United States: Challenging Regulations After Mayo And Home Concrete

In the wake of the Supreme Court of the United States' recent tax opinions in Mayo Foundation for Medical Education & Research v. United States, 131 S.Ct. 1836 (2011),  and United States v. Home Concrete & Supply, LLC, 132 S.Ct. 1836 (2012) taxpayers have additional arguments at their disposal to challenge U.S. Department of the Treasury regulations.  Those arguments are front and center in several pending U.S. Tax Court cases involving challenges to transfer pricing regulations.

Setting the Stage

In Mayo, the Supreme Court ended a decades-long debate over whether the standard of review for regulations issued pursuant to the Internal Revenue Service's (IRS's) general grant of authority under § 7805(a) was different from the standard of review for regulations issued pursuant to a specific directive in the pertinent statute.  In reaching this holding, the Supreme Court rejected the idea that it should "carve out an approach to administrative review good for tax law only."  Although many initially saw this decision as a victory for the IRS, others recognized the significance of the administrative law statement, which provided a clear signal that the IRS, like other federal agencies, is subject to the Administrative Procedure Act (APA) in promulgating its rules and regulations.  The IRS, while acknowledging that it is subject to the APA generally, has taken the position that almost all regulations it issues are "interpretative" regulations not subject to various requirements under the APA.

After Mayo, appellate courts quickly applied the APA to cases involving challenges to regulations.  In Burks v. United States, 633 F.3d 347 (5th Cir. 2011), the U.S. Court of Appeals for the Fifth Circuit noted that regulations "are generally subject to notice and comment procedure pursuant to the Administrative Procedure Act" and that the IRS's allowance for such notice and comment after final regulations were enacted was not an acceptable substitute for pre-promulgation notice and comment.  In Cohen v. United States, 650 F.3d 717 (D.C. Cir. 2011), the U.S. Court of Appeals for the District of Columbia Circuit stated: "The IRS is not special in this regard; no exception exists shielding it—unlike the rest of the Federal Government—from suit under the APA."  In Dominion Resources, Inc., v. United States, 681 F.3d 1313 (Fed. Cir. 2012), the U.S. Court of Appeals for the Federal Circuit invalidated regulations under § 263A as violating the APA because Treasury did not provide a reasoned explanation for deciding upon a regulation.

In Home Concrete, the Supreme Court rejected the IRS's attempt to overrule a prior Supreme Court opinion that had addressed the precise question under an almost identical predecessor statute.  The Supreme Court pointedly held that its prior interpretation of a statute meant that "there is no longer any different construction that is consistent with [the prior opinion] and available for adoption by the agency."  Because of this approach, the Supreme Court found it unnecessary to address several APA arguments advanced by the parties and amici and addressed in some of the lower court opinions on the issue.  In comments reported in the tax press following the Supreme Court's decision, high-ranking government officials at both the IRS and the U.S. Department of Justice's Tax Division indicated that pre-Chevron decisions should be generally read as final determinations not subject to change by regulations.  As discussed below, these statements are difficult to reconcile with the IRS's litigating position in pending cases involving challenges to transfer pricing regulations issued to ostensibly overrule existing case law.

As noted, the Supreme Court in Home Concrete did not address several APA arguments.  Additionally, it did not address or clarify other issues raised by the parties, including the precise situations in which an agency can issue regulations to overrule existing judicial precedent, an agency's ability to issue retroactive regulations during litigation, and the proper role of legislative history in determining whether regulations are entitled to deference.  However, several lessons can be gleaned from the opinion.  Perhaps most importantly, taxpayers and courts should not blindly follow IRS guidance that conflicts with prior judicial precedent.  Additionally, a coordinated approach among taxpayers may be helpful in persuading a court to invalidate a regulation.  The participation of amici, while present in almost all Supreme Court cases, may be gaining traction in the Tax Court, as evidenced by recent filings in some high-profile cases. 

Pending Challenges to Transfer Pricing Regulations

It is impossible to know how many pending cases involve challenges to regulations, whether under a general Chevron analysis or on APA grounds (or both).  However, three high-profile cases in the transfer pricing arena that have received attention in the tax press are 3M Co. v. Commissioner, T.C. Dkt. No. 5186-13, Altera Corp. v. Commissioner, T.C. Dkt. Nos. 6253-12 and 9963-12, and Amazon.com, Inc., v. Commissioner, T.C. Dkt. No. 31197-12.  The first deals with Treas. Reg. § 1.482-1(h)(2), and the latter two involve Treas. Reg. § 1.482-7(d).

In 3M, the IRS determined that Brazilian legal restrictions on the payment of royalties by a Brazilian subsidiary to its U.S. parent should not be taken into account in determining the arm's-length price between 3M and the subsidiary under Treas. Reg. § 1.482-1(h)(2).  However, more than 40 years earlier, the Supreme Court in Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972), had rejected the IRS's attempt to apply § 482 where federal law prohibited the taxpayer from receiving the income the IRS was seeking to allocate to it.  Relying on longstanding and basic principles of taxation, the Supreme Court noted that "[w]e know of no decision of this Court wherein a person has been found to have taxable income that he did not receive and that he was prohibited from receiving."  The Supreme Court invoked the "complete dominion" doctrine, first enunciated in 1955 in the seminal case of Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), wherein it defined income to include all "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."  In other words, the Supreme Court held that the taxpayer could not have "income" because of the legal restrictions, and, therefore, the IRS could not use § 482 as a tool to reallocate the restricted amounts to the taxpayer.

Dissatisfied with the Supreme Court's holding, the IRS attempted to limit the scope of the opinion to federal law restrictions; however, courts universally rejected these attempts.  See, e.g., Texaco, Inc. v. Commissioner, 98 F.3d 825 (5th Cir. 1996); Procter & Gamble v. Commissioner, 961 F.2d 1255 (6th Cir. 1992); Salyersville Nat'l Bank v. United States, 613 F.3d 650 (6th Cir. 1980). It is worth noting that, in United States v. Basye, 410 U.S. 441 (1973), decided shortly after First Sec. Bank, the Supreme Court phrased its holding as involving situations where the taxpayer "could not have received that income as a matter of law" without any distinction among federal, state or foreign law.

The First Sec. Bank court noted that the IRS's own regulation—Treas. Reg. § 1.482-1(b)(1) (1971)—was consistent with the complete dominion and control concept because it assumed that a group of controlled taxpayers have "complete power" to shift income.  The Supreme Court also noted that its holding comported with the statement in the regulations that the "purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer."

The IRS conceded the domestic law application (Rev. Rul. 82-45, 1982-1 C.B. 89; GCM 38545 (Oct. 17, 1980)), but issued regulations in 1994 intended to overrule a foreign law application.  Treas. Reg. § 1.482-1(h)(2) provides, in part, that "a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time."  Although the regulation also contains a deferred income election that permits the deferred recognition of restricted income, subject to a matching deferral of deductions, it may be difficult in most situations to meet these requirements.  In promulgating the new regulation, the IRS relied on the fact that Treas. Reg. § 1.482-1(b)(1) (1971)—the "complete power" regulation cited by the Supreme Court in First Sec. Bank—had been repealed.  Additionally, it appears that the IRS interpreted the Supreme Court's statement that its holding was consistent with the "parity treatment" provided in the § 482 regulations as meaning that First Sec. Bank can properly be applied only where the end result of its application is consistent with the arm's length standard underlying § 482.  Finally, the IRS's position relies on an expansive view of the scope of its continuing power to issue regulations clarifying and defining the law in light of the existing judicial landscape.

The validity of Treas. Reg. § 1.482-1(h)(2) has not been challenged in a judicial proceeding in the 20 years since its promulgation.  Because 3M was only recently filed, no summary judgment motions have yet been filed on the issue, but given the legal nature of the regulations issue, it is likely that one will be filed in the near future.  The Supreme Court's approach in First Sec. Bank of focusing on whether the taxpayer could have "income" instead of jumping straight to § 482, and the subsequent application to foreign law restrictions, provide strong support for 3M's position.  Whether 3M succeeds may also depend on how the Tax Court interprets Home Concrete and on the Supreme Court's apparent admonition to the government that the Supreme Court has the last word.

In Altera, the taxpayer is challenging, under Mayo and the APA, the rule including stock-based compensation in the calculation of cost-sharing payments (Treas. Reg. § 1.482-7(d)(1)(iii)).  The parties filed cross-motions for summary judgment in May 2013, and final briefs on the issue were filed in September 2013.  (Amazon, which filed its petition after Altera, has indicated in filings that it has the same issue and appears to be awaiting the outcome of the summary judgment motions before taking any action on its own.)  The crux of the taxpayer's argument is that the APA applies to the regulation at issue and the IRS failed to justify the adoption of its regulations.  In Motor Vehicle Mfrs. Ass'n of the United States Inc. v. State Farm Mutual Auto. Ins. Co., 463 U.S. 29 (1983), the Supreme Court required that an agency "articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made."  Absent such a satisfactory explanation, the Supreme Court held, the regulation can be rejected under the APA.

The Altera taxpayer's argument was supported by an amicus brief submitted by several trade associations that described their members as being U.S. corporations representing more than  $1 trillion in market capitalization and encompassing a broad cross-section of industries vital to the U.S. economy.  That brief was devoted entirely to why the procedural requirements of the APA apply to IRS informal legislative rulemaking and how courts interpret APA requirements, weigh agency attempts at compliance and remedy failures to satisfy those requirements.  Although the Tax Court denied the motion for leave to file the amicus brief, this is just one of several recent cases where amici have submitted briefs.  Whether to allow amici to participate is discretionary, and the Tax Court has recently allowed such participation in some cases while not allowing it in others.  In Advo, Inc., v. Commissioner, 141 T.C. No. 9 (Oct. 24, 2013), a § 199 case, the Tax Court allowed Limited Brands, Inc., and Meredith Corporation to file an amicus brief supporting the taxpayer's position subject to the IRS's request that it be allowed to file a reply to the brief.  The Tax Court subsequently denied the amici's request to file a response to that reply.  In Thrifty Oil Co. v. Commissioner, T.C. Dkt. No. 1376-10, the Tax Court allowed an amicus brief by another taxpayer with the same or similar issue.  After the court decided against the taxpayer in Thrifty Oil, it used statements by the other taxpayer in its amicus brief against it when its case was decided.  In several recent unpublished Orders, the Tax Court has examined whether "the proffered information is timely, useful, or otherwise helpful."  The court has also considered whether amici are advocates for one of the parties, have an interest in the outcome of the case, and possess unique information or perspective.

Closing Thoughts

Taxpayers that have followed the regulations at issue in the above cases should consider filing protective refund claims in the event the regulations are ultimately invalidated.  In general, the statute of limitations for tax refund claims is three years from the filing of the relevant return (or two years from the date of payment, if later).  If the IRS issues a notice of claim disallowance, the taxpayer must either bring suit to contest the disallowance within two years after the issuance of this notice or obtain an extension of time to file such a suit with the IRS.  The latter process can be initiated by filing IRS Form 907, Agreement to Extend the Time to Bring Suit.  For more information, see "Second Circuit Reaffirms Taxpayer's Use of Protective Refund Claims."  For future filings, taxpayers should consider whether to file Form 8275-R, Regulation Disclosure Statement, to further protect against penalties for positions contrary to regulations.

Additionally, taxpayers that are aware of pending cases involving the same or similar issues may want to consider coordinating their efforts.  This could take the form of engaging in dialogue with other taxpayers on legal arguments and strategy, or seeking to participate in a case as an amicus.  The ultimate decision on whether to coordinate, and in what manner, depends on several factors and should be considered as part of an overall strategy in defending one's case against the IRS.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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