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Petaluma FX v. Commissioner: The D.C. Circuit Erases Temporary Regulations

Posted on July 20, 2015

We welcome back guest blogger Andy Grewal who discusses the DC Circuit’s recent decision in Petaluma.  Keith

It took more than 7 months from the close of oral arguments, but the D.C. Circuit finally issued its decision in Petaluma FX v. Commissioner.  The unusually long wait shouldn’t be surprising, given that the case involved some open questions of tax and administrative law, which I’ve discussed here and here. However, the long wait for guidance was apparently for naught, because the D.C. Circuit resolved the case through a strange reading of a TEFRA regulation’s effective-date provision.  In doing so, the court avoided the broad questions raised in Petaluma’s brief, but it unwittingly stepped into a thicket of issues related to Treasury’s authority to issue retroactive regulations.

In Petaluma, the taxpayers argued that the Tax Court lacked jurisdiction over its sham partnership.  Although Section 6233 grants the Treasury the authority to issue regulations extending TEFRA to sham partnerships, Petaluma argued that the relevant regulations (Temp. Regs. 301.6233-1) failed to comply with the APA’s notice and comment requirements.  Those regulations, issued in 1987, remained on the books until they were finalized in 2001, after the tax year at issue in the case.

The government did not meaningfully dispute that the temporary regulations governed the jurisdictional question.  However, it argued that the regulations satisfied the APA.  To determine the validity of the temporary regulations, the D.C. Circuit thus had to explore the relationship between tax and administrative law.

But in a surprise move, the D.C. avoided that task.  It concluded, contrary to both parties, that the 2001 final regulations applied retroactively to Petaluma’s 2000 tax year, making the taxpayers’ procedural challenges to the temporary regulations irrelevant.  Petaluma had to prove some defect in the final regulations, but it had not done so.  The D.C. Circuit’s prior opinion in Petaluma held that the temporary regulation controlled the controversy and the government was on board with that view, so Petaluma understandably never presented a challenge to the final regulations.

My new article in Bloomberg BNA,Petaluma Takes a Bizarre Turn,” explains the flaws in the court’s analysis.  In brief, the D.C. Circuit failed to heed the final regulation’s preamble and applied a strange construction to its effective-date provision.  The preamble plainly states that the final regulations “apply to unified partnership proceedings with respect to partnership taxable years beginning on or after October 4, 2001” and, for prior years, taxpayers “are directed to the temporary regulations.” T.D. 8965, 66 F.R. 50541, 50544 (Oct. 4, 2001).  This leaves no doubt about the Treasury’s intention to issue the final regulations prospectively, but the D.C. Circuit did not even cite the preamble.

The body of the regulation seemingly parrots the preamble, saying first that the final regulations apply to future tax years and then saying that taxpayers should look to the temporary regulations for prior years.  See  Reg. 301.6233-1(d) (“This section is applicable to partnership taxable years beginning on or after October 4, 2001. For years beginning prior to October 4, 2001, see § 301.6233-1T contained in 26 CFR part 1, revised April 1, 2001.”).  However, the D.C. Circuit read the second sentence as incorporating the temporary regulations into the final regulations via cross-reference.  As detailed in my BNA article, that interpretation suffers from a technical flaw.

The temporary regulations, not the final regulations, should have controlled the controversy, and the court’s contrary and erroneous holding stemmed from its inquisitorial approach.   When a court independently raises a dispositive issue after oral arguments and never seeks briefing on that issue, mistakes are inevitable.

Petaluma leaves one wondering why the court would take such unusual steps to resolve the case.  The D.C. Circuit might have believed that its reading of Final Reg. 301.6233-1(d) allowed it to avoid some of the fundamental questions raised in Petaluma’s brief, but its holding actually implicates complex issues of administrative law.  The court held that the final regulation applies retroactively to “all tax years,” Slip Op. at 14, but it made no mention of the special issues raised by this retroactivity.

As my BNA article explains, the court’s facile extension of the final regulations to prior tax years raises serious concerns.  Although the Treasury may generally enjoy the authority to issue retroactive regulations, the issues are far more complex where, as here, the governing statute is not self-executing and where the final regulations purportedly cure defects in prior regulations.  However, these special issues received no attention from the court.

In dismissing the taxpayers’ challenge, the D.C. Circuit emphasized that, upon publishing the final regulations, the Treasury removed the temporary regulations from the books.  In the court’s view, this established that those regulations were of “no continuing significance” and were “no-longer-operative.”  Slip Op. at 15.  The temporary regulations enjoyed force only because they were cross-referenced in the final regulations.

This strange analysis could create massive problems for the government.  In Petaluma, the dismissal of the temporary regulations did not hurt the IRS because the final regulations allegedly incorporated the otherwise-defunct temporary ones.  But there are various final regulations that remove and replace temporary regulations, and the body of those final regulations might not always contain alleged cross-references of the type seen in Reg. 301.6233-1(d).  Rather, the Treasury may cross reference temporary regulations only in the Preamble of the final regulations.

In these circumstances, a final regulation’s removal of temporary regulations could nullify the effect of the temporary regulations for prior tax years.  That is, if temporary regulations were in effect from, say, 2008 to 2010, and final regulations are issued in 2011, taxpayers who are engaged in disputes concerning their 2008-2010 tax years can legitimately argue that the temporary regulations no longer apply.  After all, the Treasury will likely have removed the temporary regulations from the books, and Petaluma is quite clear about the consequences of such removal.

Taxpayers should thus closely examine any temporary regulations that have been replaced by final regulations, especially when the governing, taxpayer-adverse statute depends for its effect on regulations.  In this situation, the removal of the temporary regulations would retroactively eliminate the IRS’s ability to enforce the statute, unless the temporary regulations are cross-referenced in the body of the final regulations.

I don’t think this is a terribly sensible result because in legal drafting, it’s quite common to remove provisions even though they remain effective.  When amending the tax code, for example, Congress routinely replaces a particular section or subsection.  Yet no one seriously suggests that that removal renders the section or subsection ineffective in disputes over prior tax years. Nonetheless, Petaluma clearly gives enterprising taxpayers some ability to disregard temporary regulations, at least in litigation that might end up in the D.C. Circuit.  I would not recommend planning a transaction under this approach, but once a matter has reached the dispute stage, it makes sense to deny the effect of any adverse temporary regulations that have been scrapped from the books and for which no final regulation makes a cross-reference.

Petaluma should also provide some measure of encouragement for taxpayers who wish to present arguments along the lines of those contained in the taxpayers’ brief.  That is, rather than go through the gymnastics with the final regulations, the court could have simply rejected the challenge to the temporary regulations.  The court’s decision not to do so reflects some acknowledgement regarding the seriousness of those challenges.  In other words, taxpayer challenges to temporary regulations remain viable in the D.C. Circuit, except where they have been subsequently removed by final regulations in circumstances similar to those in Petaluma.

The court also left the door open to challenges regarding Reg. 1.6662-5(g), which extends the gross valuation misstatement penalty to zero-basis circumstances.  I explained the defects in that regulation here and also debated my conclusions with attorney Michael Schler in Tax Notes.  During oral arguments, the D.C. Circuit seemed hostile to the taxpayers’ arguments, but rather than reject them, the court deemed the arguments waived.  Petaluma thus adopted a cautious approach and reserves on the validity of Reg. 1.6662-5(g). Slip Op. at 18.

It’s unclear whether Petaluma will provide the last word on the Section 6233 temporary regulations.  The taxpayers still have time to petition for a rehearing, but it’s unknown to me whether they intend to do so.  Petaluma suffers from faulty legal analysis, so perhaps the court will be receptive to correcting its mistake.  Nonetheless, the D.C. Circuit almost always leaves its panel decisions undisturbed.  Thus, a petition for panel rehearing or an en banc petition would face uphill battles.  However, I’m aware of at least one other circuit that is considering a challenge to the Section 6233 regulations and may blog about it as the case develops.

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