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Fixing Tax Law’s APA Problem

Posted on Nov. 14, 2022
Reuven S. Avi-Yonah
Reuven S. Avi-Yonah

Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law at the University of Michigan. He thanks Dan Deacon for his helpful feedback.

In this article, Avi-Yonah examines the post-Mayo revolution that has occurred in the application of the Administrative Procedure Act to tax regulations, and he offers two solutions to the problem of using notice and comment for those regs.

Copyright 2022 Reuven S. Avi-Yonah.
All rights reserved.

The APA Tax Revolution

Since the Supreme Court decided in Mayo that tax regulations are subject to the Administrative Procedure Act’s notice and comment procedures because they are not always interpretive rules (as Treasury had previously believed), there has been a revolution in applying the APA to tax regulations.1 In many cases, courts have declared tax regulations and notices invalid because they either did not follow proper APA notice and comment procedures, or did not adequately take into consideration adverse comments received during the procedure.2

This revolution was led to a significant extent by one academic — professor Kristin Hickman of the University of Minnesota Law School — who has repeatedly argued that all tax regulations issued under section 7805 are legislative and therefore must be adopted through notice and comment.3 While other academics have disputed Hickman’s position as a distortion of the APA,4 many courts have adopted it, and Treasury has stopped arguing that tax regulations are interpretive in litigation, even though this position still appears in the Internal Revenue Manual.5 Hickman has won the debate, and the APA revolution in tax law is here to stay.

If that is the case, tax law faces a significant problem, similar to problems identified in the administrative law literature. The problem is that participation in notice and comment is costly and requires expertise, and the only participants who are likely to have the resources and expertise are the affected taxpayers — that have an incentive to oppose the regulations. The public interest in the proper administration of tax law to protect the fisc is not represented.6 Not-for-profit tax advocacy groups and some tax professors sometimes take the opposite side, but they tend to be outgunned.

In what follows, I first illustrate the problem with the unanimous reviewed opinion of the Tax Court in Altera. I then propose two solutions: First, Treasury needs to clearly articulate the alternative to its approach and why it rejected it; second, Congress should create a public advocate to represent the interest of the broader public in the proper administration of tax law.

Example: Altera v. Commissioner

The issue in Altera7 was whether the cost of stock options issued by a corporate parent should be included in the costs to be shared under a cost-sharing agreement with a foreign subsidiary. Having lost in Xilinx on the same issue when the regulations only said “all costs,” Treasury responded by specifically mandating the inclusion of the cost of options. But this regulation was unanimously invalidated by the full Tax Court because it was legislative and Treasury ignored adverse comments by multinationals that the regulation was inconsistent with the arm’s-length standard.

As the Ninth Circuit ultimately held, the regulation was valid as an application of the “commensurate with income” standard of section 482, because this standard was specifically adopted by Congress in 1986 to address the limitations of arm’s length in the absence of comparables, and there could be no comparables because an unrelated party would not agree to share the costs of stock options when it could not affect the stock price of the issuer of the options. When there are no comparables, any result is arm’s length because it cannot be proved that it is not, and “commensurate with income” requires including the costs of the options because otherwise, the subsidiary has to contribute very little to developing the intangible.

Altera illustrates the two problems of applying notice and comment to tax regulations. First, Treasury did not clearly specify why it rejected the alternative of explicitly modifying the arm’s-length standard in the regulation to exclude the stock option issue. Second, the comments were completely one-sided because it was not anticipated that the Tax Court would invalidate the regulations; this problem was partially remedied by amicus briefs on appeal, but there are now too many cases in which taxpayers argue that regulations should be invalidated to expect tax professors to weigh in on each one.8

Two Potential Solutions

There are two potential solutions to this problem. First, as Daniel Deacon of the University of Michigan Law School has cogently argued, Treasury must clearly spell out what the alternative to its preferred regulatory approach was, and why that alternative was rejected.9 Second, because courts may still reject Treasury’s position as biased against the affected taxpayers, Congress should appoint a public advocate experienced in administrative law as well as tax law to argue for the public interest.10

In Altera, this approach would have meant that Treasury had to explain that modifying the arm’s-length standard, which has been in the regulation since 1935, would greatly offend our major trading partners as well as the OECD. It also would be inconsistent with Treasury’s position since the 1988 white paper11 that Congress did not intend “commensurate with income” to modify the arm’s-length standard. Treasury could also point out that all U.S. tax treaties require it to follow arm’s length in all treaty cases, and arguably even in non-treaty cases like Altera if the arm’s-length standard is customary international law.

Also, if there were a public advocate, she presumably would have made the same arguments that the amici made on appeal, which may have persuaded the Tax Court not to invalidate the regulation (and saved a lot of litigation costs, because the regulation is still presumptively invalid in every circuit other than the ninth, so this issue may well be relitigated).

Conclusion

At this point, even if one disagrees with Hickman, it is hard to argue that she has not won the argument because too many courts have followed her approach and subjected tax regulations to the APA. But this means that the same problems that administrative law scholars have identified in other areas now bedevil tax law, and something needs to be done about it. As the Lorax observed, someone must speak for the trees.

FOOTNOTES

1 Mayo Foundation for Medical Education and Research v. United States, 562 U.S. 44 (2011) (“We are not inclined to carve out an approach to administrative review good for tax law only. To the contrary, we have expressly ‘recognized the importance of maintaining a uniform approach to judicial review of administrative action.’”).

2 For some recent examples, see Hewitt v. Commissioner, 21 F.4th 1336 (11th Cir. 2021); Mann Construction Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022); CIC Services LLC v. IRS, No. 3:17-cv-00110 (E.D. Tenn. 2022); Liberty Global Inc. v. United States, No. 1:20-cv-03501 (D. Colo. 2022); Green Valley Investors v. Commissioner, 159 T.C. No. 5 (2022).

3 Kristin E. Hickman, “Coloring Outside the Lines,” 82 Notre Dame L. Rev. 1727 (2007); see also Patrick J. Smith, “The APA’s Arbitrary and Capricious Standard and IRS Regulations,” Tax Notes, July 16, 2012, p. 271.

4 See, e.g., John A. Townsend, “The Report of the Death of the Interpretive Regulation Is an Exaggeration,” SSRN 3400489 (Dec. 14, 2021); James M. Puckett, “Structural Tax Exceptionalism,” SSRN 2702569 (Feb. 4, 2016); Puckett, “Reasonable Tax Rules: Advancing Process Values With Remedial Restraint,” SSRN 4245072 (Oct. 14, 2022).

5 Internal Revenue Manual sections 32.1.5.4.7.4.1 and 32.1.2.3(e).

6 For discussions on this problem in the administrative law literature, see, e.g., Michael Sant’Ambrogio and Glen Staszewski, “Democratizing Rule Development,” SSRN 3615896 (Mar. 5, 2021); Cynthia R. Farina et al., “Rulemaking 2.0,” 65(2) U. Miami L. Rev. 1001 (Winter 2011); and Leslie Book, “A New Paradigm for IRS Guidance: Ensuring Input and Enhancing Participation,” SSRN 1947457 (Oct. 22, 2011).

7 Altera Corp. v. Commissioner, 145 T.C. 191 (2015), rev’d, 926 F.3d 1061 (9th Cir. 2021). For discussion on Altera, see, e.g., Reuven S. Avi-Yonah, “The Implications of Altera,” Tax Notes Federal, June 29, 2020, p. 2324; Avi-Yonah, “Altera and the Arm’s Length Standard,” SSRN 3219744 (Aug. 22, 2018); and Avi-Yonah, “Altera, the Arm’s Length Standard, and Customary International Tax Law,” U. Mich. Public Law Research Paper No. 571 (Oct. 30, 2017).

9 Daniel T. Deacon, “Responding to Alternatives,” Working Paper, University of Michigan (2022).

10 Neil Komesar and Wendy Wagner, “The Administrative Process From the Bottom Up: Reflections on the Role, if Any, for Judicial Review,” 69 Admin. L. Rev. 891, 944 (2017):

As we have noted, public interest groups lack both the resources and the incentives to engage all the rules that affect the broader public, and their advocacy is further diminished by a series of nontrivial representational challenges. . . . To address the shortfall, the establishment of a public advocate may offer a valuable, added corrective. The public advocate would be an institutional addendum that tasks one or more independent advocates (or an office of advocates) with rigorously representing the diffuse public or, when needed, separate subgroups of the public. These advocates could not only provide sophisticated representation, where little is now present for dispersed interests, but they could also clarify the rules and the evidence to reduce the excessive obscurity and increased costs of information we described earlier.

11 Notice 88-123, 1988-2 C.B. 458.

END FOOTNOTES

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