Tax Notes logo

Taking a Hard Look at Court Review of Treasury Regulations

Posted on Dec. 16, 2016

As the holiday season is upon us, we are also in the season of lists: best movies, books, songs, to name a few. We have not taken the plunge with a post discussing our top posts of the year though my suggestion is just search Keith Fogg and pick up the last ten posts for a good place to start.

No doubt one of the most important tax procedure cases of 2015 and beyond is Altera, which Susan Morse and Stephen Shay discussed most recently in Treasury on the Right Side of the APA in Altera and in one of our most read posts of 2015 in Pat Smith’s A Massive Loss and a Huge Rebuke for the IRS from the Tax Court in Altera Decision. As our readers likely recall, in Altera, the Tax Court unanimously rejected parts of regulations under Section 482 requiring related parties to share stock based compensation costs. The case has major significance beyond the substance because it marked the first time that the Tax Court specifically held that Treasury regulations, whether issued under a grant of general authority or under a specific statutory mandate, were subject to the APA’s notice and comment requirements. After opening that door, the Tax Court applied a “traditional” administrative law arbitrary analysis under APA § 706(2)(A), which empowers a court to invalidate a rule that is “arbitrary” and “capricious.”  In invalidating the regulation, the Tax Court relied on case law including the 1983 Supreme Court State Farm decision which essentially imposed on agencies rulemaking principles embedded in the 1943 Supreme Court Chenery decision. Chenery stands for the general proposition that courts should evaluate agency action based on the reasons that motivated the agency at the time of the agency’s original action, rather than allow agencies to come up with after the fact explanations to justify earlier agency conduct.

IRS has appealed Altera and the case is teed up in the 9th Circuit. No matter how the case is resolved, the battle over the validity of Treasury regulations and other IRS guidance is one that is likely to place the courts in the difficult position of applying administrative law principles to test the procedural soundness of the agency’s conduct in issuing guidance.

With that in mind, I noted with interest Arbitrariness Review Made Reasonable: Structural and Conceptual Reform of the Hard Look, an article in the current Notre Dame Law Review by administrative law scholars Sidney Shapiro and Richard Murphy. In the article, Professor Shapiro and Professor Murphy provide a comprehensive history of how under the arbitrary standard in APA § 706(2)(A) court review of agency rulemaking morphed from a relatively light touch to a more thorough hard-look requiring that “an agency must establish that, at the time it took its action, it had a contemporaneous rationale sufficient to satisfy the requirements of ‘reasoned decisionmaking.’”

After detailing the ways that courts have shifted from a light touch, the authors make the policy argument and argue against the modern hard-look review that the Tax Court appears to be employing in Altera:

In the abstract, nothing could sound more reasonable than for courts to insist that agencies actually base their actions on good reasons. As implemented, however, modern arbitrariness review has made the rulemaking process unduly onerous and time-consuming, with important rules often taking many years to complete. Once completed, these rules are then subject to judicial review that can be political and unpredictable, making it difficult for agencies to guess whether an explanation for a rule will be upheld under hard look review. This state of affairs is all the more problematic given agencies’ notorious lack of sufficient resources to carry out their assigned statutory missions.

The authors propose allowing the agencies the opportunity to defend the substance of rulemaking on reasons that were not necessarily the ones the agency relied on in proposing the rules in the first instance:

[T]his Article proposes a simple reform that may, on first hearing, sound heretical but that proves to have surprisingly strong roots in both the history of administrative law and current judicial practice. Specifically, courts should relax their bar on post hoc rationales, allowing agencies to rely upon them so long as they are based on information exposed to outside scrutiny during the notice-and-comment process.

There is lots in this article, and I have not fully digested it nor the many proposals that administrative law scholars have offered over the years to cut back on the excesses of court review of agency rulemaking. As the authors make clear, the APA is riddled with at times competing values, and with hard-look review, “the courts advanced legitimate administrative law values, including accountability, accuracy, and fairness, but with a loss of agency effectiveness and efficiency, which are also administrative law values of the first rank.”

Finding the balance between these at times competing values is now what courts will be doing when evaluating Treasury regulations and perhaps subregulatory guidance as well. In IRS’s Budget Likely ‘Miserable’ for 2017 and Beyond [free link not available] earlier this week BNA’s Daily Tax Report reported how the prospects for IRS budgets in the near and mid-term look pretty bleak. To be sure, some fear a more efficient IRS and Treasury, and would be happy to tie the agency up in knots to ensure that the agency cannot promulgate rules that some view as overreaching. No doubt that the inclination to impose onerous process requirements on Treasury is at least atmospherically related to how far Treasury deviates from a clear statutory mandate to issue guidance. Yet as courts wrestle with some of these principles in cases of first impression we should be worried about hamstringing an agency that has a vast and complex statutory regime to administer, and often not enough resources to do all that Congress and taxpayers expect.

Subject Areas/Tax Topics
Copy RID