded that it would not be reasonable to exclude ordinary shares since ownership is more easily traced there, Srinivasan and Garland pressed him, asking how could that be known from the regs, given the lack of explanation in the rules.

Explanations by the government not originally present in the regs made during litigation cannot save a deficient reg, under Securities and Exchange Commission v. Chenery Corp., 318 U.S. 80 (1943). While the government argued that the taxpayers had waived a Chenery argument by not addressing it themselves, the court seemed skeptical of that assertion since Chevron step two arguments were made by the taxpayer.

Smith said it was striking that the court appeared to be “extremely sympathetic” to the argument that the regs made no attempt to explain the government's position.

Based on the questions asked during oral arguments, Joseph B. Judkins of Baker McKenzie said it was clear that the D.C. Circuit was applying Chevron step two in a way that overlapped with the State Farm reasoned decision-making standard. He added that it appeared the IRS may have failed to satisfy the “bedrock requirement” of reasoned decision-making.

“They didn’t say why it was difficult. . . . A mere conclusory statement that it’s hard doesn’t tell you anything,” Judkins said. An adequate explanation would have provided at least a minimal path for the court to follow the agency’s decision-making process, he added.

Under the APA standard set forth in Motor Vehicle Mfrs. Assn. of United States Inc. v. State Farm Mut. Automobile Ins. Co., 463 U.S. 29 (1983), an agency needs to articulate a reasoned explanation for its actions or else its rule will be invalid as arbitrary and capricious.

Further, based on Supreme Court precedent in FCC v. Fox Television Stations Inc., 556 U.S. 502 (2009), the lack of a more detailed explanation for denying commenters’ requests could be especially problematic for the IRS since its regs shifted on its previous policy. In that case, the Court made clear that while a change in policy does not require “a more searching review,” a reasoned explanation for an action needs to demonstrate awareness that such a position change is occurring.

The regs at issue were a pivot from an older position enunciated in Rev. Proc. 91-12, 1991-1 C.B. 473, which allowed proof of ownership for bearer shares.

“What changed in that nine-year period to cause the agency to alter its position?” Judkins asked. “There’s nothing in the proposed or final rule to signal that. And you see the court pressing the government on that . . . [with] two judges pressing vigorously.”

If the D.C Circuit were to invalidate the reg based on State Farm analysis, it would not mark the first time a circuit court has done so within the tax context. In Dominion Resources Inc. v. United States, No. 11-5087, (Fed. Cir. 2012), the Federal Circuit held that regs under section 263A as applied to property temporarily withdrawn from service were not a reasonable interpretation of the statute and failed to provide a reasoned explanation. But, given the D.C. Circuit’s prominence in the administrative world, a tax decision here would still be notable.

“There’s still an open question of the extent to which State Farm overlaps with Chevron step two, with more and more courts embracing that . . . even though there’s not perfect symmetry,” Judkins said. “In Good Fortune Shipping you see a panel of very sophisticated administrative law experts applying these concepts in a relatively seamless way,” Judkins said.

Dispelling Limitations

A taxpayer-favorable decision in Good Fortune Shipping could also negate an IRS argument that Altera is limited to regs involving empirical analysis.

“The [D.C. Circuit] is not looking at this in the context of tax regulations specifically. It’s looking at it in the context of all agency regulations. And the rules that apply, apply very broadly. They are not limited to empirical analyses,” Judkins said, pointing to Supreme Court precedent in Fox Television and Encino Motor Cars v. Navarro, 579 US _ (2016). He argued that the IRS position is another attempt to establish tax exceptionalism to counter a concept well established in the broader administrative law world.

Smith also argued that the IRS’s position of limited applicability was wrong, adding that he was unaware of any cases that had made such a distinction in drawing the line where the APA was pertinent.

“But clearly that is an argument that the government has made,” Smith said. “That’s their defense . . . and if the decision in this case comes out in the way the oral arguments seem to suggest, that would totally refute the idea that State Farm and arbitrary and capricious are limited to factual and empirical kinds of determinations.”

At least one practitioner has argued that SIH Partners LLLP v. Commissioner, 150 T.C. No. 3 (2018), may be interpreted as an attempt by the Tax Court to confine Altera to transfer pricing regs. The court there attempted to differentiate its facts from State Farm since Treasury’s rules on pledges and guarantees reflect a policy judgment and the administrative record does not reflect any substantive alternatives being presented to Treasury.

Given the IRS’s general avoidance of the APA previously, the ripples of a taxpayer-favorable decision may be felt in myriad other regs. For years the IRS, as evidenced by Internal Revenue Manual 32.1.1.2.6, has viewed most of its regs as interpretive, tying the effect of the regulation directly to statutory authority. The APA exempts interpretive regs from notice and comment. The IRM also previously opined that it was not necessary for the IRS to justify its rules or address alternatives, instruction that seemingly could have resulted in a violation of the APA’s arbitrary and capricious standard.

Judkins predicted that many regs could be challenged and more litigation like Good Fortune Shipping may be forthcoming, given the historic disdain at Treasury and the IRS for the reasoned decision-making requirement of the APA.

According to Smith, Altera has already started to change the landscape, with better APA compliance in regulation writing since the Tax Court’s unanimous decision, but that won’t remedy the noncompliance of regs previously drafted under the old standard.

“The Tax Court intended [Altera] to be a wake-up call. But still that leaves a lot of regulations out there that were written in a way that they’d be vulnerable,” Smith said.

A taxpayer-favorable decision in Good Fortune Shipping may expose that vulnerability even further.