A Two-Pronged Approach for Challenging Tax Regulations

For a taxpayer, it must be disappointing when the courts uphold your challenge to a state revenue agency auditor’s application of a regulation that resulted in an assessment for additional tax. Yet substantive challenges — including a taxpayer’s assertion that the auditor included transactions that are not taxable under state law, or that the auditor made calculation or sampling errors in the audit — are not the only means to prevail against an assessment. In some cases, it may be worthwhile to mount a challenge against the revenue agency itself, arguing that the applicable regulation or policy expands or restricts the statute it is meant to interpret, or is so ambiguous that a reasonable interpretation cannot be had. To be sure, administrative challenges are not an easy road to victory. There are many factors to consider in evaluating whether such challenges are worthwhile.

Is It Possible?

The first order of business is to review the state’s administrative procedure act (APA) to determine whether there is an avenue by which the validity of the regulation can be contested. Before a regulation can take effect, it must be subjected to a rigorous rulemaking process. Perhaps a step was missed, such as giving proper notice about a hearing on the proposal, or the regulation did not go through the process at all. Granted, administrative violations of this sort are difficult to prove, and the revenue agency is certainly going to fight tooth and nail to persuade the court to uphold the regulation’s validity. If the facts align, however, the impact of the taxpayer’s victory goes far beyond its case. Similarly situated taxpayers will benefit if the court rules that the regulation fails because administrative procedures were not properly followed. This is so even if the revenue agency’s policy position is correct.

A challenge asserting that a regulation is an erroneous interpretation of the statute faces a more difficult road. Here, rules on judicial deference to state agency interpretations must be carefully scrutinized. There is plenty of U.S. Supreme Court precedent concerning judicial deference. However, these rulings do not apply to states because they do not address issues of constitutional stature. And, as with so many state practices, states’ judicial deference policies are anything but uniform. In 2010 a legal scholar counted 12 jurisdictions where policies adhere closely to the Supreme Court’s judicial deference standards for federal agencies under Chevron.¹ However, for state courts that follow the Chevron standard, it must be kept in mind that in some cases, its application may give an anomalous result. The Chevron standard is one of reasonableness. If a court finds the revenue agency’s interpretation reasonable, Chevron instructs it to go no further and give the interpretation deference. That the agency’s interpretation is reasonable, however, does not necessarily mean it is correct. Thus, the revenue agency’s erroneous interpretation will nonetheless stand. Moving away from Chevron, some state courts are highly deferential, giving the revenue agency’s interpretation controlling weight unless it is beyond doubt that the interpretation is contrary to the statute. Other state courts, either by statute or by court decision, give agency interpretations no weight at all, reviewing such interpretations de novo. Most courts fall somewhere between the latter two extremes, giving agency interpretations only due deference or some other measure of respect.

The Strategy in Action

An excellent illustration of the interplay between substantive and procedural challenges to a revenue agency’s regulation is exemplified by the California Superior Court decision in Bekkerman.² The taxpayer mounted a two-prong attack on the revenue agency’s regulatory interpretation of the underlying statute. The taxpayer prevailed on the substantive issue but lost on the procedural. It would not matter if the taxpayer had won on the procedural ground and lost on the substantive. The outcome would be the same; that is, the regulation would be unenforceable.

Bekkerman’s facts are straightforward. In 1995 California legalized the sale of cellphones in bundled transactions; that is, the customer could purchase a phone and a service contract in a single transaction, rather than having to purchase the two separately. To entice customers into purchasing a device as well as a cellular service contract, retailers offered steep discounts on the price of a phone if the customer also purchased a service contract. If the retailer was not the service carrier, the carrier paid the retailer a commission on each bundled sale. If the retailer and the carrier were the same entity, no commission was paid. The regulation at issue, Cal. Code Regs. tit. 18, section 1585, specifies how sales tax on bundled transactions should be calculated. Regulation 1585 requires sales tax to be calculated on the unbundled price of the cellphone (service contracts in California are not taxable) and makes no distinction between retailers that are not service carriers and those that are. The regulation allows all retailers who engage in bundled cellphone transactions to charge the sales tax to the customer.

The taxpayer made a bundled purchase from a cellular service carrier that operated its own retail stores. The bundled price of the phone was $249, yet sales tax was charged on the phone’s unbundled price of $599. Substantively, the taxpayer petitioned the court to invalidate Regulation 1585 because the regulation runs afoul of provisions in the state’s tax code that requires sales tax to be calculated on a percentage of gross receipts.³ Procedurally, the taxpayer asked the court to invalidate the regulation because the revenue agency did not follow the procedures for the rulemaking process set out in the state’s APA.⁴

First, the court articulated the legal parameters within which it would decide the matter. It noted that in regulatory challenges in which it is alleged that the regulation is an improper interpretation of statutory law, the revenue agency’s interpretation of the statute is reviewed by the court de novo, and not entitled to any weight, although the court may take notice of the agency’s expertise. Procedurally, the revenue agency’s failure to comply with the APA is grounds to invalidate the regulation in its entirety.

Turning to the merits, the court noted that California law requires sales tax to be calculated on the gross receipts of tangible personal property sold by a retailer, and gross receipts generally denotes the price of the sale. The taxpayers argued that the price of the phone charged in a bundled transaction must be the price the customer paid for the phone, which, in this case, was $249. The revenue agency countered that the discounted price of the cellphone is not the phone’s true price because whether the customer receives the discount price is contingent on the purchase of a service contract. However, the taxpayer’s receipt showed that sales tax was charged on the price of the telephone only, and did not include a charge for the service contract. The court pointed out it would have been impossible for the retailer to charge sales tax on the service contract, because (a) charges for cellular service are billed monthly; and (b) charges for cellular services are not subject to tax. Moreover, the court said, even if it was permissible for the revenue agency to adopt a regulation at odds with the statute, Regulation 1585 does not comport with the idea that taxable receipts should include a portion of the service provided. The regulation does not define sales tax in terms of the price of services; rather, it taxes the price of an unbundled telephone. The revenue agency made no showing of how the price of cellular service could serve as a proxy for an unbundled telephone. Thus, the court said, “to the extent Regulation 1585 was intended to tax a portion of the price of cellular service, it is arbitrary and capricious.” Further, the court said, Regulation 1585 is better explained as an attempt to tax the value of the phone sold. Sales tax, however, is based on the consideration paid for tangible personal property and not on some other measure of value. Thus, the court said, the revenue agency “may not justify Regulation 1585 on the theory that it captures the true market value of discounted cellular telephones.”

The court then addressed the taxpayer’s contention that the regulation was invalid in its entirety because the revenue agency did not follow the requisite administrative procedures before adopting it. Under the state’s APA, there are five requirements an agency must fulfill before a regulation can be validly adopted:

1. give notice of the adoption of the proposed regulation;

2. provide a complete text of the proposed regulation with a statement of reasons for its adoption;

3. provide interested parties with an opportunity to comment;

4. respond to those comments in writing; and

5. maintain a record of the rulemaking process.

The taxpayer argued that the revenue agency failed the second requirement because it did not provide an adequate statement of reasons, as it did not properly assess the regulation’s economic impact on retailers and individuals. The statement of reasons provided said the regulation would have no economic impact on businesses and individuals. In addition, the notice of the proposed regulatory action stated that the regulation would have no adverse impact on businesses and individuals. That assessment by the revenue agency was not the case. There was indeed an adverse impact because the regulation assessed sales tax on cellphones far above the price actually paid. Further, notwithstanding the regulation’s obvious negative impact, the record contained no analysis of the agency’s assertion that the regulation would have no adverse impact on businesses and individuals.

The court agreed with the taxpayer that the record contained little in the way of economic analysis, but the record did contain factual information regarding the same. The court pointed to the text of the initial proposed regulation, which stated that non-carrier retailers would be permitted to recoup all sales taxes from customers. From this, the court concluded that there was at least “some factual information supporting an initial assessment that the regulation would not adversely impact business.” The “factual information” contained in the record regarding the regulation’s impact on individuals was also sparse, but the court said that from the agency’s “final statement of reasons,” one could “infer that the Department considered taxable receipts on bundled sales involving commissions to approximate taxable receipts on unbundled sales of cellular telephones.” The court found this was enough to conclude that the regulation would have no adverse impact on consumers. Finally, the court rejected the taxpayer’s argument that the revenue agency should have provided notice and held a second hearing on the proposed regulation after adopting amendments to the original text. The court found the amendments were discussed at the initial hearing, and the changes were agreed to, so there was no need for a second hearing. Thus, the court concluded, the regulation was properly adopted under the APA.

Conclusion

When a taxpayer considers mounting a substantive challenge to a regulation, it might want to consider mounting a procedural challenge, too. It will not always be to the taxpayer’s advantage to pursue this route, but prevailing on such a challenge would have just as much of a beneficial effect on the taxpayer as prevailing on a substantive challenge. In other words, a win is a win. For taxpayers that have the right factual foundation, it’s a strategy worth looking into.