Abstract
Since the 2011 decision in Mayo Foundation for Medical Education & Research v. United States that the Supreme Court will not carve out an exception from the Administrative Procedure Act for tax, judges and scholars have debated the application of administrative law to the field of tax. However, these two groups often only incompletely engage with each other. Even within the academic discussion, articles do not always fully engage in a true discussion of ideas. These articles do show that academics are firmly entrenched on each side of this tax exceptionalism debate, about whether tax is or should be permitted special exceptions to generally applicable procedural rules. A review of cases decided since Mayo shows that it is inaccurate to say that there has been an end to tax exceptionalism, but it is true that there is debate over its acceptance in many different issues related to taxation. In some areas, tax exceptionalism is truly dead; in others it remains well-entrenched. This Article lays out the existing debate among judges and academics and then struggles to find common ground.
I. Introduction
An ideal tax system might assess tax liabilities based on what each person can afford to pay calculated according to a metric that all taxpayers accept. Instead, most governments strive to create generally applicable tax systems. Those generally applicable systems grow beyond their operating statutes because statutes invariably contain ambiguity in their language or their application to particular taxpayers. Therefore, guidance is created to enable the tax system to apply more generally. Guidance may also be needed because the legislature delegates to the tax administrative agency the discretion to create part of the tax system. These two reasons for guidance—ambiguity needing explication or purposeful gap-filling—creates different justifications for tax guidance.
In both circumstances, tax guidance is a necessary tool for the tax system to be administered. One tax professor turned circuit court judge included, on his list of attributes that have shaped the federal income tax, “a practical and workable tax system” and stated further that “[t]he importance of this criterion is so well established that its application has become, through habit, almost mechanical.” One could debate whether administrability is less important than other important goals of taxation, such as equity and efficiency. However, only a properly administered tax system can accomplish its other objectives. It is for this reason that practicality may be given significant weight. It is often recognized in developing countries that “[t]he best tax policy in the world is worth little if it cannot be implemented effectively,” but that truth exists as well in developed nations.
With tax guidance’s importance to the administration of the tax system, how it is created has been an issue found worthy of debate since well before the Supreme Court decided, in the 2011 decision in Mayo Foundation for Medical Education and Research v. United States, that it was “not inclined to carve out an approach to administrative review good for tax law only.” Mayo’s attack on tax exceptionalism in the administration of the tax system, and consequently on the tools used in such administration, has percolated through many cases. The post-2011 debate explores the exact meaning or requirements of administrative process in the area of tax law. Several cases have received significant attention, but several hundred cases raise issues of the application of the Administrative Procedure Act (“APA”) to tax, as shown in a survey of federal cases on Westlaw conducted in November 2023. Courts are developing the law based on the particular facts of the cases before them. Therefore, it should not be surprising that the law is not developing uniformly.
Courts have decided cases and academics have debated the merits of both the cases and the underlying theory of administrative procedure. Judicial opinions can be placed along a spectrum on these issues; while academics have formed two camps, seemingly at bitter odds on the value of requiring additional process and different process in the creation of tax guidance. Courts sometimes, but rather infrequently, reference the academic debate.
It is critical that the dialogue between bench and ivory tower improve for there to be the best development of this area of law. Academics are thinking through these issues broadly and have sufficient opposing views to allow judges to see many different aspects of these issues. The difficulties academics face in order to participate in judicial discussions—which can occur only if courts permit the filing of amicus briefs—underscores a dangerous tendency in our democracy to devalue higher education and the professors that lead it. This tendency is more troubling as academics strive to continue a respectful dialogue, but some members of the bench (unfortunately) have issued harangues against taxation and the Internal Revenue Service (the “Service”). If nothing else, I think academics must continue to model a respectful, if contentious, debate on these issues critical to the operation of the tax system.
To encourage greater collaboration on these important issues, this Article has three objectives. In Part I, it examines what courts and the Treasury Department have said at various intersections of administrative procedure and tax law since 2011. Five different groups of cases are highlighted: the deference to be given to tax guidance, the validity of Notices that do not go through the APA’s notice-and-comment procedure, what is required for regulations to survive an APA arbitrary-and-capricious review, the Treasury Department’s use of temporary regulations, and the applicability of reasoned decision making to deficiency notices. The government has had some success in litigation but not consistently across issues. A scorecard would show that the APA is not universally changing process requirements, but it has changed the way tax guidance is created.
Part II reviews the academic literature on these issues that has been published since Mayo. This debate has two sides that are neither balanced nor monolithic. At times the opposing sides talk past each other, a style unfortunately continued in the structure of this Part for ease of comprehension. Each group of positions is, thus, set out in turn. Nevertheless, many good arguments have been framed, much good information has been compiled, and empirical studies begun and some completed.
Part III explores the common ground that exists between academics. The stated goal for everyone is the creation of good guidance; the disagreement is what that means and how best to achieve it. That the goal is in furtherance of a workable regime that provides taxpayers good information is not a small thing. Although some taxpayers may seek to dismantle the tax system, that is not the accepted academic position. Most academics strive (at least most of the time) to not depict the Service or the Treasury Department as the bad guy. Some judges, however, do not share that disposition and (unfortunately) do not maintain a neutral tone in analyzing the issues before them. This Part then lists some next steps to further the academic debate. It urges judges to review that debate and, no matter where a judge comes out on the issues, to respect the agency tasked with raising our government’s revenue and to center the role of administration in the application of the tax law.
Lurking behind much of this discussion of tax guidance and the APA is that there are two primary sources of administrability concerns in the tax system: in enforcement and in taxpayer compliance. These two aspects are in tension in most realistically funded systems. The more money spent in enforcement, the less that is available for increasing pre-filing outreach and services. Additionally, when a system becomes so complex as to make administration in either area difficult or nearly impossible, the system arguably cannot be said to advance the rule of law. This is the risk we are running with the modern federal tax system. This theoretical concern underpins questions of how to balance process and the costs of that process. This Article, thus, questions the extent to which a law can be said to be binding without thoughtful consideration of its future administration.
One way to reconcile the two aspects of administration is by reframing the purposes of administration to reflect an examination of a taxpayer’s tax burden compared with other taxpayers’ burdens. Many people view tax administration as taxpayer versus the government in that one taxpayer’s burden is evaluated as what that taxpayer pays or does not pay. Unsurprisingly, this is the basis for all of the tax litigation discussed in Part I. However, changing the framing of the consideration to larger issues shows that selective relief of taxation, possibly through the failure to create tax guidance that would support the government’s revenue-raising function, means that some taxpayers pay relatively more in taxes than the person relieved.
This problem of relative tax burdens is not necessarily addressed by increasing process. Even if the goal is to create a transparent system with significant input from the public in its creation, that alone does not solve inequitable or inefficient application of the law. Moreover, if changing the process required of tax authorities results in selective tax reduction or the creation of less guidance, it may change relative taxation without the public’s recognition of (or participation in) that fact.
II. Where We Are Today
Congress granted the Secretary of the Treasury, and subsequently the Secretary’s designees, the authority to “prescribe all needful rules and regulations for the enforcement” of the Code. Consequently, the Treasury Department and the Service, as a bureau within the Treasury Department, issue significant amounts of guidance. Although most tax regulations proceed through the APA’s notice-and-comment process, few adhere to a strict form of notice and comment before their issuance, and, in addition, the Service issues a lot of sub-regulatory guidance that has historically been excepted from notice and comment.
That guidance is now subject to challenge for its compliance with administrative procedure. The Government Accountability Office has found that the Treasury Department makes an effort to comply with the APA and “demonstrate[s a] willingness to listen to taxpayers and consider potential changes to regulations,” but it has not fully addressed the full range of its procedural obligations, some imposed by the executive rather than Congress. How sufficient that response has been is for courts to determine as cases percolate through litigation. The levels of deference to be given to, and the amount of process required of, these various forms of guidance and to final agency actions has seen significant litigation since 2011. This Part looks closely at cases involving deference to tax guidance; the Service’s use of notices which do not go through notice and comment; the requirements for notice and comment for regulations; the requirement that regulations not be arbitrary and capricious; the Treasury Department’s use of temporary regulations; and deficiency notices.
A. Deference to the Taxman
A seminal case in 2011, Mayo, resolved as a doctrinal matter that courts should apply the Chevron standard to tax regulations rather than the less deferential standard established by the earlier case of National Muffler. Therefore, despite launching what has since developed into broad-based attacks on the procedures used in tax matters, Mayo was a win for the government. In a case over regulations that defined medical residents as employees rather than students for purposes of the FICA tax, the district court had sided with the taxpayer on the grounds that the statutory terms were not ambiguous and that, consequently, the regulations were invalid. The Eighth Circuit and the Supreme Court disagreed, with the Supreme Court wanting a uniform administrative rule regarding the validity of agency regulations—the so-called Chevron standard—to apply to both tax and non-tax areas. Mayo did not, however, define the scope of its call for administrative uniformity.
Despite Mayo’s statement of the law, issues of deference and the degree of deference required by Chevron remain uncertain, much as Chevron remains a complicated issue of law for all agencies. Not all cases get past the initial review of Chevron’s step one. For example, in Loving v. Internal Revenue Service, which involved regulations regulating tax return preparers, the district court noted that the regulations were “[t]o close a gap in the federal oversight of tax professionals” and that the “Court does not gainsay the importance of such regulation in a field of over 80 million tax returns; indeed, it may very well have significant salutary effects in several related areas.” Nevertheless, the court held that the Treasury Department did not have the statutory authority under an 1884 statute to require the competency testing, continuing education, and ethics requirement imposed by the regulations under a Chevron step one analysis.
The D.C. Circuit’s opinion, written by then-Judge Brett Kavanaugh, applied Chevron review to find that there was no statutory authority despite sounding sympathetic to the government’s position. The opinion noted that “[t]he federal income tax code is massive and complicated.” Nevertheless, the district court subsequently awarded attorney’s fees to taxpayers because the government’s position was not substantially justified. At the same time, “[t]he Court will not diminish the difficulty of Plaintiffs’ accomplishment simply because their victory turned out to be so sweeping.”
Similarly, courts might read into regulations various requirements that it prefers were there. In Duquesne Light Holdings, Inc. v. Commissioner, a corporate taxpayer relied on the consolidated return regulations to duplicate $199 million of loss deductions. The Third Circuit read into the regulations a rule that clearly did not permit double deductions, eliciting a strong dissent that argued that the regulations were clear and that the agency just regrets them. An informal notice cannot, according to the dissent, alter the plain language: “To allow otherwise would frustrate the scheme of the Administrative Procedure Act, essentially permitting the IRS ‘to create de facto a new regulation’ through the back door.”
Issues of deference also arise for lower levels of tax guidance. A Notice describing a tax evasive transaction was given deference for purposes of determining penalties. The Fifth Circuit said that a Notice has “less weight than a statute or regulation, but it is authority nonetheless.” This deference can trickle down to even lower levels of guidance. In one instance, the Service acknowledged that its instructions were ambiguous, but the Tax Court found that this “cannot affect the operations of the tax statute or petitioners’ obligations thereunder” and noted that the Service had published a Notice with detailed guidance the year before taxpayers filed their return.
Nevertheless, to date these lower-level guidance pronouncements are not given deference, although at least one court has permitted a taxpayer to avoid penalties on the grounds that Instruction for Form 1040 was a basis for reasonable reliance. The lack of deference often works against taxpayers. In Bobrow v. Commissioner, a taxpayer rolled over two Individual Retirement Accounts (IRAs) within a one-year period on the basis of advice that section 408(d)(3)(B) applied per IRA. Although neither party mentioned it, IRS Publication 590, Individual Retirement Arrangements, explicitly sanctioned the taxpayer’s interpretation. Nevertheless, the Service prevailed on the matter of the rollovers and subsequently revised Publication 590. The court warned that “taxpayers rely on IRS guidance at their own peril.” The Treasury Department issued a policy statement in 2019 assuring the public that it would not seek judicial deference for subregulatory guidance and, to improve transparency, the Service updated the rules for its FAQs to permit taxpayers’ reliance on administrative pronouncements to eliminate penalties but not to avoid paying taxes properly owed.
An issue similar to the proper amount of deference a court should give to Treasury Department- and Service-created guidance is the extent to which tax guidance is carved out of Executive Level inter-agency review. In other words, do the other parts of the executive branch owe deference to the tax authorities? Until recently, tax exceptionalism was pretty much the norm in this area. But, in 2018, the Treasury Department and the Office of Management and Budget entered into a memorandum of agreement that reconsidered the scope of the exemption of tax regulations from Office of Information and Regulatory Affairs (OIRA) review that had been granted in a 1983 memorandum and a 1993 letter. President Donald Trump’s Executive Order 13789 had directed the agencies to reconsider the earlier exclusion of many tax regulations and, in response, the Treasury Department agreed to submit guidance for review if it has an effect on the economy of $100 million or more. However, a 2023 memorandum of agreement reversed course and clarified that tax regulation are not subject to the OIRA review.
In 2021, the Government Accountability Office (GAO) completed a study looking at international rules promulgated under the Tax Cuts and Jobs Act of 2017, and the GAO concluded that Treasury Department regulations should be subject to more extensive executive review. In particular, the GAO found that, between December 2017 and October 2020, the Treasury Department and the Service proposed eight regulations and finalized six of them implementing four international provisions, and it concluded that the agency did some procedural work to comply with the APA but “did not fully address”: (i) the Congressional Review Act to permit Congress to review regulations before they take effect, (ii) the Regulatory Flexibility Act to address concerns that small entities may be disproportionately affected, or (iii) the Paperwork Reduction Act to minimize the burden of information collection requiring information be submitted to the OIRA.
In short, the amount of deference that courts and executive departments should give to various forms of tax guidance is still very much an open issue, and the full effect of Mayo remains to be seen.
B. Notice(s) of Displeasure with Pre-Enforcement Review
In its 2021 decision in CIC Services, LLC v. Internal Revenue Service, the Supreme Court examined the reach of Mayo and general administrative law processes in the context of the Service’s use of Notices. The Service has increasingly used Notices to inform the taxpaying public of its positions. This is likely a strategic as well as a financial decision. The Service posits that Notices are equivalent to Revenue Rulings, and they are created by the Service’s National Office without the more costly public comment period used for regulations. In 2018, almost 63% of Notices contained purely procedural or ministerial matters, 19% introduced regulations or proposed regulatory language that taxpayers could rely upon, and the remaining ones dealt with other announcements. Since Mayo, taxpayers have challenged Notices that they argue are substantive and change taxpayer rights and obligations but are issued without following the APA’s notice-and-comment procedure.
CIC Services challenged Notice 2016-66’s third-party reporting requirement for tax advisors who facilitate certain micro-captive insurance transactions. The Service did not use notice-and-comment procedures when creating the Notice. At first blush, this administrative issue was not going to be addressed because the district court ruled that the challenge was barred by the Anti-injunction Act (the “AIA”), inasmuch as the Code’s plain language made the penalty for failing to satisfy the reporting requirements a tax for AIA purposes. The AIA precludes lawsuits brought ”for the purpose of restraining the assessment or collection of any tax” except as otherwise authorized by the Code. The Sixth Circuit affirmed the district court’s conclusion that the AIA precluded the suit, although it complained that “Defendants ‘do not have a great history of compliance with APA procedures . . .’” and quoted Professor Kristin Hickman. Judge John Nalbandian dissented on the ground that the reporting requirement was not a tax but was, instead, information gathering that may (or may not) result in tax, and so the AIA should not apply. He was troubled that the government gave taxpayers the binary choice to comply or violate the law and, thus, “risk financial ruin and criminal prosecution.” The Sixth Circuit denied the plaintiff’s ensuing petition for rehearing en banc, but the presence of two concurrences and a dissent (discussed in detail in Part III below) highlighted the tension on the court.
The Supreme Court stepped into this morass, with Justice Elena Kagan’s majority opinion referencing Professor Hickman in the first paragraph of her opinion and concluding that a potential penalty is not a tax, and, therefore, could be reviewed under the APA because the AIA did not apply. Justice Kagan avoided grand pronouncements and emphasized the facts of the particular third-party reporting requirement at stake in the case. If Congress had legislated it, Justice Kagan wrote, the AIA would have applied. Key to the decision was the fact that the purpose of the plaintiff’s challenge was to set aside the Notice rather than to avoid the tax penalty, and Justice Kagan concluded that, as such, this was not a big threat to the tax system because of its limited reach to the normal regulatory process. Justice Sonia Sotomayor concurred, remarking that the Court’s conclusion might well have been different if CIC were a taxpayer rather than a mere advisor. Justice Kavanaugh also concurred (which is especially noteworthy because, as a circuit court judge, he had emphasized the sweeping nature of the AIA), and therefore opined that the Court was carving out a new exception to the AIA.
On remand, the district court vacated the asserted penalties on the ground that the legislative rule imposing the penalties was invalid because the rule was issued without the required notice-and-comment procedures. “While the IRS may ultimately be correct that micro-captive insurance arrangements have the potential for tax avoidance or evasion and should be classified as transactions of interest, the APA requires that the IRS examine relevant facts and data supporting that conclusion.” This opened the door to procedural challenges for guidance deemed substantive.
Before CIC Services, courts were divided as to whether the AIA would preclude this type of pre-enforcement challenge. Although the Supreme Court generally interprets the APA as having a presumption in favor of pre-enforcement judicial review of agency rules and regulations, the AIA operated to defer judicial review of tax cases until post-enforcement refund and deficiency actions. This requires individuals or entities seeking to challenge the validity of a Treasury regulation or Service rule to first pay the tax and then seek a refund or else challenge a Service assessment via a Tax Court deficiency proceeding.
Since Mayo but before CIC Services, the D.C. Circuit had, at times, embraced a narrower reading of the AIA. Cohen v. United States involved a Notice setting forth the process required to claim a refund for telephone excise taxes that the Service admitted it should not have collected. In Cohen, the taxpayers challenged the Notice on the basis that the Notice violated the APA. Before Mayo was decided, the district court held that it lacked jurisdiction and that the taxpayers had failed to state a claim under the APA. According to the court, the Notice was merely a statement of IRS policy and did not carry the force of law.
The D.C. Circuit, sitting en banc, reversed the district court in Cohen under the APA. Citing Professor Hickman, and presaging the result in CIC Services, the D.C. Circuit concluded that “the fight is over process, not disputed funds.” According to the court of appeals, through the Notice the Service had made commitments that curbed its discretion, so the Notice binds it and alters legal obligations. Judge Kavanaugh’s dissent held that taxpayers should have exhausted the administrative process. “Approximately 90 million Americans followed these simple instructions and promptly received their refunds.” He (somewhat counter-intuitively) cited Professor Hickman twice for the lack of the power for judicial review but noted that this choice is odd. “It is true that Professor Hickman argues for changing the state of the law, but she acknowledges frankly that it ‘is perhaps quixotic to suggest that the courts rethink doctrine firmly rooted in 40 years of jurisprudence.’”
The D.C. Circuit focused only on the AIA issue and whether it had the authority to hear the case. It decided that the suit was not to restrain the assessment or collection of taxes: “The IRS envisions a world in which no challenge to its actions is ever outside the closed loop of its taxing authority.” Arguing for administrative law uniformity, the D.C. Circuit’s majority concluded that “[t]he IRS is not special in this regard; no exception exists shielding it—unlike the rest of the Federal Government—from suit under the APA.” As the majority opinion went on to say, “Allowing Appellants to proceed without first filing a refund claim will not open the courthouse door to those wishing to avoid administrative exhaustion procedures in other cases.” “There may be good policy reasons to exempt IRS action from judicial review. Revenue protection is one. . . . But Congress has not made that call.”
Since CIC Services, taxpayers have won their challenges to the use of Notices for defining listed transactions under section 6011. Expanding CIC Services to taxpayers using other abusive (at least in the Service’s eyes) schemes, the Sixth Circuit, in Mann Construction, Inc. v. United States, invalidated a Notice covering life insurance in trust on the grounds that the Notice was a legislative rule creating “new substantive duties” subject to the APA and not exempt from notice and comment. Consequently, the taxpayer there did not have to disclose the transaction despite the 15-year-old guidance. The Sixth Circuit overturned the district court, which had earlier granted the government summary judgment. Although the court of appeals concluded this substantive rule needed to comply with APA procedures, the lower court concluded that even if a reporting regime sweeps more broadly than necessary, it is not necessarily arbitrary and capricious, and that the requirement (and ensuing penalty) did not arise from the Notice.
The conflict between courts arose in Mann Construction over the extent to which Congress had been aware of, and had blessed, the procedures adopted by the Service. The district court ruled that Congress had authorized the Serviceto promulgate the Notice without notice and comment, noting that Congress has had many opportunities to change the law if it did not agree with the Service’s procedures. The three-judge panel of the Sixth Circuit reversed, referencing Mayo: “[t]he question is whether Congress amended the APA’s prerequisites, not whether the IRS did. While the cross-reference is probative of whether Congress was aware of the IRS’s transaction-listing procedures, it does not alone suffice to show an express exemption from the APA procedures.” After the Service voluntarily refunded the penalties, the Sixth Circuit reversed the district court’s nationwide injunction against enforcement of the Notice on the grounds that the refund mooted the case. Therefore, although it is likely that the government is held to a higher standard in the Sixth Circuit, the parameters of that standard remains unkown.
Similarly, in Green Valley Investors, LLC v. Commissioner, the Tax Court threw out a Notice requiring disclosure of conservation easement transactions. Acknowledging the large amount of tax revenue at stake, a minimum of a $22.5 million deduction for each of four taxpayers, the majority disagreed that Congress had authorized the different process. Unlike in Mann Construction, the court concluded that there was no reason to think Congress knew of the Service’s process and “we believe that Congress operates under the expectation that administrative agencies respect their APA obligations . . . .”
Opinions issued by other judges in Green Valley reached different conclusions regarding the government’s adherence (or not) to APA procedures. On one hand, Judge Pugh’s concurrence argued that Congress had added the APA on top of the Service’s earlier processes because the requirements were not incompatible. On the other hand, Judge Gale’s dissent, citing to this Author, agrees that the Notice is a legislative rule but that Congress had exempted it from the notice-and-comment process. Judge Nega’s dissent agreed with Gale, arguing that this legislation was in a framework of Congress trying to shut down this type of transaction. “Congress was aware of the IRS’s rulemaking in this area when it enacted the [American Job Creation Act (AJCA)] to bolster the IRS’s efforts by adding a penalty to the existing regime.”
Most recently, in Govig & Associates v. United States, the issue concerned Notice 2007-83 and whether the AIA prevented the taxpayer’s challenge. The court permitted the challenge under the APA despite the AIA because the Notice levied an affirmative reporting obligation. Thus, the taxpayers could maintain a suit to set aside the Notice. Concluding this was not a tax and that a taxpayer ignoring it faced the possibility of criminal prosecution, the court stated that the tax refund process was an insufficient alternative. The taxpayer still lost its procedural challenge because it was time barred by six years, but the taxpayer was permitted to challenge the substance of the Notice in that it was too vaguely worded and the Service lacked the statutory authority to issue it.
Despite Justice Kagan’s desire to limit the reach of CIC Services, these rulings may signal its wider application to the extent it operates anywhere tax revenue is not the only goal. In other words, all reporting provisions could be suspect, in particular if there is the possibility of criminal sanctions no matter how unlikely that possibility. Since CIC Services, as discussed herein courts have struck down Notices for listed transactions, although dissents continue to be issued.
Notices stating an intent to issue future regulations face queries because they affect taxpayer behavior, although they are more difficult to challenge because they do not purport to be legally binding. However, in 2019, the Treasury Department announced that it will include a statement in Notices seeking comments for issuing proposed regulations that if the Department does not issue proposed regulations within 18 months, taxpayers can rely on the Notice. Illustrating the quagmire in which the government finds itself, the ability to rely upon proposed regulations or other guidance violates the APA because it creates a substantive rule without using the notice-and-comment process. However, as with many tax matters, no one has the standing to litigate that position.
This debate over the extent to which lower-level guidance affects substantive rights and obligations is likely to proliferate beyond Notices, although claims that the AIA limits litigation is more likely outside the context of reporting requirements. The concern arose with respect to consideration of tax-exempt status, and the district court permitted the challenge using Cohen, arguing that the question did not implicate the Treasury’s bottom line. Less clear are rules for lower levels of guidance. The Department of Justice had previously argued that lower forms of tax guidance carry the force of law, similar to regulations; however, courts generally did not give them the full weight of law but an unquantifiable amount of deference. The Supreme Court has refrained from deciding this issue. For example, in United States v. Cleveland Indians Baseball Co., the Court did not define the appropriate level of deference to be given Revenue Rulings but held that the Service’s interpretation in Rulings “attracts substantial judicial deference.” For Revenue Procedures, the Tax Court has determined that for deference to apply there needs to be some evidence of the Revenue Procedure’s persuasiveness. This posture on deference may delay procedural challenges against these forms of guidance.
C. Arbitrary and Capricious Regulations
Another group of tax cases in the years since Mayo involve regulations that have gone through notice and comment but concern the different question whether they are, nonetheless, arbitrary and capricious under the APA. The judicial outcome has varied depending upon the regulation and whether the particular preamble accompanying issuance of the regulation is sufficiently responsive to the comments solicited during the comment period. In 2019, the Treasury Department said that it agrees that best practice is to use the notice-and-comment process and that it will include a statement of good cause if it claims an exemption from that process. To date, two circuits have split over the regulations for conservation easements, possibly setting the stage for future Supreme Court review: the Sixth Circuit gave the regulations Chevron deference, but the Eleventh Circuit declared the regulations invalid, and the Supreme Court declined to resolve the conflict at this time. Regulations governing the consolidated return rules and exemptions from the foreign source income rules have similarly been challenged. Like the Notices above, these challenges also raise the question whether procedural review must be deferred because of the AIA.
A threshold question for this type of APA litigation is the nature of the regulation, whether it is interpretive or legislative. Before Mayo, the Treasury Department expansively defined interpretive regulations as those issued under the catchall provision of section 7805 that grants the Treasury Department the power to issue “all needful rules and regulations.” Under this interpretation, regulations were legislative, and therefore required notice and comment, only when they originated from specific authority in a particular Code provision. The Treasury Department has since taken a more conciliatory position in this regard on the nature of regulations.
In Dominion Resources Inc. v. United States, decided shortly after Mayo, a taxpayer challenged a regulation regarding the capitalization of interest (as opposed to current deductibility) for improvements to existing property. The regulation was old: A notice announcing upcoming regulations was published in 1988, a notice of proposed rulemaking was issued in 1991, and the final regulations were published in 1994. Noting the procedural concern, the Court of Federal Claims granted the United States’s motion for summary judgment albeit with some trepidation. Applying State Farm’s hard-look review, the court stated that “[h]ere too, it is a stretch to conclude that Treasury ‘cogently explain[ed] why it has exercised its discretion in a given manner,’” but since the path can be discerned “albeit somewhat murkily” the Court of Federal Claims nevertheless concluded that the “lack of exactitude and the ensuing confusion” did not “signify that Treasury acted to establish the final rule in an arbitrary and capricious manner.”
Despite the length of time that the regulation at issue in Dominion Resources was on the books, the Federal Circuit reversed and invalidated the regulation as arbitrary and capricious. The court of appeals concluded that the regulation was an unreasonable interpretation of the statutory language and, thus, violated State Farm. The “IRS,” rather than the more accurate description of the Treasury Department, provided no rationale in the original Notice, the proposed rulemaking, or the final regulations; therefore, the regulation was arbitrary and capricious.
With respect to the circuit split over the regulations regarding conservation easements, in Oakbrook Land Holdings LLC v. Commissioner, the Sixth Circuit agreed with the Tax Court that the concise statement of the regulation’s basis and purpose in its preamble was adequate and that any failure to address public comments did not violate the APA. In Hewitt v. Commissioner, the Tax Court did not raise the APA issue and, then, the Eleventh Circuit declared the regulations invalid on procedural grounds.
Earlier in Oakbrook Land Holdings, a divided Tax Court had held that the two-page summary of comments on the regulation was adequate for APA purposes. Although holding that the regulations constituted a legislative rule because they added something to the statutory requirements, the Tax Court focused on the 700-plus pages of commentary on the regulations with only 13 dealing generally with matter at issue in the case, and even in those cases only a few sentences concerned the specific dispute challenged in the lawsuit. The preamble discussed seven major groups of comments but not this one; “an agency cannot reasonably be expected to address every comment it received.” That the regulation was 45 years old and the statute had been amended many times since that time weighed in favor of upholding the regulation. Judge Toro concurred in the result because the statute required it, but he held that the regulation violated the APA. Citing Professor Hickman, he argued that the Treasury Department should have known that six columns in the Federal Register was insufficient. Judge Holmes dissented after expressing sympathy for “hundreds or thousands of taxpayers,” lamenting that “the Treasury Department gets to ignore basic principles of administrative law that require an agency ‘to give reasoned responses to all significant comments in a rulemaking proceeding.’”
It was at the circuit court level that courts disagreed over the level of detail necessary in the Treasury Department’s response to comments. Agreeing with the Tax Court, the Sixth Circuit concluded in Oakbrook Land Holdings that the statement of purpose was “dictated by competing considerations,” and this balancing is not meant to be particularly onerous. It was important to the Sixth Circuit that Congress had amended section 170 over 30 times since the regulation’s promulgation. This narrow reading of the court’s duty to oversee the regulatory process saw some judges concur in the judgment but not with respect to the APA matter. In the Eleventh Circuit, however, the Hewitts raised an APA challenge on appeal and, after discussing Oakbrook Land Holdings (especially Judge Toro’s discussion of the APA), the court found that one commenter’s comments were significant and not addressed. That was sufficient in the court’s view to invalidate the 45-year-old regulations.
An earlier case in the Ninth Circuit, Altera Corp. & Subsidiaries v. Commissioner, ultimately sided with the government despite the government’s loss by a 17-0 margin in the Tax Court. Altera dealt with the consolidated return regulations and the issue of qualified cost-sharing agreements and how to account for stock-based compensation costs. This dispute was not a new one; the 2003 regulations at issue in Altera were foreshadowed by a similar dispute concerning regulations that had been issued in 1994.
The Tax Court in Altera imposed a high standard on the Treasury Department to avoid its regulations being deemed arbitrary and capricious. Concluding as a matter of administrative law that Chevron step two incorporates the reasoned decision-making standard of State Farm, the Tax Court criticized the Treasury Department for ignoring complaints raised during the comment process that the regulation defining arm’s length did not include comparables, as commentators said was required. The Tax Court also criticized the Treasury Department for for failing to provide, when the final rule was issued, expert opinions, empirical data, or papers that supported its position. The Treasury Department instead addressed comments by simply stating the Department “do[es] not agree” despite acknowledging contrary “data may not be available.” The Tax Court viewed the matter as a slam dunk in the taxpayer’s favor.
The Ninth Circuit reversed, thus upholding the regulatory process used by the Treasury Department in Altera. The court decided, “Our task, of course, is not to assess the better tax policy, nor the wisdom of either approach . . . .” Accepting that there were no comparables and that the earlier 1994 and 1995 regulations had changed the focus from comparables to outcomes, the court of appeals determined that these regulations were a continuation of equalizing outcomes by looking at internal costs. In that light, the Ninth Circuit concluded that the Treasury Department gave sufficient notice and responded to relevant comments; it was just that most comments were not on point and sought to change the focus of the regulation.
The government failed to convince the D.C. Circuit in 2019 that the regulations at issue were not arbitrary and capricious in Good Fortune Shipping SA v. Commissioner. At issue in Good Fortune Shipping were regulations governing qualification for a reciprocal tax exemption that was denied because the taxpayer corporation had bearer shares. The Tax Court had held that the statute was ambiguous, that the regulations were a reasonable interpretation of the statute, and that the Treasury Department explained its choices in the regulatory preamble. The D.C. Circuit disagreed and held that the regulations were not a reasonable interpretation of the statute, looking at the regulation’s substance. It concluded that the Treasury Department’s position that proof of ownership of bearer stock is too inconclusive was not reasonable because the Department had permitted this before and did not show that anything had changed. The Treasury Department had retreated from the prohibition in 2010, so “the agency’s decision to treat bearer shares less favorably in 2003 than in 1991 is all the more inexplicable.”
Most recently, the Tax Court, in 3M Co. & Subsidiaries v. Commissioner, upheld regulations as not invalid under Chevron step two or State Farm. At issue were regulations promulgated under section 482’s transfer pricing regime; the majority held that the regulations are not invalid because they dealt with an ambiguous term under the statute and proposed a reasonable interpretation. The majority also noted that, in 1994, the proposed regulation had received four comments—all from industry groups. A concurrence and a dissent in 3M Co. & Subs. debated an issue raised in many of the academic articles relating to the potential disruption that would occur if long-standing regulations were declared invalid. Judge Toro’s dissent argued that the preamble to the regulations did not contain a reasoned explanation of why the challenged regulations overturned caselaw or respond to comments. He admits this might “create[] some wrinkles that may not be present when courts review rulemaking by other agencies” because of the AIA. “This may seem unfair and may subject to an APA challenge regulations long on the books, but if the current state of the law is unsatisfactory from Treasury’s perspective, relief must come from Congress (or perhaps the Supreme Court), not us.”
The Third Circuit had reached a conclusion similar to the majority holding in 3M Co. in 2019 in the case of SIH Partners LLP v. Commissioner. There the Third Circuit was unwilling to “find half-century old regulations arbitrary and capricious, based on insights gained in the decades after their promulgation, when the challenger, here Appellant, has not made a showing that those insights were known or, perhaps, at least should have been known to the agency at the time of the regulations’ promulgation.” The court in SIH Partners worried that regulations adopted in 1964 with no comments on the proposed regulations on point should be invalidated. In the underlying decision, the Tax Court had decided that “[t]he agency did not act arbitrarily or capriciously by failing to address contrary viewpoints or findings of fact that were never developed or presented.” Moreover, the Third Circuit argued that the taxpayer could have structured its transaction to achieve desired results: “[t]he circumstance that its tax planning did not lead to a result favorable to it does not provide us with a reason to adopt a questionable construction of a well established statute and the regulations under it.”
Also before these courts was the issue, discussed above with respect to Notices, as to whether the AIA required the delay of litigation. Before CIC Services, the D.C. Circuit had ruled on the AIA’s application to regulations in Florida Bankers Association v. Department of Treasury. The issue in that case was an income reporting regulation issued in 2012 “aimed at detecting and deterring tax cheats at home and abroad” by requiring banks to report interest income earned by aliens from certain treaty countries. The lower court noted that although the interest is not taxable in the United States, the Treasury Department had argued that the information is necessary to comply with information sharing agreements with other countries. The bankers association countered that the Treasury Department had acted arbitrarily and capriciously by failing to consider that some people would withdraw funds from U.S. banks in response to the reporting requirement.
The Court of Appeals for the D.C. Circuit overturned the district court in Florida Bankers in favor of application of the AIA to defer litigation, although the decision is problematic after CIC Services. The district court had permitted review of the regulations despite the AIA but found in favor of the government as the Treasury Department had not acted arbitrarily and capriciously. The lower court had concluded that the regulations did not restrain the assessment or collection of taxes as it only imposed a reporting requirement on banks; however, the D.C. Circuit overturned the lower court on the grounds that the AIA and Declaratory Judgment Act did, in fact, bar the suit. The issue for the court was that the challenge to the regulatory features of the tax also challenged the tax for failure to comply (although this tax was termed a penalty). Judge Henderson issued a scathing dissent that this was not a tax but a regulation. Without this challenge, according to Henderson, taxpayers can only challenge the law at risk of criminal prosecution.
Shortly before Florida Bankers was decided and seemingly at odds (at least to some degree) with its conclusions, the Supreme Court ruled in Direct Marketing Association v. Brohl, which involved the Tax Injunction Act (TIA), a law similar to (but not identical with) the AIA but involving federal courts’ power to judge state taxes, that the lawsuit could proceed. In Direct Marketing, the Supreme Court limited states’ TIA protection. At issue was a Colorado reporting obligation for businesses that do not pay sales tax. The district court had concluded that the reporting obligation burdened interstate commerce and was unconstitutional. The Tenth Circuit overruled it, holding that the statute fell within the TIA’s ambit, so that this was an issue for Colorado courts. The Supreme Court then unanimously overturned the Tenth Circuit on the grounds that the reporting obligation was not a tax assessment for TIA purposes, and so courts could rule on its validity. Enforcement of reporting obligations may improve the government’s ability to collect taxes, but the “TIA is not keyed to all activities that may improve a State’s ability to assess and collect taxes.” The Court thus remanded the case to be decided by the lower court, allowing a pre-enforcement constitutional review of the law.
To the extent that courts find that lower levels of guidance create substantive rights, that guidance, too, should face challenges for being arbitrary and capricious. For example, in Scholl v. Mnuchin, the Service had issued an FAQ that permitted economic impact payments to incarcerated people but then carved them out. The court concluded that the agency’s process was final and not interlocutory or tentative. The decision to deny payments to a specific segment of the population determines a right, and the exclusion because of incarcerated status was held to be arbitrary and capricious. Through cases such as Scholl, courts may extend arbitrary-and-capricious review to greater amounts of tax guidance in the near future.
D. Temporary Regulations
The Treasury Department’s issuance of temporary regulations without claiming or, alternatively, supporting its claim for an exemption from the APA’s notice-and-comment requirements is another issue that has gained judicial scrutiny since Mayo. Although subject to debate, the Treasury Department’s coupling temporary and proposed regulations (similar in concept to other agencies’ interim-final regulations) provoke complaints that temporary regulations rarely go through the notice-and-comment process but, nonetheless, have the same authority as final regulations that have completed both internal and external review. This policy results in a delayed comment period until after publication of guidance that is binding. Before Little Sisters of the Poor v. Pennsylvania (which did not involve tax) was decided, judges had trended toward disallowing this procedure in tax cases. It is uncertain how, and whether, courts will apply Little Sisters of the Poor in tax cases.
The Treasury Department previously justified its use of temporary regulations with the argument that section 7805(e)’s requirement that the Treasury Department issue proposed regulations when it issues temporary regulations operates as a specific exemption from notice-and-comment procedures. A counter-argument is that this requirement is in addition to the APA requirements, so that the government needs a good cause exception to issue temporary regulations without notice and comment and must also publish a proposed regulation. In 2019, the Treasury Department stated it may issue a Notice before seeking comments to encourage dialogue, but any temporary regulations will set forth a justification for good cause in the preamble.
Earlier in one post-Mayo case, a district court was critical of the Treasury Department’s use of temporary regulations. The Chamber of Commerce had filed a lawsuit in Texas to block temporary inversion regulations promulgated by the Treasury Department in April 2016 which were issued simultaneously with proposed regulations. Section 7874, the statutory basis for the regulations, ignored certain inversions of a U.S. corporation into a non-U.S. legal domicile and required the parent corporation to remain subject to U.S. taxation. Congress enacted the statute in 2004 to target inversions using a merger of a U.S. corporation into a foreign corporation if the foreign acquirer’s shareholders do not retain a meaningful stake in the new foreign parent corporation. The regulations extended the definition of disqualified mergers to mergers of a U.S. corporation with a foreign corporation where U.S. shareholders retain a smaller stake in the corporation than defined in the statute if the merger has other aspects that make the inversion appear abusive. The district court held that this litigation was not prohibited by the AIA and that Congress had not exempted temporary regulations from the APA. The appeal was dismissed by government motion.
Similarly, in Liberty Global, Inc. v. United States, at issue were the section 245A temporary regulations, which the Treasury Department created because of a statutory drafting error between the effective dates of the Global Intangible Low-Taxed Income (GILTI) and the applicable dividends received deduction. Temporary regulations were adopted in June 2019 even though the Treasury Department had been aware of the problem in October 2018, and the regulations were made retroactive back to the Tax Cuts and Jobs Act of 2017 when the problem was created. According to the district court, the agency had time (seven months) to do notice and comment, and it did not have good cause to forego notice and comment. Therefore, the temporary regulations were held to be invalid for failing to follow the APA’s process.
However, courts were not always so exacting. In Intermountain Insurance Service of Vail, LLC v. Commissioner, for example, the D.C. Circuit upheld the regulations issued in response to losses in litigation. The court held that the regulations were validly promulgated. “[O]pen-mindedness review focuses not on whether the Commissioner responded to litigants, but rather on whether he has ‘afforded the comments [received during the comment period] particularly searching consideration.’” The Treasury Department received only one comment on point and responded to it in the preamble; therefore, the regulations were valid.
Courts may prefer to skirt this issue when it can, as the Tax Court did in Rogerson v. Commissioner. In Rogerson, the Tax Court ruled on passive activity loss regulations that were introduced in 1988 as temporary regulations that were finalized in 1992. Skirting the APA issue, the Tax Court held that it did not need to pass on the validity of the regulations because, even if they were invalid, the taxpayer would lose under the statute, noting that the taxpayer was a successful entrepreneur in air transportation who had two yachts that he rented out. Nevertheless, the taxpayer was not subjected to penalties because he reasonably relied on his accountant.
In Petaluma FX Partners, LLC v. Commissioner, the D.C. Circuit considered the issue of temporary regulations but noted that the taxpayer challenged temporary regulations that had since been finalized. The temporary regulations had been promulgated in 1987, and the proposed regulations cross-referenced the temporary ones in 1999 and were finalized in 2001. Despite the process, the court held that any procedural deficiency of the temporary regulation is “of no continuing significance.” Moreover, the court somewhat surprisingly included in dicta: “Nor are we aware of any basis on which Petaluma could assert those same procedural challenges to the Final Regulation.” This may have been a narrow statement that the taxpayer identified no comment it believes the Service erroneously disregarded.
In a non-tax case, Little Sisters of the Poor, that was not mentioned in the later Liberty Global LLC, the Supreme Court majority appeared to bless the interim-final process, at least when the majority approves of the substance of the regulations. At issue was a regulatory exception issued through interim-final rulemaking to what Pennsylvania argued was the Affordale Care Act’s (ACA’s) contraceptive mandate. Justice Thomas’s opinion accepted legally-binding interim-final regulations adopted without first giving the public an opportunity to submit comments. The agencies issuing the regulations had asked for comments in conjunction with the publication of the rules and arguably took the comments it received into account in the final regulations. However, the final regulations did not make many changes from the interim rules. Thus, the opportunity for public participation occurred after the agency adopted legally-binding regulations. Justice Kagan’s concurrence accepted that there was statutory authority to issue the regulations but, incorporating the State Farm reasoned decision-making requirement, questioned whether reasoned decision-making was met. Nonetheless, after Little Sisters of the Poor, the focus may be more appropriately on the agency’s communication to the public, or notice, rather than the public’s submission of information to the agency, or public participation. This changed focus has not yet been applied in tax cases.
E. Deficiency Notices
Finally, taxpayers are demanding enhanced administrative process with respect to the deficiency notices they receive. To this end, taxpayers have argued that deficiency notices are final agency actions that demand reasoned decision making. Without that reasoning, they argue, taxpayers cannot know from examining the deficiency notices the entirety of the government’s argument. To date, courts have proven unwilling to extend the APA in this way.
The two cases on point both focus on the process of review of deficiency notices and conclude that they are not final IRS agency action. In QinetiQ U.S. Holdings, Inc. & Subsidiaries v. Commissioner, involving a deficiency notice denying a large tax deduction, the Tax Court opinion did not address the APA question whether the notice contained an “explanation of how, or why, the [Service] had arrived at its final determination.” But the Fourth Circuit said that the APA did not apply. Parties in tax litigation receive de novo review, the court of appeals said, and the opportunity to raise new issues is incompatible with the “final agency action” required to trigger the APA’s requirements. In this instance, the “specific body of law” of the Code trumps the APA. The notice of deficiency was sufficient to satisfy the Code, and the court of appeals could “discern no prejudice to QuinetiQ due to absence of additional information in the Notice of Deficiency.”
Similarly, except that it focused on the Service’s potential flexibility because the notice of deficiency did not constitute final agency action, the court in Ax v. Commissioner permitted the Service to amend its answer to raise new matters in support of its position despite the fact that such matters were not initially set forth in the notice of deficiency. If Congress had committed the action of assessing deficiency solely to agency discretion, the reviewing court could only review the decision; however, here the Tax Court’s jurisdiction is broad. The APA contemplates that specific statutes can override the APA, and in this case the statutory provisions did so. Thus, with respect to deficiency notices, courts have been unwilling to use the APA to increase the procedural hoops the government is required to go through in such cases.
F. Conclusion
The Supreme Court said that tax only deserves special administrative procedures if it shows good cause for doing so. At times, courts have accepted the special nature of tax issues. Therefore, although some academics have argued that those seeking to apply the APA to tax matters have already won, the scorecard shows a more complicated picture. General administrative law is to be applied, but not in all instances. Moreover, continuing uncertainty within administrative law means that there will be uncertainty in its application to tax.
As discussed above, some types of issues have been clearly decided in favor of the government, namely whether deficiency notices are subject to the APA (they are not). Taxpayers, however, have prevailed in other contexts, in particular whether IRS Notices regarding disclosure of listed transactions have the force of law. Regulations, whether issued as temporary regulations or with sufficient discussion in the preamble in response to public comments, are less clear cut. Moreover, many cases that included references to the APA did not have significant discussion of its issues, and some have concluded without much discussion that the APA did not apply. For all of these groups of cases, the inconsistent findings may be the result of the lack of consistency or predictability in administrative case law generally. It may also be a fear of the consequences of imposing heightened proceduralism in these areas.
