Supreme Court Asked to Review Variable Prepaid Forward Contracts Case

ESTATE OF ANDREW J. MCKELVEY, DECEASED,
BRADFORD G. PETERS, EXECUTOR,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

IN THE
Supreme Court of the United States

On Petition for a Writ of Certiorari
to the United States Court of Appeals
for the Second Circuit

PETITION FOR WRIT OF CERTIORARI

MARK D. LANPHER
Counsel of Record
WILLIAM J. HAUN
SHEARMAN & STERLING LLP
401 9th Street, NW
Suite 800
Washington, D.C. 20004
(202) 508-8120
mark.lanpher@shearman.com

QUESTION PRESENTED

Over a century ago, this Court held that where Congress conditions a tax result on the promulgation of regulations, but no regulations have been issued, courts are powerless to fill the gap. See Dunlap v. United States, 173 U.S. 65 (1899). But for the past 35 years, due to a widespread failure by the Treasury Department (“Treasury”) to promulgate needed regulations, lower courts addressing tax cases have been engaging in what they and scholars call “phantom” regulation — making the rules that Congress commanded Treasury to make in order to reach substantive results that courts believe Congress intended. True to both the “phantom” moniker and the belief in tax law exceptionalism underlying the doctrine, neither lower courts nor Treasury have ever squared phantom regulation with this Court's precedent. Here, the Second Circuit expanded the doctrine in new and troubling ways, leaving Petitioner retroactively subject to tens of millions of dollars in taxes as to which no statute or regulation provided fair notice. The question thus presented is:

Whether, or under what circumstances, the Judiciary may enforce an ambiguous provision of the Internal Revenue Code by filling a statutory gap, when Congress delegated gap-filling responsibility to Treasury but Treasury has failed to promulgate required regulations.

PARTIES TO THE PROCEEDING AND RULE 29.6 STATEMENT

Petitioner is the Estate of Andrew J. McKelvey, who is deceased, through Bradford G. Peters, the Estate's executor.

Respondent is the Commissioner of Internal Revenue.

Because the Petitioner is not a corporation, a corporate disclosure statement is not required under Supreme Court Rule 29.6.

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TABLE OF CONTENTS

OPINIONS BELOW

JURISDICTION

STATUTORY PROVISION INVOLVED

STATEMENT OF THE CASE

REASONS FOR GRANTING THE PETITION

CONCLUSION

TABLE OF APPENDICES

Appendix A: Opinion, Estate of McKelvey v. Comm'r, No. 17-2554 (2nd Cir. Sep. 26, 2018)

Appendix B: Concurring Opinion, Estate of McKelvey v. Comm'r, No. 17-2554 (2nd Cir. Sep. 26, 2018)

Appendix C: Judgment, Estate of McKelvey v. Comm'r, No. 17-2554 (2nd Cir. Sep. 26, 2018)

Appendix D: Opinion, Estate of McKelvey v. Comm'r, No. 26830-14 (T.C. Apr. 17, 2017)

Appendix E: Decision, Estate of McKelvey v. Comm'r, No. 26830-14 (T.C. Apr. 17, 2017)

Appendix F: Order, Estate of McKelvey v. Comm'r, No. 17-2554 (2nd Cir. Dec. 10, 2018)

Appendix G: 26 U.S.C. 1259

Appendix H: Excerpts from the Revenue Reconciliation Act of 1997, S. Rep. No. 105-33, 105th Cong. 1st Sess. (1997)

TABLE OF AUTHORITIES

Cases

15 W. 17th St. LLC v. Comm'r, 2016 U.S. Tax Ct. LEXIS 37 (2016)

Am. Power & Light Co. v. SEC, 329 U.S. 90 (1946)

Bowen v. Georgetown Univ. Hosp., 488 U.S. 204 (1988)

Cal. Bankers Ass'n v. Schultz, 416 U.S. 21 (1974)

Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)

City of Arlington, Tex. v. F.C.C., 569 U.S. 290 (2013)

City of Milwaukee v. Illinois & Michigan, 451 U.S. 304 (1981)

Dunlap v. United States, 173 U.S. 65 (1899)

ETSI Pipeline Project v. Missouri, 484 U.S. 495 (1988)

First Chicago Corp. v. Comm'r, 88 T.C. 663 (1987)

Francisco v. Comm'r, 119 T.C. 317 (2002)

Francisco v. Comm'r, 370 F.3d 1228 (D.C. Cir. 2004)

Gen. Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)

Hillman v. I.R.S., 263 F.3d 338 (4th Cir. 2001)

Int'l Multifoods Corp. v. Comm'r, 108 T.C. 579 (1997)

Jefferson v. United States, 546 F.3d 477 (7th Cir. 2008)

Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44 (2011).

McCulloch v. Maryland, 17 U.S. 316 (1819)

Mistretta v. United States, 488 U.S. 361 (1989)

N.L.R.B. v. Noel Canning, 573 U.S. 513 (2014)

Nat'l Cable & Telecomms. Ass'n v. Brand X Internet Servs., 545 U.S. 967 (2005)

Norton v. S. Utah Wilderness Alliance, 542 U.S. 55 (2004)

Occidental Petroleum Corp. & Subsidiaries v. Comm'r, 82 T.C. 819 (1984)

Pittway Corp. v. United States, 102 F.3d 932 (7th Cir. 1996)

Principal Life Ins. Co. & Subsidiaries v. United States, 95 Fed. Cl. 786 (2010)

Progressive Corp. & Subsidiaries v. United States, 970 F.2d 188 (6th Cir. 1992)

Temsco Helicopters, Inc. v. United States, 409 F. App'x 64 (9th Cir. 2010)

United States v. Mead Corp., 533 U.S. 218 (2001)

Statutes and Rules

U.S.CONST. ART. I § 7 CL. 1

Rev. Rul. 2003-7, 2003-1 C.B. 363

5 U.S.C. § 706(1)

26 U.S.C. § 163(i)(5)

26 U.S.C. § 246A(f)

26 U.S.C. § 457A(e)

26 U.S.C. § 1001

26 U.S.C. § 1092

26 U.S.C. § 1259

26 U.S.C. § 1260

26 U.S.C. § 7805

28 U.S.C. § 1254(1)

Other Authorities

Amandeep S. Grewal, Substance Over Form? Phantom Regulations and the Internal Revenue Code, 7 HOUS. BUS. & TAX. L.J. 42 (2006)

David M. Schizer, Hedging Under Section 1259, TAX NOTES, Jul. 20, 1998

Kiran Manda, Stock Market Volatility during the 2008 Financial Crisis (April 1, 2010), http://web-docs.stern.nyu.edu/glucksman/docs/Manda2010.pdf

Phillip Gall, Phantom Tax Regulations: The Curse of Spurned Delegations, 56 TAX LAW 413 (2003)

Rebecca M. Kysar, On the Constitutionality of Tax Treaties, 38 YALE J. INT'L L. 1 (2013)

William M. Paul, Constructive Sales Under New Section 1259, TAX ANALYSTS (Sept. 15, 1997)

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OPINIONS BELOW

The Second Circuit's opinion (App.1a-32a) is reported at 906 F.3d 26. The concurring opinion of Judge Cabranes (App.33a) is reported at 906 F.3d at 41. The Tax Court's opinion (App.36a-68a) is reported at 148 T.C. 312. The Second Circuit's order denying rehearing (App.71a-72a) is unreported.

JURISDICTION

The Second Circuit entered its opinion on September 26, 2018. App.1a. On December 10, 2018, it denied a timely rehearing petition. App.71a-72a. This Court has jurisdiction under 28 U.S.C. § 1254(1).

STATUTORY PROVISION INVOLVED

Section 1259 of the Internal Revenue Code, 26 U.S.C.§ 1259, which is reprinted at App.73a-79a.

STATEMENT OF THE CASE

I. The Constructive Sale Statute And Treasury's Failure To Promulgate Necessary Regulations

Congress enacted the “constructive sale” statute in 1997, responding to the growth in novel transactions as to which tax law did not have clearly established rules. App.80a-84a (S. Rep. No. 105-33, 105th Cong. 1^st Sess. (1997) (Senate Finance Committee Report discussing the constructive sale statute's genesis)). The constructive sale statute, codified at 26 U.S.C. § 1259, identifies four types of contracts that can trigger “recognition” of gain for income tax purposes even though they do not possess the traditional qualities necessary for “realization” of gain (e.g., selling, exchanging, or otherwise disposing of an asset).

Relevant here are sections 1259(c)(1)(C) and 1259(d)(1), which apply to “forward contracts.” Forward contracts typically require the future delivery of a fixed amount of property for a fixed price as set forth in the contract. However, some forward contracts can be variable, as these sections recognize. These sections treat a taxpayer as having constructively sold appreciated stock, requiring a taxpayer to recognize gain, if the taxpayer enters into the following type of forward contract with respect to such stock: “[A] contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.” App.76a (§ 1259(d)(1) (emphasis added)). If a taxpayer enters into such a contract, the taxpayer will be required to recognize gain on stock, even before the gain on such stock is realized through an actual sale.

Congress did not define what it means for an amount of potentially deliverable property to be “substantially fixed.” Congress did not indicate how broad a range in the amount of potentially deliverable property would be enough to remove a given forward contract from section 1259's ambit. Nor did Congress indicate whether, under some circumstances, the variation in potentially deliverable property in a forward contract should be disregarded based on factors impacting the likelihood that any specific amount of property would be delivered.

Instead, Congress directed Treasury to fill in these gaps (and define “substantially” more generally in the constructive sale statute). In section 1259(f), Congress said “[t]he Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section.” App.78a (§ 1259(f) (emphasis added)).¹ In addition, Congress gave Treasury separate discretionary authorization to promulgate regulations to treat taxpayers as having made a constructive sale to the extent that a taxpayer “enters into 1 or more other transactions (or acquires 1 or more positions) that have substantially the same effect as” one of the listed categories of transactions. App.75a (§ 1259(c)(1)(E)). Given the essential nature of “substantially fixed” to the definition of “forward contracts” under section 1259(c)(1)(C) and 1259(d)(1) (and the critical role “substantially” plays in the statute generally), regulations clarifying the meaning of “substantially” were both “necessary [and] appropriate to carry out the purposes of” section 1259. See App.78a (§ 1259(f)); see, e.g., David M. Schizer, Hedging Under Section 1259, TAX NOTES, Jul. 20, 1998, p. 352 (“Although central to the statute's meaning, the word 'substantial' is imprecise — a fundamental ambiguity in the regime, at least until clarified in regulations.”).

Many who weighed in on the meaning of “substantially fixed,” and the need for regulations to implement the constructive sale statute generally, did not envy Treasury's task. Indeed, one commentator — until recently the Acting Chief Counsel of the Internal Revenue Service (“IRS”) — called it “daunting” given the complex considerations involved. William M. Paul, Constructive Sales Under New Section 1259, TAX ANALYSTS (Sept. 15, 1997) at 1472.

Nevertheless, the legislative history expanded on Congress's expectations for forthcoming regulations. The relevant report from the Senate Committee on Finance (the “Senate Report” or the “Report”) stated that a contract “providing for delivery of an amount of property, such as shares of stock, that is subject to significant variation under the contract terms does not result in a constructive sale,” precisely because the amount of property to be delivered would not be “substantially fixed.” App.89a (emphasis added). And the Senate Report identified “many of the factors” Treasury could take into account to clarify the sort of transactions that could constitute constructive sales under regulations. See App.92a.

The Senate Report gave multiple examples. In one example, the Report described a collar transaction where a taxpayer simultaneously sells a call option at $110 per share and buys a put option at $95 per share, effectively transferring the rights to all gain above $110 and all loss below $95. See App.91a. In another example, the Report described a taxpayer that enters into an “in-the-money” option, such as a taxpayer who purchases a put option with a strike price at $120 while the stock is trading at $100. App.92a. In each of these examples, the Senate Report did not take a position on whether that amount of uncertainty rendered the transactions constructive sales — it simply illustrated all of the economic factors Treasury could consider in promulgating regulations, including the duration of the contracts, the volatility of the stock, and the range in potentially deliverable property or price. App.91a-92a. Recognizing the inherent economic complexity in identifying when such transactions constitute constructive sales, the Senate Report suggested that regulations should be “applied prospectively, except in cases to prevent abuse.” App.91a.²

It has been more than twenty years since the constructive sale statute was enacted. Notwithstanding Congress's statutorily expressed command to regulate, Treasury has never done so.

II. Andrew McKelvey's Contracts

In 2007, taxpayer Andrew McKelvey, the founder of Monster Worldwide, Inc. (“Monster”), entered into two variable prepaid forward contracts (“VPFCs”). Under their terms, McKelvey received approximately $194 million in exchange for his promise to deliver somewhere between approximately 5.4 and 6.5 million Monster stock shares (or cash), on future settlement dates.³ The precise “amount of property” to be delivered depended on the stock price at those future dates. The stock was trading at approximately $32 per share when he entered the VPFCs. At settlement, if the stock was trading at approximately $40 or above, he would be required to deliver 5.4 million shares. If the stock was trading at approximately $30 or below, he would be required to deliver 6.5 million shares. If the stock was trading somewhere in between, the amount to be delivered would be calculated based on contractually-specified formulae.

McKelvey entered into his VPFCs to gain immediate access to cash without having to sell stock and while hedging the risk that Monster stock price would decline. In that regard, a VPFC is similar to a combination of the collar transaction and the in-the-money put option described in section 1259's legislative history, and is also similar to other run-of-the-mill contracts that allow taxpayers to borrow money against the value of assets they own without selling them, such as home equity loans and reverse mortgages.

There is no dispute that McKelvey's VPFCs were not constructive sales under section 1259 when he entered them — they were not contracts to deliver a “substantially fixed” amount of property.⁴ App.14a (“The Commissioner had previously acknowledged that VPFCs did not incur capital gains when executed”). Because McKelvey could ultimately be required to deliver anywhere from 5.4 to 6.5 million shares of stock, which would depend on where the stock was trading a year later, there was “significant variation under the contract terms.” App.89a. And although no regulation ever explained the statute's implementation, the IRS had issued a Revenue Ruling recognizing that a VPFC with comparable terms was not a constructive sale under section 1259. See Rev. Rul. 2003-7, 2003-1 C.B. 363.

In the 11 months after entering his VPFCs, McKelvey witnessed Monster's stock price drop from approximately $32 per share to approximately $17 per share. While a dramatic drop, this shift was typical of the volatility occurring throughout the stock market in 2008.See Kiran Manda, Stock Market Volatility during the 2008 Financial Crisis, at2(April1,2010),http://web-docs.stern.nyu.edu/glucksman/docs/Manda2010.pdf (observing that “the S&P 500 lost about 56% of its value from the October 2007 peak to the March 2009 trough.”).

With this volatility and the dip in Monster stock's value, McKelvey faced a choice: either deliver in one month's time what would likely be 6.5 million shares, the maximum number of shares he could be required to deliver under his VPFCs, or, extend his delivery obligations, giving his Monster shares time to recover the value they lost, in the hope that he would be required to deliver only 5.4 million shares. Given the historic volatility Monster had witnessed, such a turnaround was certainly possible.

McKelvey chose to extend his VPFCs' respective delivery dates, each by about 17 months. McKelvey paid approximately $11 million in aggregate to his counterparties in consideration for these extensions.⁵ There was no change, however, to the formulae by which he would be required to determine the amount of property to be delivered, or to the potential variation set forth by the terms of the contracts (the range was still between 5.4 and 6.5 million shares).

McKelvey died a few months after his extensions. At his death, McKelvey still had not settled his VPFC obligations. Accordingly, both McKelvey's VPFC obligations and his Monster shares passed on to Petitioner, his Estate. Petitioner settled the VPFC obligations by delivering shares to McKelvey's counterparties.

III. The Tax Court Decision

The IRS issued a deficiency notice against Petitioner claiming that McKelvey had realized short-term capital gain, and was required to recognize long-term capital gain upon extending his VPFCs. Specifically, the IRS claimed that McKelvey realized short-term capital gain because extending his VPFCs constituted an exchange of property (the “original” VPFCs) for materially different property (“new,” extended VPFCs) under 26 U.S.C. § 1001. And the IRS claimed that McKelvey was required to recognize long-term capital gain because his “new” VPFCs were constructive sales (even though his “original” VFPCs were not).

The IRS argued that the “new” VPFCs were constructive sales because, even though the potential variability in the amount of property to be delivered was unchanged from the “original” VPFCs, the drop in stock price had made it more likely that McKelvey would be required to deliver 6.5 million shares. Particularly, the IRS argued that, based on a probability analysis by its expert witness, the likelihood that Monster stock would rise above the VPFC's floor price by the settlement date (the floor price being the threshold necessary to cause McKelvey to owe fewer than the maximum number of shares) was only about 15%. The IRS argued that this probability rendered the amount of property to be delivered under the “new” VPFCs “substantially fixed,” even though the range of variation in potentially-deliverable property (i.e., between 5.4 and 6.5 million shares) remained the same as it had been under the “original” VPFCs.

In the Tax Court, Petitioner argued first that the VPFC extensions did not constitute an “exchange of property” given that he had only obligations under the VPFCs (and thus no property rights) at the time of the extensions. Accordingly, there were no “new” VPFCs to analyze under the constructive sale statute. Second, Petitioner argued that even if there were “new” VPFCs, they would not be constructive sales given, among other things, the lack of regulations explaining when, whether, or how one should use shifts in market dynamics to conclude that the amount of property to be delivered under a given contract was “substantially fixed.”

Petitioner argued that, absent regulations, the court could only construe section 1259's plain language. This required the court to treat as not “substantially fixed” any amount of property that remained subject to a real possibility of significant variation. Here, given that (1) the amount of property due under the “original” VPFCs had the same contractually stated variability as the amount of property due under the “new” VPFCs, and (2) the IRS conceded that the original amount of property due was not “substantially fixed,” Petitioner claimed that the amount of property due under the “new” VPFCs could not be deemed “substantially fixed” either. Indeed, given the very real possibility that, in the next 17 months, Monster stock would recover by the same amount it had just dropped in the preceding 11 months, no one knew whether McKelvey would ultimately need to deliver the minimum number of shares, the maximum number of shares, or some number in between.

The Tax Court rejected the Commissioner's threshold argument — that McKelvey's extensions constituted a property exchange — obviating any need for the Tax Court to decide the constructive sale question. See App.67a-68a.

IV. The Second Circuit Decision

The Second Circuit reversed the Tax Court. The Second Circuit held:

See App.19a, 28a-29a. Accordingly, McKelvey's Estate, the Petitioner, is now retroactively subject to tens of millions of dollars in taxes. The precise amount will be determined in Tax Court.

The Second Circuit admitted that its holding that the “new” VPFCs were constructive sales relied on a probability analysis that “is neither explicitly authorized nor prohibited by any relevant statute.” App.26a. Indeed, it had to do so. Petitioner had explained that the Commissioner's position “asks [the Second Circuit] to apply an unspecified economic test to draw lines that neither Treasury nor the IRS has ever seen fit to draw.” Pet'r Br. 49.

The Second Circuit similarly recognized that its holding was not based on any regulation, while also understating the significance of this admission. The Second Circuit stated that Congress merely “authorized” Treasury to promulgate regulations “to implement the constructive sale statute,” App.26a, even though Petitioner had explained that “Congress[ ] mandate[d]” regulations. See Pet'r Br. 51-52 (emphasis added); see also § 1259(f) (“The Secretary shall prescribe such regulations. . . .”) (emphasis added). The Second Circuit recognized that “the relevant Senate Report contemplated that the Treasury Department would” promulgate regulations, and that “no such regulations have been issued.” App.26a. “Nevertheless,” the Second Circuit explained that it was “persuaded to” employ probability analysis in the “context” of VPFCs to determine whether the amount of potentially deliverable property due under the contracts was “substantially fixed.” See App.26a. It did so because it believed “[t]he Internal Revenue Code should not be readily construed to permit” a contrary result. See App.28a.⁷

The Second Circuit implicitly recognized that the drawing of lines based on an extra-statutory probability analysis would encroach on the expertise of other branches of Government, but ultimately concluded that such concerns were tolerable. In the Second Circuit's view, the percentage of likelihood that Monster stock would recover by the settlement of the “new” VPFCs was “sufficiently low” that “the low share price at execution of each amended contract rendered the amount of shares to be delivered at settlement 'substantially fixed.'” App.28a-29a. Put simply, the Second Circuit concluded that the “significant variation under the contract terms,” (App.89a), which had been enough to preclude constructive sale treatment at inception, could now be disregarded due to the drop in stock price.

The Second Circuit provided no explanation as to why 15% was a “sufficiently low” likelihood such that a court should disregard the contracts' variability in the amount of deliverable property. Nor is there any explanation as to why the Second Circuit could ignore the possibility that, in the next 17 months, the stock price would recover the amount it had lost in the prior 11 months. Instead, the court simply attached the label “substantially fixed” to its conclusion. This back-of-the-envelope approach is a striking contrast to the view of those who commented on the “daunting” task facing Treasury in promulgating regulations. See supra p. 4.

More importantly, the Second Circuit evidenced no compunction about enforcing an ambiguous provision of the Internal Revenue Code by filling a gap that Congress reserved for Treasury. Petitioner made this error the thrust of its rehearing or reconsideration petition, but the Second Circuit summarily denied the petition. App.71a-72a. The Second Circuit's decision bespeaks the widespread lower-court phenomenon in tax law of “phantom” regulation.

REASONS FOR GRANTING THE PETITION

This Petition presents an ideal opportunity for this Court to provide much needed guidance to lower courts on what to do when faced with tax provisions that depend on non-existent Treasury regulations. This is a recurring issue of substantial importance, as hundreds of Internal Revenue Code provisions are in need of implementing regulations. Lower courts have applied inconsistent and problematic approaches to address this problem, but have generally concluded that they are free to “phantom” regulate in Treasury's place. As set forth below, that not only creates a substantial fair notice problem — it is fundamentally inconsistent with this Court's precedent.

This case presents the appropriate vehicle for the Court to reaffirm its precedent and to clarify that the rules this Court applies when reviewing inaction of other administrative agencies apply equally when reviewing Treasury inaction. Such a ruling may or may not prompt Treasury to do its job. But, at the very least, it would provide much needed certainty to tax law.

I. The Second Circuit's Decision Evidences A Widespread Need For Guidance In Tax Law: What To Do When Treasury Fails To Regulate?

Eight years ago, this Court explained that it is “not inclined to carve out an approach to administrative review good for tax law only.” Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 55 (2011). But this case reveals that lower courts continue to resist a “uniform approach to judicial review” in tax cases. Id. Indeed, in an ironic incident of fate, the very same year that this Court issued Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), which informs the judicial review of much agency action, the Tax Court embarked on its own unique approach to judicial review of administrative inaction that continues unabated: “phantom” regulation.

“Phantom” regulation is a specific outgrowth of the fact that the Internal Revenue Code currently includes hundreds of provisions “requiring regulations to be issued to achieve a particular result.” Phillip Gall, Phantom Tax Regulations: The Curse of Spurned Delegations, 56 TAX LAW 413, 414 (2003).⁸ “In a great many of those cases,” not only is there no promulgated regulation, “no regulation project has ever been announced.” Id. Some of those spurned rulemaking commands would, if exercised, benefit taxpayers (such as issuing them a rebate or a credit); others would, if exercised, impose a tax.

The Tax Court began phantom regulating in 1984, when it was confronted with a taxpayer who wanted a statutorily promised benefit that was conditioned on the promulgation of missing regulations. Instead of following this Court's decision in Dunlap (discussed infra), the Tax Court ruled not only as though the needed regulations had been promulgated, but as though the content of those regulations was known to the court. See Occidental Petroleum Corp. & Subsidiaries v. Comm'r, 82 T.C. 819, 829 (1984) (justifying such action because “the failure [of the Treasury Secretary] to promulgate the required regulations can hardly render the new provisions of section 58(h) inoperative. We must therefore do the best we can with these new provisions.”). This approach was in direct contradiction to Dunlap and other key doctrines discussed infra, but neither the Tax Court — nor any Circuit Court — has ever grappled with the disconnect.

Now, as Petitioner's case reveals, phantom regulation is so “well established,” see Int'l Multifoods Corp. v. Commissioner, 108 T.C. 579, 587 (1997), that Treasury has turned its nonfeasance into a weapon. Uncertainty in the tax law is strategically preserved so that, even in the absence of any suggestion of taxpayer abuse, Treasury can issue deficiency notices premised on non-existent regulations and ask courts to fill in gaps that Treasury was commanded to fill, with the effect of retroactively imposing taxes.

Instead of squaring with this Court's precedent — that, in the absence of needed regulation, would render certain statutory provisions unenforceable as applied — the Tax Court has contrived its own “imprecise tests” to permit phantom regulation. 15 W. 17th St. LLC v. Comm'r, 2016 U.S. Tax Ct. LEXIS 37, at *51 (2016) (Holmes J., concurring). They include:

Id. at *51-52 (internal quotation marks and citations omitted) (alterations in original) (emphasis in original).

In some cases, the Tax Court is explicit about the fact that it is making policy judgments in Treasury's place. See, e.g., First Chicago Corp. v. Comm'r, 88 T.C. 663, 677 (1987) (“We do not relish doing the Secretary's work for him, but we have no other course to follow.”). And, after making up the needed regulation, the court will explicitly give itself the deference this Court reserves for an agency's reasonable statutory constructions. See id. at 676 (“Had [the Secretary] promulgated a regulation providing for the same result that we reach here, that regulation would not be 'unreasonable' or 'plainly inconsistent with the revenue statute.'”). Yet the Tax Court's tests are as internally inconsistent as they are inconsistently applied. For example, despite the “whether-how” test discussed above, the Tax Court made no mention of that test in a case where the plain language of the Internal Revenue Code provision at issue expressly said that regulations would determine “whether income is described in [the section].” Francisco v. Comm'r, 119 T.C. 317, 322 (2002) (emphasis added) (citation omitted).

Several Circuits have encountered the phantom regulation phenomenon before this case, but only the Ninth Circuit appears to have expressly acknowledged the Tax Court's phantom regulation tests. See Temsco Helicopters, Inc. v. United States, 409 F. App'x 64, 67 (9th Cir. 2010). In that case, however, the Ninth Circuit found that “[t]he language of the statute and its legislative history do not establish that regulations are a precondition to applying” the provision at issue, rendering the propriety of phantom regulating a moot question. See id. The D.C. Circuit has identified this issue, but — as is often the case when the phantom regulation request works to a taxpayer's benefit — neither party raised it. See Francisco v. Comm'r, 370 F.3d 1228, 1230 n.1 (D.C. Cir. 2004). The D.C. Circuit therefore held it had “no occasion to pass upon” whether the court should “have held the statute incapable of application” due to the lack of promulgated regulations. Id. The Seventh Circuit has embraced phantom regulation, while simultaneously warning Treasury not to keep outsourcing its regulatory responsibilities to the Judiciary: “In a statute less clear on its face, failure to promulgate regulations as Congress orders could result in a provision not enforceable due to the Secretary's failure.” Pittway Corp. v. United States, 102 F.3d 932, 936 (7th Cir. 1996). More recently, the Seventh Circuit expanded its warning — holding that “if the IRS's failure to promulgate documents which it was legally obligated to provide prejudices the taxpayer, this failure precludes application of the penalty” at issue. Jefferson v. United States, 546 F.3d 477, 484-85 (7th Cir. 2008). By contrast, the Fourth Circuit flatly rejected the application of phantom regulation, even though it arose in a case where the Tax Court applied phantom regulation to benefit taxpayers. See Hillman v. I.R.S., 263 F.3d 338, 343 (4th Cir. 2001) (“this is an inequity in the United States Tax Code that only Congress or the Secretary (as the holder of delegated authority from Congress) has the authority to ameliorate”).

Here, the Second Circuit has gone beyond these cases and embraced phantom regulation even where no taxpayer asked for it, where the court recognized regulations were expected to answer the precise question at issue, and where a taxpayer would be retroactively taxed.

The “considerable debate” over phantom regulation has been widely observed. Principal Life Ins. Co. & Subsidiaries v. United States, 95 Fed. Cl. 786, 801 n.34 (2010). Courts and scholars have detailed how phantom regulation evidences “yet another instance of tax law's wandering away from general principles of administrative law,” one that is particularly hard to square with separation of powers principles. 15 W. 17th St. LLC, 2016 U.S. Tax Ct. LEXIS at *49 (Holmes J., concurring); see also Amandeep S. Grewal, Substance Over Form? Phantom Regulations and the Internal Revenue Code, 7 HOUS. BUS. & TAX. L.J. 42, 60 (2006) (“courts and the IRS have likely underestimated the degree to which the use of 'phantom' regulations subverts Congress's desire to implement its policy objectives through the use of regulations developed pursuant to the notice and comment procedures in the Administrative Procedure Act [“APA”].”); Gall, Phantom Tax Regulations: The Curse of Spurned Delegations, 56 TAX LAW. at 448 (“Through the Secretary's failure to prescribe regulations, the authority delegated by Congress to the Secretary has essentially been re-delegated to the courts. The courts' willingness to accept that delegation from the Secretary arguably violates the constitutional principle [that delegated authority cannot be re-delegated].”). This brewing debate requires the guidance only this Court can provide.

II. The Varying Phantom Regulation Approaches That Lower Courts Have Developed To Address Treasury Inaction Are Divorced From This Court's Precedent

This Court's guidance is critical not only because lower courts are in need of a clear rule to confront Treasury's widespread nonfeasance — but, equally problematic, lower courts have never reconciled phantom regulation with this Court's precedent. Instead, lower courts addressing Treasury inaction act “in apparently blissful disregard for the APA” and the principles that underlie our Constitution's allocation of power. 15 W.17th St. LLC, 2016 U.S. Tax Ct. LEXIS at *52 (Holmes J., concurring).

At least three conflicts between phantom regulation and this Court's precedent are in need of redress:

A. Filling In Gaps Delegated To Treasury Is Inconsistent With Dunlap

Not a single lower court has ever reconciled phantom regulation with Dunlap, the one case in which this Court addressed an analogous situation. Here, after the Second Circuit rejected Petitioner's argument against “this Court . . . apply[ing] an unspecified economic test to draw lines that neither Treasury nor the IRS has ever seen fit to draw,” Pet'r Br. 49, Petitioner devoted its rehearing or reconsideration petition to explaining how the Second Circuit's decision raised a conflict with Dunlap. But like every other court before it, the Second Circuit blew past the problem.

In Dunlap, this Court addressed a Revenue Act provision that conditioned a tax rebate for the “use [of] alcohol in the arts, or in any medicinal or other like compound” on the taxpayer showing that his use complied with “regulations to be prescribed by the secretary of the treasury.” 173 U.S. at 70 (internal citation omitted). “There were no regulations in respect to the use of alcohol in the arts at the time this alcohol was used[.]” Id. at 71. Nevertheless, the taxpayer argued that his “right to repayment was absolutely vested by the statute, dependent on the mere fact of actual use in the arts, and not on use in compliance with regulations[.]” Id. In other words, the taxpayer asked this Court to grant him the benefit prescribed in the statute, as though regulations had been promulgated and as though the Court knew their content.

This Court rejected the taxpayer's request. It held that the Revenue Act provision at issue “was conditioned on the performance of an executive act, and the absence of performance left the condition of the existence of the [rebate] unfulfilled.” Id. at 71. “[C]ongress required that the thing itself,” i.e., determining the conditions for which a taxpayer was eligible for a rebate, “should be done under official regulations,” not judicial invention. Id. at 73.

Dunlap thus set forth a key principle that should dispel phantom regulation: “courts cannot perform executive duties, nor treat them as performed when they have been neglected.” Id. at 72 (internal quotation marks and citation omitted). Rather than take on Treasury's role and craft regulations on the uses of alcohol to which the tax rebate should apply, the Court instead acknowledged “the intention of Congress to leave the entire matter to the Treasury Department to ascertain what would be needed[.]” Id. at 76; see also id. at 74 (observing that Congress left this question to “the exercise of a large discretion based on years of experience in the Treasury Department”). Despite phantom regulation being employed by lower courts for 35 years to address Treasury's nonfeasance, none of those courts have reconciled phantom regulation with Dunlap.

The Second Circuit decision here highlights the disconnect. The court was of course free to interpret “substantially fixed” in section 1259 to set forth certain outer bounds to what level of potential variation under the contract terms was sufficient, e.g., whether it was enough that McKelvey could be required to deliver anywhere from 5.4 to 6.5 million shares of stock, or whether a broader range was required. But so long as the range was broad enough, which was undisputed here, and there was genuine uncertainty as to how much property within that range would ultimately delivered, which was also undisputed here, McKelvey's contracts could not possibly fall within the plain language of “substantially fixed.” Once the Second Circuit determined that market vagaries should be consulted, contractually specified variation should be disregarded, and a “probability analysis” should be applied, it moved beyond the plain language of “substantially fixed” and into the “executive duties” Congress made subject to Treasury regulation. Indeed, the Second Circuit all but acknowledged this when it said that this case did not involve contracts to deliver “an amount [of property] within a narrow range of limits,” but instead, one where “the amount is claimed to be substantially fixed for a different reason.” App.23a (emphasis added). Cf. Mayo, 562 U.S. at 52-53 (regulations required because, even if it is possible to identify some definitions that statutory terms “plainly encompass[ ],” the “precise question at issue” needed regulations). The Second Circuit did not (and could not) justify how encroaching on the “executive dut[y]” to promulgate regulations is consistent with this Court's precedent.

B. Filling In Gaps Delegated To Treasury Is Inconsistent With Separation Of Powers And Administrative Law

1. Separation Of Powers

For the separation of powers to matter in tax law, Congress's choice of the Treasury Secretary — and not the Judiciary — to carry out a particular function must be respected, even if that means that certain statutory provisions will be rendered unenforceable when Treasury regulation is required but does not exist.

Neither the Judiciary nor the Executive possess an inherent rulemaking power. “[R]ulemaking power originates in the Legislative Branch.” Mistretta v. United States, 488 U.S. 361, 386 n.14 (1989). It can “become[ ] an executive function only when delegated by the Legislature to the Executive Branch.” Id. And it can similarly become a judicial function only when authorized by Congress in an applicable statute. See id. at 388.⁹ When Congress chooses, therefore, that the Executive — rather than the Judicial — Branch possess rulemaking authority, the Judicial Branch has no basis to usurp that authority. Concluding otherwise would undermine this Court's “expressed vigilance . . . that the Judicial Branch neither be assigned nor allowed tasks that are more properly accomplished by [other] branches.” Id. (internal quotation marks and citation omitted).

Phantom regulation allows the Judiciary to acquire rulemaking power not through Congress authorizing it, but through the Executive shirking it. And, it occurs in an ad hoc, patchwork manner that gives taxpayers no guidance as to whether, when, or how a court will phantom regulate their tax benefit or liability. Far from vindicating congressional intent, this runs directly contrary to Congress's stated goals crafting a prospective, comprehensive statute like section 1259.

Indeed, the entire premise of phantom regulation is ipse dixit: The court dislikes the result of not applying a statute's substantive provision to the case, so it simply decides the agent Congress identified in the statute's rulemaking provision should be irrelevant. See, e.g., App.28a (observing that “[i]n this case [McKelvey received a payment of] $194 million, and thus far, no capital gains taxes have been paid. The Internal Revenue Code should not be readily construed to permit that result.”); Occidental Petroleum, 82 T.C. at 829 (“the failure [of the Treasury Secretary] to promulgate the required regulations can hardly render the new provisions of section 58(h) inoperative. We must therefore do the best we can with these new provisions.”). Our system, of course, does not empower one branch to act merely because that branch thinks somebody should. Cf. N.L.R.B. v. Noel Canning, 573 U.S. 513, 538 (2014) (“It should go without saying . . . that political opposition in the Senate would not qualify as an unusual circumstance” allowing the President to disregard the standard appointment process).

Being blasé about the significance of Congress's choice to delegate a question to a specific agent not only plays fast and loose with a statute's plain meaning — it belies this Court's requirement that, for an authorization of rulemaking power to be “constitutionally sufficient,” Congress, among other things, must “clearly delineate[ ] . . . the public agency which is to apply” the authority. See Am. Power & Light Co. v. SEC, 329 U.S. 90, 105 (1946). Phantom regulation also impermissibly permits the Judiciary to speculate as to the “sort of” regulations an agency “might . . . impose . . . under the broad authority” Congress provided to Treasury, when the judicial role is typically limited to evaluating “what sort of [regulations] he [i.e., the agency head] did in fact impose under that authority.” Cal. Bankers Ass'n v. Schultz, 416 U.S. 21, 64 (1974) (emphasis in original).

If a court is ever empowered to exercise any “rulemaking” authority from Congress, then Congress must have given the Judiciary that power. Here — and in every other phantom tax regulation case — Congress gave that power to Treasury instead. No court has ever explained why the separation of powers should be modified in the Judiciary's favor simply because Treasury has failed to act on the authority Congress gave it.

2. Chevron's Structural Premises

This Court's administrative law precedent reflects these separation of powers principles. Because “the Executive Branch is not permitted to administer [an] Act in a manner that is inconsistent with the administrative structure that Congress enacted into law,” ETSI Pipeline Project v. Missouri, 484 U.S. 495, 517 (1988), one Executive agency may not re-delegate a statutorily assigned authority to another Executive agency. See id. The same logic should prohibit an agency outsourcing its statutorily-assigned rulemaking responsibility to the Judiciary. And yet that is precisely what happened here and happens across tax law.

Ensuring that “'judges . . . refrain from substituting their own interstitial lawmaking' for that of an agency” “is precisely what Chevron prevents.” City of Arlington, Tex. v. F.C.C., 569 U.S. 290, 304-305 (2013) (citation omitted). Those dissenting in City of Arlington agreed: “We give binding deference to permissible agency interpretations of statutory ambiguities because Congress has delegated to the agency the authority to interpret those ambiguities with the force of law.” Id. at 317 (Roberts, Kennedy, & Alito, JJ., dissenting) (internal quotation marks and citation omitted) (emphasis in original). But phantom regulation cuts against this Chevron premise, which itself is “rooted in a legal presumption of congressional intent, important to the divisions of power between the Second and Third Branches. . . . By committing enforcement of the statute to an agency rather than the courts, Congress committed its initial and primary interpretation to that branch as well.” United States v. Mead Corp., 533 U.S. 218, 241-243 (2001) (Scalia, J., dissenting) (explaining how this premise is “in accord with the origins of federal-court judicial review” and “[j]udicial control of federal executive officers,” even while recognizing Chevron's tension with the APA). Accordingly, once a court concludes, as the Second Circuit did here, that the “precise question at issue” is not covered by the statute's plain meaning, but rather falls within the realm of matters Congress assigned to an administering agent, then that is the agent with principal responsibility to resolve the question. See Chevron, 467 U.S. at 842-843.¹⁰

The fact that Congress's designated agent has yet to resolve the “precise question at issue” does not give the Judiciary the power to step into the agent's shoes. To be sure, courts may end up construing an ambiguous statutory provision to resolve ancillary disputes before an agency promulgates regulations. See, e.g., Nat'l Cable & Telecomms. Ass'n v. Brand X Internet Servs., 545 U.S. 967, 979-980, 982-983 (2005) (recounting the Ninth Circuit interpreting the Communications Act before the Federal Communications Commission promulgated regulations). But phantom regulation, as employed below and elsewhere in tax cases, represents something altogether different. With phantom regulation, the Judiciary is not simply beating the agency in a race to interpret ambiguous statutory terms. Rather, the administering agency (Treasury) is outsourcing its interpretive responsibility to the Judiciary and seeking enforcement of substantive provisions that the agency has yet to implement through the sort of rulemaking Congress demanded.

Approving phantom regulation's end-run around Congress's assignment of rulemaking authority allows Treasury to “administer [the Internal Revenue Code] in a manner that is inconsistent with the administrative structure that Congress enacted into law.” See ETSI, 484 U.S. at 517; cf. also Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 212-214 (1988) (denying deference on similar grounds to an agency interpretation that was never promulgated in rulemaking but crafted by appellate counsel in litigation).¹¹ At the same time, phantom regulation eliminates the very benefits that are theoretically derived from assigning Treasury rulemaking powers in the first place — agency expertise and public accountability.

“Filling gaps in the Internal Revenue Code plainly requires the Treasury Department to make interpretive choices for statutory implementation at least as complex as the ones other agencies must make in administering their statutes,” and the “formulation of [tax] policy might require more than ordinary knowledge respecting the matters subjected to agency regulations.” Mayo, 562 U.S. at 56. (internal quotation marks and citation omitted). And the rulemaking process — unlike judicial decision-making — contains mechanisms for public participation and accountability that would allow taxpayers to weigh in on rules that may impact their tax liability as that expertise is deployed. See Chevron, 467 U.S. at 865 (“Judges are not experts in the field, and are not part of either political branch of the Government. . . . While agencies are not directly accountable to the people, the Chief Executive is, and it is entirely appropriate for this political branch of the Government to make such policy choices. . . .”). Allowing a lower court to fill in the gaps on the meaning of “substantially fixed” under section 1259 violates each of these premises. Indeed, that is precisely why Congress said that “[t]he Secretary,” not the Judiciary, “shall prescribe” any “necessary or appropriate” regulations to implement the statute. App.78a (§ 1259(f) (emphasis added)). Simply put, the fact that Treasury has not done so did not give the Judiciary license to act.

3. The APA

Finally, phantom regulation is in direct tension with the statutory structure Congress created to address judicial review of agency inaction: Section 706(1) of the APA. See 5 U.S.C. § 706(1). Under that section, a court “can compel [an] agency to act” when Congress has commanded agency regulation but the agency has failed to act (as in phantom regulation cases). Norton v. S. Utah Wilderness Alliance, 542 U.S. 55, 65 (2004). But even with the power to compel needed agency action, the court “has no power to specify what the action must be.” Id. Were a court to possess such power, it would permit “undue judicial interference” with an agency's “lawful discretion,” and a court would be “entangle[d] in abstract policy disagreements which courts lack both expertise and information to resolve.” Id. at 66. It is hard to fathom how phantom regulation has not produced this exact result in tax law.

Here, not only did the Second Circuit plainly encroach into such “abstract policy disagreements,” id. — it did so with a stunningly narrow understanding of the complexities involved. The Second Circuit provided no guidance at all as to when a taxpayer should disregard contractually-specified variation in property amounts for economic analysis, how a taxpayer should interpret the various economic factors that go into a probability analysis, or what percentage variation in property amounts is, in fact, “substantially fixed.” An estimated 15% likelihood that the stock price would recover has now been held “sufficiently low” in the “context” of McKelvey's VPFCs. See App.26a-29a. What about 20%? Or 25%? How does picking 15% square with Treasury's general practice of respecting any contingency greater than 5%? See Pet'r Br. 52-53. And how would the Second Circuit's result be impacted if the VPFCs were of longer, or shorter, duration? Or if the range in potential variance in stock to be delivered was broader — say 4 million shares to 6.5 million shares? Establishing rules that would account for the myriad factors would by no means be easy. And it is by no means clear what rules Treasury will promulgate as a matter of tax policy if it ever takes up Congress's command. But that is precisely the problem taxpayers face when attempting to comply with an ambiguity-laden statute like section 1259 that is bereft of the required regulations. APA Section 706(1) ensures courts do not compound the problem by imposing their own policy preferences in the place of agency rules. Rather, the statute gives courts the tools to ensure agencies solve the problem by providing the needed rules. Phantom regulation takes the opposite approach.

C. Filling In Gaps Delegated To Treasury, At Least To Impose A Tax, Deprives Taxpayers Of Fair Notice

“Always a taxpayer is entitled to know with fair certainty the basis of the claim against him.” Gen. Utilities & Operating Co. v. Helvering, 296 U.S. 200, 206 (1935). The reason for this insistence was one recognized by the Framers: “[T]he power to tax involves the power to destroy.” McCulloch v. Maryland, 17 U.S. 316, 431 (1819) (per Marshall, C.J.). This compelled the Framers to require that all tax statutes originate in the most politically accountable portion of the Federal Government, the House of Representatives. See Rebecca M. Kysar, On the Constitutionality of Tax Treaties, 38 YALE J. INT'L L. 1, 7-9 (2013); U.S. CONST. ART. I § 7 CL. 1 (“All Bills for raising Revenue shall originate in the House of Representatives. . . .”).

Phantom regulation, however, allows Treasury and the Judiciary to take a decidedly unaccountable tact to develop tax regulations. Rather than respect Congress's decision that Treasury engage in rulemaking — with its attendant opportunity for notice and comment, allowing taxpayers to know whether and how certain tax statutes will apply to their conduct — Treasury has preserved strategic uncertainty in the tax code. Phantom regulation relieves Treasury of rulemaking's burdens while still allowing it, retrospectively, to impose taxes even in cases where there is no suggestion of abuse. Phantom regulation therefore shifts the decision-making authority Congress assigned to Treasury to the least politically accountable branch of the Federal Government, the Judiciary. As long as Treasury continues to shirk its responsibilities because it can ask lower courts to fill in statutory gaps, taxpayers confronting the hundreds of spurned delegations throughout the Internal Revenue Code will have no way to predict when they may be subject to a tax or entitled to a benefit.

III. The Second Circuit's Decision Is The Right Vehicle To Address The Significant And Recurring Problem Of Phantom Tax Regulation

There are three principal reasons why this case — which has a stipulated record, no jurisdictional problems, and a Petitioner that has consistently argued against the Judiciary regulating in Treasury's place — is the right case to address the question presented:

First, the Second Circuit's opinion leaves no doubt that it was engaged in phantom regulation. Unlike some phantom regulation cases where there may be ambiguity as to Congress's intent, this case involved a mandatory delegation of regulatory authority to Treasury to issue rules that would address the “precise question” that the Second Circuit addressed. Indeed, the Second Circuit acknowledged the IRS's theory here was based on a “different reason” than the one supported by the plain language of “substantially fixed” in section 1259, see App.23, and it further acknowledged that Congress contemplated regulations to “implement” the statute. App.26a. This puts the Second Circuit squarely in Dunlap's crosshairs. See 173 U.S. at 73 (courts cannot craft the substance of a regulation when “[C]ongress required that the thing itself should be done under official regulations”). To the extent probabilities were to be considered under the constructive sale statute, there is no question that Congress expected Treasury to do so when promulgating prospective regulations — not through the Judiciary contriving them through retroactive, ad hoc decisions.

Second, the Second Circuit's decision goes beyond even the tenuous justifications lower courts have offered for phantom regulation. In prior instances of phantom regulation — cavalier as they are with Congress's assignment of rulemaking authority and Dunlap — courts were, at least nominally, seeking to ensure that Treasury's nonfeasance did not deny a taxpayer a benefit promised by Congress, or to fulfill a congressionally mandated choice. See supra p. 16. Not so here. Section 1259 subjects taxpayers to taxes, and Congress plainly did not determine when, whether, or how market factors should apply to render a variable amount of property to be delivered under a forward contract “substantially fixed.” By retroactively imposing taxes even in the face of a mandatory rulemaking authorization from Congress that covers the question at issue, the Second Circuit's decision epitomizes the extent to which phantom regulation has sprawled beyond even its initial, questionable, confines.

Third, despite the prevalence of phantom regulation in lower courts, this Court will have few opportunities to address the problem — making it all the more important to grant review here. Treasury may occasionally contest the appropriate content of a given phantom regulation, but it has no incentive to oppose the propriety of courts engaging in phantom regulation in general. Regardless of whether Treasury is faced with a refund suit or is bringing a deficiency notice against a taxpayer, the ability of courts to engage in phantom regulation always benefits Treasury by sparing it the burdens of rulemaking and allowing it to preserve uncertainty in the tax law that it can employ strategically against taxpayers. It will also be rare for taxpayers to question the doctrine. As Dunlap shows, a taxpayer seeking a benefit Treasury has yet to effectuate wants phantom regulation. Such taxpayers should be making use of section 706(1) within the APA to compel the Treasury action they seek. But, so long as phantom regulation is allowed as an alternative, taxpayers will be more likely to seek equitable relief in Tax Court — a time-tested method that delivers faster, more tailored results to individual taxpayers than rulemaking, but which violates this Court's precedent and fails to protect other taxpayers.

Phantom regulation has already caused nearly four decades of legal morass. Now, as the Second Circuit has extended the doctrine to retroactively impose taxes, is the time for this Court to resurrect Dunlap and protect taxpayers from Treasury weaponizing its nonfeasance.

CONCLUSION

The Court should grant the Petition. 

Respectfully submitted,

MARK D. LANPHER
Counsel of Record
WILLIAM J. HAUN
SHEARMAN & STERLING LLP
401 9th Street, NW Suite 800
Washington, D.C. 20004
(202) 508-8120
mark.lanpher@shearman.com

March 8, 2019