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The Implications for Tax Litigation of the Supreme Court’s Decision in Michigan v. EPA

Posted on July 2, 2015

We welcome back Patrick J. Smith of Ivins, Phillips & Barker. Pat discusses Michigan v EPA, a Supreme Court decision from earlier this week. Somewhat lost in the shuffle of the Court’s major decisions on ACA and same-sex marriage, Michigan v EPA is a significant administrative law case that may come into play when there are challenges to the validity of select tax regulations, including the Florida Bankers challenge to regulations requiring the reporting of interest income earned by non-resident aliens. Les

On Monday of this week, the last day on which it issued decisions for the current term, the Supreme Court issued its opinion in Michigan v. EPA. This case involved a challenge to the validity of a regulation issued by the EPA. The statutory provision that was at issue in the case directed the EPA to regulate hazardous air pollutant emissions by fossil-fuel-powered electric generating plants if the agency determined that regulating these emissions was “appropriate and necessary.” As part of its analysis, the agency determined that the annual cost for the generating plants to comply with this type of regulation would be $9.6 billion and that the direct annual health benefits of imposing this type of regulation would be $4 to $6 million. However, the agency also determined that “costs should not be considered” in making the decision as to whether it was “appropriate” to regulate these emissions. The agency determined based on other considerations that regulation of these emissions was “appropriate” and “necessary.”

The regulation was challenged on the basis that the EPA’s refusal to consider costs in making the decision as to whether regulation of these emissions was “appropriate” was improper. The D.C. Circuit rejected this challenge in a split decision, with Judge Kavanaugh dissenting from the conclusion that it was proper for the EPA to exclude costs from its decision-making on whether it was “appropriate” for the agency to regulate the emissions that were at issue in this case.

The Supreme Court, in a 5-4 decision, with the majority opinion written by Justice Scalia, reversed the D.C. Circuit and agreed with Judge Kavanaugh that the EPA was wrong to exclude any consideration of costs from its decision-making on whether regulation of these emissions was “appropriate.” While the challenge to the regulation was based on Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., nevertheless, the opinion also included significant citations to the Supreme Court’s 1983 landmark decision in Motor Vehicle Manufacturers Association v. State Farm Mutual Automobile Insurance Co., in which the Court provided important guidance on the Administrative Procedure Act’s “arbitrary and capricious” standard for courts to use in reviewing agency action.

The Court’s Analysis: Arbitrary and Capricious

In fact, the Court’s analysis began with an invocation of principles applicable under the arbitrary and capricious standard, rather than with Chevron:

Federal administrative agencies are required to engage in “reasoned decisionmaking.” “Not only must an agency’s decreed result be within the scope of its lawful authority, but the process by which it reaches that result must be logical and rational.” It follows that agency action is lawful only if it rests “on a consideration of the relevant factors.” Motor Vehicle Mfrs. Assn. of United States, Inc. v. State Farm Mut. Automobile Ins. Co., 463 U. S. 29, 43 (1983) (internal quotation marks omitted).

Only after this beginning did the Court turn to Chevron:

Chevron directs courts to accept an agency’s reasonable resolution of an ambiguity in a statute that the agency administers. Even under this deferential standard, however, “agencies must operate within the bounds of reasonable interpretation.” EPA strayed far beyond those bounds when it read §7412(n)(1) to mean that it could ignore cost when deciding whether to regulate power plants.

Thus, although Justice Scalia does not explicitly refer to the two steps of the Chevron test, the foregoing passage suggests that under that framework, this decision fits under step two rather than step one. The Court elaborated on its conclusion as follows, once again invoking State Farm rather than Chevron:

Congress instructed EPA to add power plants to the program if (but only if) the Agency finds regulation “appropriate and necessary.” §7412(n)(1)(A). One does not need to open up a dictionary in order to realize the capaciousness of this phrase. In particular, “appropriate” is “the classic broad and all-encompassing term that naturally and traditionally includes consideration of all the relevant factors.” 748 F. 3d, at 1266 (opinion of Kavanaugh, J.). Although this term leaves agencies with flexibility, an agency may not “entirely fai[l] to consider an important aspect of the problem” when deciding whether regulation is appropriate. State Farm, supra, at 43.

Read naturally in the present context, the phrase “appropriate and necessary” requires at least some attention to cost. One would not say that it is even rational, never mind “appropriate,” to impose billions of dollars in economic costs in return for a few dollars in health or environmental benefits….No regulation is “appropriate” if it does significantly more harm than good.

There are undoubtedly settings in which the phrase “appropriate and necessary” does not encompass cost. But this is not one of them. Section 7412(n)(1)(A) directs EPA to determine whether “regulation is appropriate and necessary.” (Emphasis added.) Agencies have long treated cost as a centrally relevant factor when deciding whether to regulate. Consideration of cost reflects the understanding that reasonable regulation ordinarily requires paying attention to the advantages and the disadvantages of agency decisions. It also reflects the reality that “too much wasteful expenditure devoted to one problem may well mean considerably fewer resources available to deal effectively with other (perhaps more serious) problems.” Against the backdrop of this established administrative practice, it is unreasonable to read an instruction to an administrative agency to determine whether “regulation is appropriate and necessary” as an invitation to ignore cost.

The decision in Michigan v. EPA is clearly an extremely important administrative law decision, and its importance is clearly not limited to the context of the particular statute at issue here or to regulations issued by the EPA. The degree to which agencies may or must consider cost in their issuance of regulations has been an important open issue.

While this case dealt most directly with the meaning of the term “appropriate” in a particular provision in a particular environmental statute, nevertheless, by emphasizing that it is not even “rational” for an agency to ignore costs when the costs of an agency action far outweigh the benefits of that action, this decision is broadly applicable to virtually any agency decision-making exercise. It is also significant that the Court distinguished one of its prior decisions which held that in a particular statutory context it was not appropriate for the agency to consider cost:

American Trucking thus establishes the modest principle that where the Clean Air Act expressly directs EPA to regulate on the basis of a factor that on its face does not include cost, the Act normally should not be read as implicitly allowing the Agency to consider cost anyway.

Thus, the fact that a particular statutory provision authorizing or directing agency action does not explicitly refer to cost as one of the relevant considerations does not by itself mean that cost is not relevant, unless the provision does explicitly refer to other factors and omits any mention of cost. However, the Court also explicitly limited its holding in one respect. It emphasized that it was not telling the agency, in this case at least, that a formal cost-benefit analysis was required:

Our reasoning so far establishes that it was unreasona­ble for EPA to read §7412(n)(1)(A) to mean that cost is irrelevant to the initial decision to regulate power plants. The Agency must consider cost—including, most importantly, cost of compliance—before deciding whether regulation is appropriate and necessary. We need not and do not hold that the law unambiguously required the Agency, when making this preliminary estimate, to conduct a formal cost-benefit analysis in which each advantage and disadvantage is assigned a monetary value. It will be up to the Agency to decide (as always, within the limits of reasonable interpretation) how to account for cost.

State Farm and Chevron

Michigan v. EPA is also significant for the way it blends State Farm and Chevron. Another significant administrative law issue that has been the subject of some uncertainty is the relationship between the State Farm analysis and the Chevron analysis. The D.C. Circuit has treated State Farm and Chevron step two as overlapping if not essentially equivalent. Michigan v. EPA clearly confirms the correctness of that approach. In this regard, another passage from Judge Kavanaugh’s dissent in the D.C. Circuit seems particularly relevant:

In this case, whether one calls it an impermissible interpretation of the term “appropriate” at Chevron step one, or an unreasonable interpretation or application of the term “appropriate” at Chevron step two, or an unreasonable exercise of agency discretion under State Farm, the key point is the same: It is entirely unreasonable for EPA to exclude consideration of costs in determining whether it is “appropriate” to regulate electric utilities under the MACT program.

Justice Thomas and Separation of Powers Issues

Another significant aspect of Michigan v. EPA is Justice Thomas’s concurring opinion. In a prior post, I discussed the Court’s decision in Perez v. Mortgage Bankers Association earlier this year, including the fact that Justice Thomas, in his concurring opinion in that case, for the first time expressed his view that the Auer deference principle, under which an agency is given deference for its interpretations of its own regulations, may be vulnerable to challenge as an unconstitutional violation of separation of powers principles. While his analysis in that concurring opinion by implication extended to Chevron as well as Auer, in his concurring opinion in Michigan v. EPA the application of that argument to Chevron becomes explicit.

Impact on Florida Bankers and Tax Litigation

Finally, there is the question of the potential application of the holding in Michigan v. EPA in tax litigation. While it is probably the case that in many challenges to tax regulations, the cost of compliance with the regulation may not be a realistic basis for challenge, there is no principled reason why in appropriate cases, the cost of compliance with a tax regulation might not form part or all of the basis for challenge.

A case that is currently pending in the D.C. Circuit, Florida Bankers Association, presents an example of a challenge to a tax regulation where the adverse economic impact that the challengers contend flowed from the regulation at issue was the major basis for their substantive challenge to the regulation. This case involved a challenge by bankers associations to regulations issued by the IRS that required banks to report to the IRS information regarding the amount of interest income earned by non-resident aliens on accounts with the banks, even though such individuals are clearly not subject to U.S. tax on that income. The IRS argued that this information reporting was justified on the basis that it was necessary in order for the U.S. to comply with information sharing agreements it has entered into with other countries regarding interest earned in each country by citizens of the other country.

The bankers associations argued that because of fears by non-resident aliens that the information reported to the IRS would be misused by their home countries, such non-resident aliens would respond to the regulation by withdrawing substantial amount of funds from U.S. banks, thus harming the banks and the U.S. economy. The bankers associations claimed that the IRS in issuing this regulation had incorrectly concluded that the magnitude of such withdrawals would be minimal, and that this error violated the arbitrary and capricious standard.

The district court rejected this challenge, and the bankers associations appealed to the D.C. Circuit. Judge Kavanaugh is on the D.C. Circuit panel that heard oral argument on this case in early February. In light of Judge Kavanaugh’s involvement in the D.C. Circuit opinion that was reversed by Michigan v. EPA, it seems likely that the D.C. Circuit decision in Florida Bankers was held waiting the Supreme Court’s decision. If this speculation is correct, then it seems likely that Michigan v. EPA will play a significant role in the D.C. Circuit’s decision in Florida Bankers.

In a recent Tax Notes article and in prior posts here, I discussed the Anti-Injunction Act issue in Florida Bankers, and the fact that it seems likely that the D.C. Circuit opinion in the case will provide insight on whether I am correct that the Supreme Court’s decision in March in Direct Marketing will mean that the Anti-Injunction Act will be read more narrowly in the future than it has been. The Supreme Court’s decision in Michigan v. EPA provides another reason to look forward to the D.C. Circuit decision in Florida Bankers with anticipation.

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