Government Seeks Summary Judgment in Microcaptive Notice Case

CIC SERVICES, LLC,
Plaintiff,
v.
INTERNAL REVENUE SERVICE, ET AL.,
Defendants.

IN THE UNITED STATES DISTRICT COURT
EASTERN DISTRICT OF TENNESSEE
AT KNOXVILLE

Judge Travis R. McDonough

Magistrate Judge H. Bruce Guyton

DEFENDANTS' MOTION FOR SUMMARY JUDGMENT

The Defendants in this action brought under the Administrative Procedure Act (“APA”) move for summary judgment in favor of the United States. The history of the congressional enactments before and after the Internal Revenue Service issued IRS Notice 2016-66 demonstrate that Congress excepted the Notice from the notice and comment rulemaking requirement of the APA. Alternatively, the Notice just interprets Treasury Regulations (26 C.F.R.) section § 1.6011-4(b)(6) providing for Transactions of Interest, and the APA itself exempts this form of guidance from the notice and comment rulemaking requirement. Further, the administrative record demonstrates that the Notice is not arbitrary and capricious. Last, CIC's claim under the Congressional Review Act (“CRA”) fails because the CRA is inapplicable, there is no judicial review for alleged violations of it, and in an abundance of caution, the agency submitted the Notice for CRA review, anyway.

A supporting Memorandum and an Addendum of Select Authorities accompanies this motion. Citations to the IRS administrative record refer to excerpts of the administrative record separately filed in the parties' Joint Appendix to the cross-motions for summary judgment.

DATE: November 1, 2021

FRANCIS M. HAMILTON III
Acting United States Attorney

DAVID A. HUBBERT
Acting Assistant Attorney General

Nishant Kumar
KYLE L. BISHOP
NISHANT KUMAR
Trial Attorneys, Tax Division
U.S. Department of Justice
P.O. Box 227
Washington, D.C. 20044
202-616-1878 (v)
202-514-6866 (f)
Kyle.L.Bishop@usdoj.gov
Nishant.Kumar@usdoj.gov

---

CIC SERVICES, LLC, et al.,
Plaintiffs,
v.
INTERNAL REVENUE SERVICE, et al.,
Defendants.)

IN THE UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF TENNESSEE
NORTHERN DIVISION

Case No. 3:17-cv-00110-TRM-HBG

MEMORANDUM IN SUPPORT OF THE
DEFENDANTS' MOTION FOR SUMMARY JUDGMENT

Contents

INTRODUCTION

BACKGROUND

STANDARD OF REVIEW6

ARGUMENT

CONCLUSION

---

INTRODUCTION

In response to growing concern about tax shelters, between 2000 and 2003, Treasury and the IRS (hereinafter just “IRS”) proposed and finalized a regulation with notice and comment rulemaking under § 6011.¹ Since 2003, this regulation has allowed the IRS to identify abusive and potentially abusive transactions without using notice and comment rulemaking. 26 C.F.R. §1.6011-4; U.S. Dep't of the Treasury, The Problem of Corporate Tax Shelters, at i. (1999) (available at https://perma.cc/39AG-JAQN). In 2004, when enacting disclosure and penalty statutes to spur compliance, Congress recognized that IRS regulations identified six types of “Reportable Transactions” including “Listed Transactions,” and that a “Listed Transaction” is any transaction that is the “same as (or substantially similar to) a transaction that is specified by the Treasury Department as a tax avoidance transaction.” H.R. REP. 108-548(I), 260 (citing Treasury regulation 26 C.F.R. § 1.6011-4). Congress stated that the new statute would continue to rely on the IRS to define “Reportable Transactions” and “Listed Transactions.” Id. at 261-62.

When it set out reporting requirements and corresponding penalties for participants in Reportable Transactions, Congress also set parallel requirements for participants' material advisors. See §§ 6111, 6112 (incorporating the definition of Reportable Transactions in § 6707A). Thus, §§ 6707, 6707A, and 6708 impose penalties for failure to meet the requirements of §§ 6011, 6111 and 6112. § 6707A defines Reportable Transactions by reference to regulations issued under § 6011, and other provisions reference § 6707A.

In sum, to help the IRS fight the proliferation of tax shelters, Congress established a statutory framework for taxpayers and material advisors to disclose involvement in Reportable Transactions. In doing that, it expressly deferred to the IRS's own process for identifying Reportable Transactions, including the use of a notice (or other guidance) issued without notice and comment.

Reportable Transactions are “determined under regulations prescribed under section 6011” as “having a potential for tax avoidance or evasion.” 26 U.S.C. § 6707A. And 26 C.F.R. § 1.6011-4 is the regulation setting out the Reportable Transactions. This regulation was issued as a temporary regulation in 2000, see Treas. Decision 8877, 65 F.R. 11205-02, and finalized as modified in 2003, see Treas. Decision 9046, 68 F.R. 10161-01. The regulation proceeded through notice and comment rulemaking before being finalized. Since 2000, the regulation has provided for a category of Reportable Transactions call Listed Transactions that are “the same or substantially similar to transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance.” See 65 F.R. 11205-02 at 11206 and 11207; 68 F. R. 10161-01 at 10164. Notices are usually issued “when the Service determines that a public concern requires a speedy response” and are, correspondingly, a form of official guidance “[i]ssued without public notice and comment.” Stephanie Hunter McMahon, Classifying Tax Guidance According to End Users, 73 Tax Law 245, 257-58 (2020).

Since 2007, the regulation at 26 C.F.R. § 1.6011-4 also includes a category of Reportable Transactions called Transactions of Interest. See AJCA Modifications to the Section 6011 Regulations, 2007-38 I.R.B. 607, 72 F.R. 43146-01. The Preamble to the final § 1.6011-4 regulations explains that Transactions of Interest are transactions “the IRS and Treasury Department believe have a potential for tax avoidance or evasion, but for which the IRS and Treasury lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” Id. As with Listed Transactions, the regulations allow the IRS to identify Transactions of Interest by notice or other published guidance. See 26 C.F.R § 1.6011-4(b)(6). CIC does not challenge this regulation, or any other.

Notice 2016-66 (“the Notice”) was issued in accordance with the § 6011 regulations and identifies certain micro-captive insurance arrangements as Transactions of Interest. CIC, however, argues that the IRS's identification by notice of micro-captive insurance arrangements ― which CIC promotes to profit from others' tax avoidance ― violates the APA.

CIC's procedural challenge fails. The notice and comment rulemaking requirements of the APA do not apply to the Notice; Congress authorized a different process for the IRS to identify Reportable Transactions. In the alternative, the Notice simply interprets the language of the § 6011 regulations by giving a specific description of “a transaction that the IRS and Treasury Department believe has a potential for tax avoidance or evasion, but for which the IRS and Treasury Department lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” 72 F.R. 43146-01 at 43146.

Nor is the Notice arbitrary and capricious. The IRS's concern with micro-captive insurance arrangements is well-founded. The arrangements can be abusive. See, e.g., Avrahami v. Commissioner, 149 T.C. 144 (Tax Ct. 2017). CIC even admits that the transaction identified in the Notice has “a potential for tax avoidance or evasion.” (Dkt. 41 at 39:22-24 (testimony of Sean King, principal of CIC)).

Last, CIC argues that the Congressional Review Act requires the Court to strike down the Notice. The Act does not permit judicial review. Moreover, the IRS complied with it.

BACKGROUND

On November 1, 2016, the IRS released Notice 2016-66, which identified a subset of captive insurance transactions as Transactions of Interest. See ADMIN_01437-51. Captive insurers are companies whose sole purpose is to issue insurance to their parent company and affiliates. ADMIN_00314. When a business creates a “captive” insurance company to protect against certain risks, the law permits the insured business to deduct from income the premium payments made to the captive, thereby lowering the business's tax liability. 26 U.S.C. § 162(a); 26 C.F.R. § 1.162-1(a); ADMIN_00503-504. If the captive that receives those payments elects to be taxed under 26 U.S.C. § 831(b), it can exclude those premiums from income, which reduces the captive's tax liability. See, e.g. ADMIN_00265. However, if the transaction does not constitute insurance, the insured business is not entitled to deduct those payments under § 162 as insurance premiums. In addition, if the captive does not provide insurance, the captive does not qualify as an insurance company and its election to be taxed only on its investment income under § 831(b) is invalid.

The IRS identified a subset of micro-captive insurance transactions as Transactions of Interest for several reasons. The IRS had recently “learned of a large number of these arrangements,” ADMIN_01406, through its role in collecting taxes and administering the Internal Revenue Code. Eventually, some of those types of arrangements ended up in litigation. See Avrahami v. Commissioner, 149 T.C. 144 (Tax Ct. 2017) (tax years 2009-2010); Rsrv. Mech. Corp. v. Commissioner, T.C. Memo. 2018-86, 2018 WL 3046596 (Tax Ct. 2018) (tax years 2008-2010), appeal docketed at No. 18-9011 (10th Cir.); Syzygy Ins. Co. v. Commissioner, T.C. Memo. 2019-34, 2019 WL 1559540 (Tax Ct. 2019) (tax years 2009-2011); Caylor Land & Dev. Inc. v. Commissioner, T.C. Memo. 2021-30, 2021 WL 915613 (Tax Ct. 2021) (tax years 2009-2010). The IRS noted there were cases docketed with the Tax Court as well as “many others” that were “pending at various stages of administrative consideration.” ADMIN_01409.

The IRS had been aware of abusive transactions involving insurance for almost half a century. ADMIN_00461 (“The earliest pronouncement on the issue of captive insurers came from the Internal Revenue Service in Revenue Ruling 77-316,” dated January 1, 1977). In 2002, the IRS alerted “taxpayers and their representatives about certain reinsurance transactions intended to shift income to offshore related companies purported to be insurance companies that are subject to little or no U.S. federal income tax.” ADMIN_00256. In that notice, the IRS identified these transactions as Listed Transactions. ADMIN_00258. After obtaining more information about these transactions, the IRS removed them from listed status in 2004. ADMIN_00265-66. Acting on this information, the IRS issued substantial guidance to taxpayers about captive insurance and similar arrangements during the early 2000's. ADMIN_00284-307. Plus, the IRS had, in a 2015 publication alerting taxpayers to promoters of dubious schemes, already identified transactions similar to those later described in the Notice. ADMIN_00313-15.

All of this occurred while the IRS learned lessons from litigating cases about insurance and specifically captive insurance arrangements. Examples of these cases are in the administrative record. ADMIN_0433-664.

The IRS became concerned taxpayers were using captive insurance transactions to inappropriately “claim an ordinary and necessary expense deduction . . . for insurance premiums paid to an affiliated entity while that entity excludes underwriting income from taxable income.” ADMIN_01378. Still, the IRS was “not fully aware of the breadth of this arrangement,” and needed more information “to capture all variants exhibiting the characteristics that make the arrangement potentially abusive” and determine “how to distinguish” abusive transactions from non-abusive transactions. ADMIN_01406. Thus, the IRS designated a subset of captive insurance transactions as Transactions of Interest, because they had the potential to be used for “tax avoidance or evasion.” IRS Notice 2016-66, Introduction. The Notice advises participants and their material advisors of their obligations under §§ 6011 and 6111 to disclose certain information if the insurance arrangement meets specific criteria, such as the ratio of the captive's insured losses to the captive's received premium payments, less policyholder dividends. Id. § 2.01.

STANDARD OF REVIEW

The usual summary judgment standard does not apply in APA actions. “[U]nder the APA, the agency resolves factual issues to arrive at a decision that should be supported by the administrative record. The district court's only task is to determine whether or not the evidence in the record permitted the agency to make the decision it did, as a matter of law.” Oak Ridge Env't Peace All. v. Perry, 412 F. Supp. 3d 786, 808–09 (E.D. Tenn. 2019), appeal dismissed, No. 19-6332, 2021 WL 2102583 (6th Cir. Jan. 14, 2021) (internal citations omitted). A court will set aside a final agency action only if it is arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law. Latin Americans for Soc. & Econ. Dev. v. Adm'r of Fed. Highway Admin., 756 F.3d 447, 464 (6th Cir. 2014).

ARGUMENT

A. The notice and comment rulemaking requirements of the APA do not apply to Notice 2016-66.

The Administrative Procedure Act generally requires agencies to go through “notice and comment rulemaking” before promulgating a rule ― that is, the agency must notify the public of the proposed rule, offer a chance to comment, and then address those comments. See 5 U.S.C. § 553(b), (c). Here, the IRS did this in 2003 and 2007 when issuing regulations that include Listed Transactions and then Transactions of Interest as types of Reportable Transactions. CIC has not challenged these regulations. Instead, CIC challenges only Notice 2016-66, contending that it, too, should have been issued only after notice and comment rulemaking.

Agencies need not use notice and comment rulemaking (a) when Congress expressed a clear intent that the agency may use another procedure or (b) when issuing interpretative rules. 5 U.S.C. §§ 553(b)(3)(A), 559. Notice 2016-66 falls into one or both of these exceptions.

1. Through § 6707A, Congress allowed the IRS to identify Transactions of Interest without notice and comment rulemaking.

The IRS has long had broad authority to set requirements for tax-related reporting. This authority is granted to the IRS under § 6011, a part of the tax code since 1954. See Internal Revenue Code of 1954, Pub. L. 83-591, § 6011. Facing proliferating tax shelters, the IRS used this authority to demand targeted disclosures from those involved in transactions that the agency identified as ripe for tax evasion (the same information, if reported at all, was usually hidden on tax returns).² In 2003, the IRS finalized a regulation with notice and comment rulemaking under § 6011 allowing it to identify potentially abusive transactions, including six categories of Reportable Transactions. See Treas. Decision 9046, 68 F.R. 10161-01 at 10164-65.³

Congress in 2004 stiffened and broadened the statutory framework requiring disclosures regarding potential tax shelters. Specifically, Congress enacted legislation requiring taxpayers and material advisors to disclose their participation in arrangements with the potential for tax avoidance, which Congress, using the IRS's nomenclature, also called Reportable Transactions. 26 U.S.C. §§ 6111, 6112, 6707, 6707A & 6708. See American Jobs Creation Act of 2004, Pub. L. 108-357, §§ 815, 816. The purpose of this legislation is obvious: “the best way [for the IRS] to combat tax shelters is to be aware of them.” H.R. Rep. 108-548, at 261 (June 16, 2004).

This statutory regime turned on the broad authority the IRS was already given to impose reporting requirements under § 6011. Thus, § 6707A, when defining a Reportable Transaction, defers to the IRS regulations under § 6011. Related provisions, like those imposing reporting requirements and non-disclosure penalties on material advisors, incorporate the same definition of Reportable Transaction by referring to § 6707A. See 26 U.S.C. §§ 6111, 6112, 6707 and 6708.

Congress went further, also imposing penalties for failure to report on what the IRS had identified as a Listed Transaction. Listed Transactions are a type of Reportable Transaction, and information about them must be reported to the IRS because they are “the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction[.]” 26 U.S.C. § 6707A(c)(2). Regulations in place when these statutes were passed authorized the IRS to identify Listed Transactions by “notice. . . . or other form of published guidance.” See 68 F.R. 10161-01 at 10164-65 (26 C.F.R § 1.6011-4 as of March 4, 2003).

A “notice” is a form of IRS guidance “[i]ssued without public notice and comment.” McMahon, Classifying Tax Guidance . . ., 73 Tax Law at 257-58. Thus, in creating the statutory framework around Reportable Transactions in 2004, Congress clearly understood and approved the IRS's practice of identifying at least some Reportable Transactions (that is, Listed Transactions) without notice and comment rulemaking. In explaining the new provision, Congress understood the IRS would identify Listed Transactions and other “Reportable Transactions” by notice. After all, Congress stated: “The provision does not define the terms 'listed transaction' or 'reportable transaction,' nor does the provision explain the type of information that must be disclosed in order to avoid the imposition of a penalty. Rather, the provision authorizes the Treasury Department to define a 'listed transaction' and a 'reportable transaction' under section 6011.” H.R. REP. 108-548 at 261-62 (citations omitted).

In 2007, the Secretary amended the regulations to include Transactions of Interest as a kind of Reportable Transaction. See 72 F.R. 43146-01. As with Listed Transactions, the IRS could identify new Transactions of Interest via notice issued without notice and comment. See id.

Congress once again amended § 6707A in 2010. See Small Business Jobs Act of 2010, Pub. L. 111-240 (Sept. 27, 2010), 124 Stat 2504, § 2041(a). By this time, the IRS had begun to identify Transactions of Interest under the 2007 regulation, using guidance published without notice and comment. See 26 C.F.R. § 1.6011-4(b)(6). Congress was aware of this and expressly described how Listed Transactions and Transactions of Interest are both identified by “publications issued by the Treasury Department.” See Jt. Comm. on Taxation, Technical Explanation of the Tax Provisions in Senate Amendment 4594 to H.R. 5297, the “Small Business Jobs Act of 2010,” (JCX-47-10) at 18; see also Jt. Comm. on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, JCS-2-11 (March 2011) at 476. Congress thus exempted the IRS from the APA's notice and comment requirement when the agency issues guidance, like the Notice, that identifies Transactions of Interest.

i. The definition of Reportable Transaction in § 6707A incorporates the regulations under § 6011, and those regulations allow the IRS to identify Transactions of Interest without notice and comment.

Agencies are excepted from APA requirements when a statute “expressly” provides. 5 U.S.C. § 559. This exception is consistent with the bedrock principle that “statutes enacted by one Congress cannot bind a later Congress.” Dorsey v. United States, 567 U.S. 260, 274 (2012); Fletcher v. Peck, 10 U.S. (6 Cranch) 87, 135 (1810) (Marshall, C.J.). A corollary is that Congress can “make its will known in whatever fashion it deems appropriate.” Lockhart v. United States, 546 U.S. 142, 148 (2005) (Scalia, J., concurring). Thus, Congress may limit the scope of prior legislation either expressly or by implication. Dorsey, 567 U.S. at 274. This remains true even when, as here, the earlier statute (the APA) requires that any subsequent limitation be made “expressly.” “When the plain import of a later statute directly conflicts with an earlier statute, the later enactment governs, regardless of its compliance with any earlier-enacted requirement of an express reference.” Lockhart, 546 U.S. at 148-49 (Scalia, J., concurring).

Thus, while exceptions to the APA should be “narrowly construed and only reluctantly countenanced,” all that is required for such an exception is a plainly expressed “congressional intent to depart from normal APA procedures.” Asiana Airlines v. F.A.A., 134 F.3d 393, 398 (D.C. Cir. 1998). Congress is not required “to employ magical passwords in order to effectuate an exemption from the Administrative Procedure Act.” Marcello v. Bonds, 349 U.S. 302, 310 (1955); see also Asiana Airlines, 134 F.3d at 397.

§ 6707A defines “reportable transactions” as those identified by the IRS according to its own regulations, stating, “the term 'reportable transaction' means any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations prescribed under section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.” 26 U.S.C. § 6707A(c)(1) (emphasis added). Furthermore, § 6707A defines a Listed Transaction (a type of Reportable Transaction) as one “identified by the Secretary . . . for purposes of section 6011.”

This statutory language adopts the IRS's rules at 26 C.F.R. § 1.6011-4 because that is a regulation “prescribed under section 6011.” The regulation in place in 2004 allowed the IRS to identify Listed Transactions by “notice.” 68 F.R. 10161-01 at 10164-65. A “notice” is a form of IRS guidance typically issued without notice and comment. McMahon, Classifying Tax Guidance . . ., 73 Tax Law at 257-58. Indeed, Congress knew the IRS was identifying Listed Transactions by notice without notice and comment rulemaking. See IRS Notice 2004-67 (available at 2004 IRB LEXIS 408); U.S. GAO Testimony before Sen. Comm. on Fin., Internal Revenue Service: Challenges Remain in Combating Abusive Tax Shelters (Oct. 21, 2003) at *8 (available at https://perma.cc/6RLT-4CU7); H.R. REP. 108-548(I), 260.

Congress thus clearly exempted the IRS from notice and comment requirements with respect to Listed Transactions by authorizing the IRS to proceed under the § 6011 regulations. Under those same regulations, later amended, see 26 C.F.R § 1.6011-4 (as amended by 72 F.R. 43146-01), Transactions of Interest can be identified, like Listed Transactions, via guidance like a notice that is published without notice and comment.⁴

ii. Repeated Congressional enactments following IRS use of notices to identify categories of Reportable Transactions confirm that notice and comment rulemaking is not always required.

Congress, in passing and then amending § 6707A, expressed and reiterated its intent to displace APA procedures that might have otherwise applied when the IRS identified Reportable Transactions.⁵ When Congress enacted the penalties for failing to disclose information on Reportable Transactions, the IRS had already identified nearly thirty Listed Transactions. See Notice 2004-67 (available at 2004 IRB LEXIS 408). Congress was aware that almost all the Listed Transactions to date had been identified in notices, that is, guidance issued without notice and comment rulemaking. See IRS Notice 2004-67; U.S. GAO Testimony before Sen. Comm. on Fin., Internal Revenue Service: Challenges Remain in Combating Abusive Tax Shelters (Oct. 21, 2003) at *8 (available at https://perma.cc/6RLT-4CU7). But without a penalty compelling taxpayers to report these transactions, compliance was, “to put it bluntly, a joke.” S. Hrg. 107-653 at 2. So Congress lent force to the disclosure requirements with penalties that tracked what the IRS identified as potentially abusive transactions.

Two years after § 6707A, Congress enacted § 4965, which imposes a tax on nonprofit organizations that participate in Listed Transactions. See Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. 109-222, § 516. Again, Congress passed this law aware that the IRS was, under 26 C.F.R. § 1.6011-4, continuing to identify Listed Transactions “by notice, regulation, or other form of published guidance.” H.R. Conf. Rep. No. 109-455, at *125 (2006). Legislating against this backdrop, without modifying 26 C.F.R.§ 1.6011-4, “serves as persuasive evidence that Congress regarded that regulation as a correct implementation of its intent.” See Boeing Co. v. United States, 537 U.S. 437, 457 (2003) (citation omitted).

Knowing that Congress already approved the identification of Listed Transactions without notice and comment rulemaking, in 2007 the IRS mimicked the process when it amended its regulations to include Transactions of Interest. See 72 F.R. 43146-01. In 2010, Congress amended § 6707A and did not change its approach to either Reportable Transactions (which now included Transactions of Interest) or Listed Transactions. By this time, Treasury had identified three dozen reportable transactions, including four Transactions of Interest, using published guidance (mostly notices) issued without notice and comment.⁶ Congress was aware of this and expressly described how Listed Transactions and Transactions of Interest are both identified by “publications issued by the Treasury Department.” See Jt. Comm. on Taxation, Technical Explanation of the Tax Provisions in Senate Amendment 4594 to H.R. 5297, the “Small Business Jobs Act of 2010,” (JCX-47-10) at 18; see also Jt. Comm. on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, JCS-2-11 (March 2011) at 476.

Rather than curtail this practice, Congress left unchanged § 6707A's definition of Reportable Transactions as those “determined under regulations prescribed under section 6011,” as well as 26 C.F.R. § 1.6011-4's procedure of identifying certain reportable transactions by guidance issued without notice and comment.

Congress's series of enactments speaks volumes in favor of the IRS's use of notices issued without notice and comment to identify certain Reportable Transactions, including Transactions of Interest. After all, “Treasury regulations 'long continued without substantial change, applying to unamended or substantially reenacted statutes, are deemed to have received congressional approval and have the effect of law.'” Raymond v. United States, 983 F.2d 63, 66 (6th Cir. 1993) (quoting Cottage Savs. Ass'n v. Commissioner, 499 U.S. 554, 561 (1991)).

Congress's purpose and knowledge when it passed and then amended § 6707A underscores what the text of the statute already makes clear: the IRS, acting under 26 C.F.R. § 1.6011-4, can identify Transactions of Interest without notice and comment. To suggest otherwise is to argue that Congress, at one stroke, enacted a statute that expressly incorporated the IRS's pre-existing rules for identifying suspect transactions, while it implicitly invalidated most of the identifications the IRS had thus far made, for lack of notice and comment. This would be a bizarre inference to draw and one unsupported by the language of the statute.

Nonetheless, CIC argues that full-fledged APA rulemaking requirements apply, no matter what form of guidance the IRS uses to identify new transactions of interest.⁷ Accepting CIC's position would make each instance in which the IRS identified a Transaction of Interest “so nearly indistinguishable from normal notice and comment” as to deprive “of any effect” the statutory language allowing the IRS to proceed under its § 6011 regulations. Thus, CIC's position would “thwart the apparent intent of Congress in enacting the special procedure.” Compare Asiana Airlines v. F.A.A., 134 F.3d 393, 398 (D.C. Cir. 1998).

iii. Any meaningful distinction between this case and Mann Construction favors the Government.

Another district court in this Circuit has addressed the question “whether an IRS notice requiring disclosure of a potentially abusive transaction was issued without notice and comment in violation of the APA,” and has ruled for the Government. Mann Construction, Inc. v. United States, ― F. Supp. 3d ―, 2021 WL 1923412, at *1 (E.D. Mich., May 13, 2021) (appeal pending at case no. 21-1500 (6th Cir.)). After analyzing the language of § 6707A, the court found that Congress, “through its enactment of [that statute], endorsed the flexible reporting regime that the IRS had already developed.” Id. at *13. After reviewing the series of legislative enactments following § 6707A, it concluded that “Congress reinforced a reporting regime that was operated without notice and comment and that, under Congress's supervision, has grown considerably in scope.” Id. The court upheld an IRS notice that was issued without notice and comment and identified a Listed Transaction.” Id. at *14.

CIC claims that Mann Construction's analysis does not apply here because that case addressed Listed Transactions rather than Transactions of Interest. See dkt. 72 at 6. That argument fails on close inspection. In passing § 6707A in 2004, Congress ratified the IRS's use of notices to identify Listed Transactions. See Mann Construction, Inc., 2021 WL 1923412, at *10, *14. Although, unlike Listed Transactions, Transactions of Interest were added to 26 C.F.R. § 1.6011-4 after § 6707A was enacted, this makes no difference. The IRS mimicked the Listed Transaction process when it added Transactions of Interest to the Reportable Transactions regulations. Although the IRS is now also identifying Transactions of Interest via notice, it is still using the same form of published guidance and still proceeding “under regulations prescribed under section 6011.” Thus, the IRS is still within the terms of § 6707A.⁸

If there is any meaningful difference between this case and Mann Construction, it cuts against CIC. Participating in a Listed Transaction, then failing to report it, exposes participants and advisors to especially heavy penalties. See § 6707A(b)(2). The maximum penalty for failing to report a Listed Transaction is four times the penalty for failing to report other kinds of Reportable Transactions (or ten times, for a natural person). See id.; see also H.R. Conf. Rep. No. 109-455, at 126, 127. It would make no sense for Congress to require the IRS (acting under 26 C.F.R. § 1.6011-4(b)) to identify Transactions of Interest through notice and comment, while allowing the IRS (acting under the same regulation) to identify Listed Transactions without notice and comment, when involvement in Listed Transactions exposes participants and advisors to much higher non-reporting penalties.

iv. The Court's earlier ruling focused on language within § 6111 rather than the crucial definition of Reportable Transaction in § 6707A.

Nothing in the Court's ruling on CIC's motion for preliminary injunction undercuts the analysis above. The Court may have found the Government's compressed argument about the APA “unpersuasive” at that time. Dkt. 82 at *10 n. 6. But that “first glance” should not foreclose a fuller examination of the issue. The Government's response to the preliminary injunction motion was compressed because CIC failed to present any merits argument in its opening brief.

In its ruling, the Court cited and emphasized the language in § 6111(c) authorizing the Secretary to “prescribe regulations which . . . provide such rules as may be necessary to carry out the purposes of this section.” Dkt. 82 at *10 n. 6 (emphasis added by the Court). But §6111(c) is not the source of authority for the Notice or for the 26 C.F.R. § 1.6011-4 regulation that allows the IRS to identify Transactions of Interest by notice. The Notice is allowed under 26 C.F.R. § 1.6011-4, and the source of authority for that regulation is § 7805 and § 6011, as the 2003 and 2007 versions of 26 C.F.R. § 1.6011-4 both confirm. See 68 F. R. 10161-01, Introduction and 10163 (Part I); see 72 F.R. 43146-01, Introduction and 43149 (Part I).

Thus, § 6111(c) does not bear on the matter at hand. ⁹ Instead, the definition of Reportable Transaction is set out in § 6707A, which incorporates 26 C.F.R. § 1.6011-4. That is true whether ― once a Reportable Transaction has been identified ― one then turns to examining the participant's obligation to report on that transaction under § 6011 or the material advisor's obligation to report under § 6111. While § 6111 requires information from a material advisor (rather than a participant) for a Reportable Transaction, it still defines Reportable Transaction by recourse to § 6707A. See 26 U.S.C. § 6111 (b)(2).

2. Alternatively, Notice 2016-66 is an interpretive rule the APA categorically exempts from the notice and comment requirement.

A Transaction of Interest is “a transaction that the IRS and Treasury Department believe has a potential for tax avoidance or evasion, but for which the IRS and Treasury Department lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” Introduction, 72 F.R. 43146-01 at 43147. The regulation provides “the IRS [will] identif[y] [Transactions of Interest] by notice, regulation, or other form of published guidance 26 C.F.R. §1.6011-4(b)(6) (as amended by 72 F.R. 43146-01). CIC does not challenge the regulation, and the Notice just puts the proverbial meat on the bones of this regulation. The requirements for Reportable Transactions already existed and the micro-captive insurance transactions described in the Notice already had the potential for tax avoidance (as described in the “Background,” above). The recordkeeping and disclosure requirements of participating in a transaction with the potential for tax avoidance, or profiting by advising others to do so, flow from the statutes and regulations and not the Notice. Thus, the Notice is an interpretive rule that does not require notice and comment.

Agencies are generally required to use notice and comment rulemaking to issue legislative rules, but not interpretive ones. Tenn. Hosp. Ass'n v. Azar, 908 F.3d 1029, 1042 (6th Cir. 2018). Distinguishing between legislative and interpretive rules has proven difficult. Id.; Cmty. Nutrition Inst. v. Young, 818 F.2d 943, 946 (D.C. Cir. 1987). Generally, legislative rules “grant rights, impose obligations, or produce other significant effects on private interests.” United States v. Cinemark USA, Inc., 348 F.3d 569, 580 (6th Cir. 2003). In contrast, an interpretive rule “states what the administrative agency thinks the statute means, and only reminds affected parties of existing duties,” id. (citations and internal quotations omitted), or “explains more specifically what is meant” in a legislative rule, Interport, Inc. v. Magaw, 135 F.3d 826, 829 (D.C. Cir. 1998).

A relevant factor here is the source of authority. “The difference between legislative and interpretative rules 'has to do in part with the authority — law-making versus law-interpreting— under which the rule is promulgated.'” Dismas Charities, Inc. v. U.S. Dep't of Just., 401 F.3d 666, 679 (6th Cir. 2005) (internal citations omitted). As explained above, Congress expressly gave the IRS authority to issue regulations to support the abusive tax shelter reporting framework. Those regulations allowed the IRS to identify potential tax avoidance transactions, including those for which it needed more information, by notice without notice and comment rulemaking. The source of the authority is the statutes and the regulations. “The notice and comment rulemaking requirements were intended to 'assure fairness and mature consideration of rules of general application.'” Id. at 678. The regulations at 26 C.F.R. § 1.6011-4 are rules of general application and were issued with notice and comment. The Notice interprets the regulations. Like the memorandum challenged in Dismas Charities, the Notice simply says what the law is, by specifying transactions to which the law applies. Cf. id. at 680.

The Court concluded in ruling on the preliminary injunction motion that the Notice was a legislative rule because, in its absence, CIC would not have to report micro-captive transactions to the IRS. Dkt. 82 at *9. But a rule is not legislative just because it makes a legal change to the status quo. In Dismas Charities, the Department of Justice changed its interpretation of a statute requiring that prisoners be incarcerated in “penal or correctional facilit[ies].” 401 F.3d at 670. Under its new interpretation, community correction centers no longer qualified, causing many inmates to be transferred to other facilities. Id. at 670-71. The Sixth Circuit still held that the rule was interpretive and noted that whether a rule has a substantial impact on affected parties does not help determine whether it is a legislative or interpretive rule. Id. at 681; see also Cent. Texas Tel. Co-op., Inc. v. F.C.C., 402 F.3d 205, 214 (D.C. Cir. 2005); Lewis v. Huntington Nat'l Bank, 838 F. Supp. 2d 703 (S.D. Ohio 2012) (agency opinion letters applying FLSA regulations to mortgage loan officers held interpretive, not legislative).

The Notice did not impose a reporting obligation on CIC; that was accomplished by the regulation that defines Reportable Transactions, and a statute that requires material advisors to provide information on them. See I.R.C. §§ 6011 & 6111 and 26 C.F.R. § 1.6011-4. CIC challenges neither of these. Nor does the Notice impose a penalty if CIC fails to report. That penalty flows from another Congressionally enacted statute. See I.R.C. § 6707A.

True, the Notice plays a role by identifying certain micro-captive transactions as Transactions of Interest as that concept is defined in the (unchallenged) regulation at 26 C.F.R. § 1.6011-4(b). But the fact that an agency has issued a specific interpretation of an expansive term does not transform the resulting guidance into a legislative rule. See Am. Inst. of Certified Pub. Accountants v. Internal Revenue Serv., 746 F. App'x 1, 11-12 (D.C. Cir. 2018).

B. Notice 2016-66 is not Arbitrary and Capricious.

The Government should also prevail against Count II of the complaint, which alleges that the Notice was irrational and thus violated the APA, because, according to CIC, (1) the IRS already has access to most of the information “legitimately” needed to assess the validity of captive insurance transactions; and (2) the scope of the Notice includes both legitimate and non-legitimate captive insurance transactions. (Compl. ¶¶ 49, 56). CIC's challenge must fail given its concession that captive insurance transactions have “a potential for tax avoidance or evasion.” (Dkt. 41 at 39:22-24 (principal of CIC, stating captive insurance companies can “most definitely” be used for tax avoidance or evasion purposes)). It strains credulity for CIC to also contend the IRS acted arbitrarily and capriciously in deciding these transactions have the “potential for tax avoidance or evasion.” Notice 2016-66, Introduction.

The Supreme Court has clearly explained the scope of review under the “arbitrary and capricious” standard. Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). A court should only set aside agency action in the limited circumstances when it finds the agency: (1) relied on factors Congress did not intend for it to consider; (2) entirely failed to consider an important aspect of the problem; (3) offered an explanation for its action that runs counter to the evidence before the agency; or (4) offered an explanation “so implausible that it could not be ascribed to a difference in view or the product of agency expertise.” Id. at 43.

The Court only determines whether the evidence in the administrative record permitted the agency to act as it did. Air Transp. Ass'n of America, Inc. v. Nat'l Mediation Bd., 719 F. Supp. 2d 26, 32 (D.D.C. 2010) (citation and internal quotation omitted). This is a highly deferential standard, lest the Court “become a superagency that can supplant the agency's expert decision maker.” Ethyl Corp. v. Envtl. Prot. Agency, 541 F.2d 1, 36 (D.C. Cir. 1976); see also id. Rather, the Court must focus on whether the agency considered the relevant factors and has provided an explanation that rationally connects the data with the choice made. Latin Americans for Soc. & Econ. Dev., 756 F.2d at 464. The administrative record need only show the agency “engaged substantively with the question” at hand and adequately explained the reasoning that supported its conclusion. Id. at 40-41 (citations omitted). A court should “uphold a decision of less than ideal clarity if the agency's path may reasonably be discerned.” State Farm Mut. Auto. Ins. Co., at 43 (citations and internal quotations omitted).

Here, the Court's deferential review will confirm what CIC already admitted to this Court: captive insurance transactions “most definitely” can be used for tax avoidance or evasion purposes. (Dkt. 41 at 39:22-24).

First, the IRS clearly relied on the factors directed by Congress. It characterized the transactions identified in the Notice as Transactions of Interest because they were “of a type which the Secretary” determined had “a potential for tax avoidance or evasion.” 26 U.S.C. § 6707A(c)(1); ADMIN_01437-38.

Next, CIC cannot show the IRS failed to consider important aspects of the problem. CIC complains the IRS seeks information from taxpayers that it could otherwise obtain. (Compl. ¶¶ 45-49, 56). But the decision about what information to obtain and how is left to the IRS's discretion. Cf. Tiffany Fine Arts, Inc. v. United States, 469 U.S. 310, 323 (1985) (“The decision of how many, and which licensees to contact is one for the IRS – not Tiffany – to make”). And because these arrangements involve multiple parties (including the captive, the insured(s), and persons related to the captive and insured(s)), the income tax filing and reporting by any one party would not reveal the nature of the arrangement.

To the extent that CIC argues the information sought through the disclosure requirement is already available to the IRS from other filings by CIC, that reveals there is a minimal burden placed on CIC in responding to the Notice (since it has, by implication, already compiled the information). If CIC complains that the cost of disclosure is too burdensome, it has failed to support that contention. When a challenger to an administrative action criticizes an agency for failing to consider data, “they had better obtain and submit the data.” USA Group Loan Svcs., Inc. v. Riley, 82 F.3d 708 (7th Cir. 1996).

Plus, obtaining the information this way brings substantial benefits to the IRS. CIC asserts that “most, if not all, of the information which the IRS seeks through compliance with Notice 2016-66 is already available to it by virtue of IRS Form 1120 (PC).” Dkt. 59 at ECF p. 17. This is not true, and CIC presents no evidence to support this assertion. Instead CIC cites (rather, mis-cites) to a Declaration that does not make the assertion, and CIC has never put its Form 1120 into the record, either. In any event, CIC is wrong. In most cases, the IRS cannot tell from the Form 1120-PC which transactions are potentially abusive. The Form 1120-PC also does not tell the IRS who participated in these transactions. Thus, the Form 8886 from participants and Form 8918 from material advisors identify the participants and collect the information in one location. The Forms also provide information about the breadth of participation.

Form 8886 and Form 8918 include information beyond other IRS forms, such as a description of the transaction in sufficient detail to allow the IRS to understand the tax structure and to identify the parties to the transaction; when and how the taxpayer became aware of the transaction; the authority by which the captive is chartered; a description of all types of coverage provided by the captive; a description of how premiums were determined; a description of claims paid by the captive; and a description of the assets held by the captive. See Notice 2016-66 § 3.05.

CIC also misses the mark in arguing that the Notice unfairly includes non-abusive captives along with abusive captives. The purpose of this Notice ― and more, generally, the Transaction of Interest regime ― is to allow the IRS to learn about transactions that may have a potential for tax avoidance or evasion, but for which the IRS lacks enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction (and thus a Listed Transaction). See 72 F.R. 43146-01. Besides, the IRS is entitled to the information without the need to prove the transaction is fraudulent or otherwise abusive. See United States v. BDO Seidman, 337 F.3d 802, 809-810, 812 (7th Cir. 2003).

The last two prongs of the State Farm test are quickly addressed. In its complaint, CIC does not suggest that the IRS's explanations in support of the Notice run counter to the evidence before the agency. Nor does CIC suggest the IRS offered an explanation “so implausible that it could not be ascribed to a difference in view or the product of agency expertise.” State Farm, 463 U.S. at 43. Thus, the Court should find that the IRS did not act arbitrarily or capriciously.

C. The Congressional Review Act is neither a jurisdictional grant nor a waiver of sovereign immunity.

CIC also asks the Court to set aside the Notice because of alleged noncompliance with the Congressional Review Act (“CRA”). (Compl. ¶ 62). This claim fails for four reasons that are individually dispositive. First, the CRA bars any claim or relief premised on a “determination, finding, action, or omission” of any CRA requirement, and also bars “judicial review” of such issues. 5 U.S.C. § 805; see also Montanans for Multiple Use v. Barbouletos, 568 F.3d 225, 229 (D.C. Cir. 2009). Second, plaintiffs lack standing to bring such a challenge. The CRA's review procedures protect the interests of Congress—not the interests of captive insurance companies (or their material advisors) that seek to avoid IRS scrutiny. Third, the notices did not constitute “rules” for CRA purposes because they particularly apply to disclosures related to financial structures and accounting practices. 5 U.S.C. § 804(3)(A). Simply stated, the Notice does not come within the scope of the CRA. Finally, the IRS submitted the Notice for review, in any event. ADMIN_01414-36.

CONCLUSION

Congress set up a statutory framework to support the IRS's efforts to scrutinize, using targeted reporting requirements, transactions ripe for tax avoidance. Thus, the statutory definition of a Reportable Transaction adopts what the IRS, under the § 6011 regulations, identifies as one. This was true when Congress created the statutory definition in 2004 and held true when Congress amended other parts of the statutory framework in 2010 while leaving the definition of Reportable Transaction unchanged. Regulations at 26 § C.F.R. 1-6011.4 allow the IRS to identify Transactions of Interest using guidance like a notice that is issued without notice and comment. Thus, Notice 2016-66 is procedurally proper. There is no plausible ground to characterize it as arbitrary and capricious, either, when CIC itself has conceded that micro-captive transactions have a potential for tax evasion. And CIC's claim under the Congressional Review Act is baseless. Accordingly, the Court should grant the IRS summary judgment.¹⁰

DATE: November 1, 2021

Respectfully submitted,

DAVID A. HUBBERT
Acting Assistant Attorney General

NISHANT KUMAR
KYLE L. BISHOP
Trial Attorneys, Tax Division
U.S. Department of Justice
P.O. Box 227
Washington, D.C. 20044
202-514-2986 (v)
202-514-6866 (f)
Nishant.Kumar@usdoj.gov
Kyle.L.Bishop@usdoj.gov