Background

In Mayo Found. for Med. Educ. & Research v. United States, 562 US 44 (2011), the United States Supreme Court held that Chevron deference was the appropriate standard of review for determining the validity of all Treasury regulations. Before Mayo, the Treasury Department took the position that it was not held to the same notice and comment rulemaking standard under the Administrative Procedure Act (APA) to which other agencies were traditionally held. In Mayo, the Court explained that it was "not inclined to carve out an approach to administrative review good for tax law only". This case signaled the end of what has been referred to as "tax exceptionalism". 

Since Mayo, courts have begun to invalidate Treasury regulations and other guidance for violating APA procedures. In the court decisions discussed below, two general APA tenets are apparent. First, Treasury and the IRS, like all agencies, must undertake certain notice and comment procedures to comply with the APA. Second, courts may review agency action and set it aside where agency action is contrary to statute, in excess of statutory authority, arbitrary or capricious, or procedurally defective under the APA.

Temporary Regulations and the Good Cause Exception

In Liberty Global, Inc. v. United States, 1:20-cv-03501-RBJ (D. Colo. Apr. 4, 2022), the taxpayer presented multiple arguments regarding the invalidity of temporary regulations under Code section 245A, which Treasury attempted to issue with retroactive effect under its interpretation of section 7805(b)(2). 

Under the TCJA's new participation exemption system, a fixed percentage of CFC income is deemed earned in the United States and subject to tax under the global intangible low taxed income (GILTI) regime. Section 245A exempts the remaining CFC income from US taxes upon repatriation. These newly-enacted TCJA provisions include mismatched effective dates for CCFCswith non-calendar year ends, with GILTI kicking in after section 245A in certain cases. As a result, these taxpayers may have repatriated income that was not subject to GILTI. The temporary regulations overwrite the statutory language to deny these taxpayers the full dividends received deduction allowed under section 245A.

In a motion for summary judgment, Liberty Global argued that, while section 7805 allowed Treasury to issue temporary regulations with respect to section 245A, any such temporary regulations were subject to notice and comment requirements under the APA. The government argued that section 7805(e) is more specific than the APA and authorizes the creation of immediately effective temporary regulations without notice and comment procedures. The court disagreed with Treasury and determined that nothing in section 7805(e) established procedures meant to override APA procedures.

In doing so, the court determined that Treasury was required to comply with notice and comment procedures in issuing the temporary regulations under section 245A, that Treasury did not have good cause to depart from those procedures, and that the resulting error was not harmless. Accordingly, the court held that the temporary regulations are invalid.

The court did not reach Liberty Global's additional arguments, including whether Treasury had the authority to issue the temporary regulations as they were (1) contrary to the express language of the statute (i.e., section 245A contained no ambiguity that would give Treasury gap-filling authority to promulgate regulations) and/or (2) impermissibly retroactive. 

An appeal, in this case, would be to the Tenth Circuit and similar cases may be litigated in other circuits as well. 

Significance: The court confirmed that section 7805 does not take precedence over the APA and struck yet another blow to the notion that Treasury is not bound by the APA. The court emphasized that taxpayers should be afforded an opportunity to comment on rules before they take effect and draw attention to the promulgation process of the TCJA implementing regulations.

Validity of One Old Regulation Splits Circuits

In two recent conservation easement cases, the Sixth and Eleventh Circuit Courts came to opposite conclusions concerning the validity of the proceeds rule under Treas. Reg. § 1.170A-14(g)(6)(ii). The individual cases were discussed in previous alerts, IRS' Failure to Comply with APA Results in Regulation Invalidity in Hewitt and Oakbrook Splits Circuits in APA Notice and Comment Challenges.

In Hewitt v. Commissioner, the Eleventh Circuit reversed the Tax Court's holding and held that the proceeds regulation is invalid under the Advanced Pricing Agreement (APA). The court found that the IRS and Treasury failed to respond to significant comments when the final regulations were promulgated, and therefore failed to comply with the APA.

In Oakbrook v. Commissioner, the Sixth Circuit affirmed the Tax Court's holding that the taxpayer was not entitled to a charitable contribution deduction for a donation of a conservation easement. The court determined that the proceeds regulation was valid because it determined that the comments to which Treasury did not respond were not significant. In a concurring opinion, one judge concluded that the regulation was invalid under the APA but concurred in the result because the deed failed to meet the requirements of the statute.

Significance: These regulations were promulgated decades ago, long before Mayo. The Hewitt case could encourage taxpayers to challenge older regulations promulgated before Treasury was "on notice" that all Treasury regulations were subject to the APA. This may be especially relevant where large amounts are at stake under a historically controversial regulation and the IRS swept taxpayer comments into a general statement of consideration. 

Clearing the Anti-Injunction Act Hurdle

Recent taxpayer challenges to the validity of IRS sub-regulatory guidance with legislative effect have also invoked the APA.

In CIC Services LLC v. IRS, 141 S. Ct. 1582, 209 L. Ed. 2d 615 (2021), the Court held that a suit to enjoin Notice 2016-66, which required taxpayers as "material advisors" to report information about certain insurance agreements called micro captive transactions, does not trigger the Anti-Injunction Act even though a violation of the Notice may result in a tax penalty. The Anti-Injunction Act generally bars any person from bringing a suit in any court for the purpose of restraining the assessment or collection of any tax. The Court determined that a suit by a material advisor was not for the purpose of restraining the assessment or collection of a tax but rather for the purpose of avoiding the significant regulatory burdens imposed under the notice. The Court highlighted that Notice 2016-66 imposes substantial compliance costs that are unconnected to taxpayers' potential tax liability, the causal chain between the reporting requirements to any tax is attenuated, and the Notice is enforced by criminal as well as tax penalties.

The case was remanded back to the district court for arguments on the merits, where taxpayers can argue that Notice 2016-66 is a "legislative-type rule" that fails to comply with mandatory notice-and-comment requirements under the APA and is arbitrary and capricious.

Importantly, in Mann Construction Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022), the Sixth Circuit set aside IRS Notice 2007-83, which designated a cash value life insurance trust as a listed transaction, because the IRS did not satisfy the notice and comment procedures for promulgating legislative rules under the APA. 

The court rejected the government's argument that Notice 2007-83 is an interpretive rule that did not require notice and comment, emphasizing the associated financial penalties and criminal sanctions.

The court further rejected the argument that Congress exempted the IRS from the APA's notice and comment procedures with respect to Notice 2007-83. While Congress may have been aware of the IRS's existing guidance on procedures, the court emphasized that the "statutes do not say anything, expressly or otherwise, that modifies the baseline procedure for rulemaking established by the APA". 

Significance: Upon finding Notice 2007-83 was a legislative rule, the court looked for express statutory language that would make the APA's procedures inapplicable to the IRS. Not finding any, the court invalidated the Notice.

Outlook

These cases highlight the risk Treasury and the IRS take when they do not comply with APA procedures and provide taxpayers the opportunity for notice and comment. We will be watching Liberty Global and other cases challenging the validity of the TCJA's implementing regulations closely. Although Treasury and the IRS may adjust their practices to prevent challenges to future guidance, we also expect challenges to historical regulations and sub-regulatory guidance vulnerable to APA challenges.