On April 11, 2016, the US Tax Court issued its T.C. opinion in Ax v. Commissioner. The notice of deficiency in the case determined that certain premium payments made to a captive insurance company were not established by the taxpayer to be (1) insurance expenses and (2) paid. But this is not a run of the mill captive insurance case—at least not yet.
The Internal Revenue Service (IRS) moved for leave to amend its answer in the case to assert additionally that (1) the taxpayers’ captive insurance arrangement lacked economic substance and (2) amounts paid as premiums were neither ordinary nor necessary (and to allege facts in support of both assertions). The taxpayers opposed, citing Mayo Foundation for Med. & Educ. Research v. United States, 562 U.S. 44, 55 (2011), and arguing that the Administrative Procedure Act (APA) and SEC v. Chenery, 318 U.S. 80 (1943) barred the IRS from “raising new grounds to support [the IRS’s] final agency action beyond those grounds originally stated in the notice of final agency action.” The taxpayers also argued that the IRS’s new assertions constituted “new matters” that did not meet required heightened pleading standards under the Tax Court’s Rules of Practice and Procedure. Ultimately, the Tax Court sided with the IRS.
In Mayo, the Supreme Court held that tax regulations are subject to the same deference principles as other federal regulations. The taxpayers cited Mayo for the proposition that federal administrative law principles apply equally in tax cases. Indeed, Mayo emphasized that the Supreme Court had in its past expressly recognized the importance of maintaining a uniform approach to judicial review of administrative action. But the Tax Court focused and relied on the narrow holding of Mayo rather than its broader administrative law principles.
Section 706(2)(F) of the APA provides a general rule that a reviewing court that is subject to the APA must hold unlawful and set aside an agency action unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing court. The Tax Court held that this provision of the APA did not apply to the Tax Court because it was exempted by section 703 of the APA, which provides that the APA’s form and venue of proceeding provisions do not apply where “prior, adequate, and exclusive opportunity for judicial review is provided by law.” When the APA was enacted in 1946, the Tax Court’s statutory authorization to review deficiencies was already codified in the Internal Revenue Code of 1939—and thus, per the court, there was a prior, adequate and exclusive statutory opportunity for judicial review.
Ax is consistent with the Tax Court’s ruling in Qinetiq U.S. Holdings, Inc. v. Commissioner, No. 14122-13 (Tax Ct. Dec. 27, 2013) (unpublished order denying motion to dismiss). In Qinetiq, the taxpayer, who also cited Mayo, argued that the IRS’s notice of deficiency violated the APA because it was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The taxpayer reasoned that the notice lacked more than a couple of sentences explaining the IRS’s rationale for the deficiency. The court concluded that the notice was not arbitrary and capricious, because the court believed that the notice served its purpose by notifying the taxpayer that a deficiency had been determined and by giving the taxpayer the opportunity to file a petition with the Tax Court. The court emphasized that it was well settled that the court is not subject to the APA. Qinetiq is currently on appeal in the Court of Appeals for the Fourth Circuit.
In a similar vein, Chenery provides that a reviewing court must judge the propriety of an agency’s action solely by the grounds invoked by the agency. The taxpayers in Ax argued that the IRS could not add post-hoc grounds to support the final agency action in the notice of deficiency. The Tax Court differentiated Chenery on the basis that it was separately statutorily authorized to make its own determinations, citing several statutory provisions indicating that the IRS is not limited to the arguments made in a notice of deficiency and that the court has jurisdiction over matters not raised in the notice of deficiency.
On the burden of proof issue, the Tax Court held that only the “economic substance” assertion should be considered a “new matter.” This is an important holding. In Tax Court litigation, the taxpayer generally bears the burden of proof because the IRS’s determination is generally presumed to be correct. The IRS, however, bears the burden of proof under Tax Court Rule 142(a) for any “new matter[s]” pleaded in the answer. The court held that the IRS’s assertion that the taxpayer’s premium payments were neither ordinary nor necessary was implicit in the IRS’s original assertion that the amount paid was not established to be an insurance expense, relying on several recent cases where this inquiry was part of the determination of whether an item was an insurance expense. The IRS’s motion for leave indicated that the additional assertion was being made only in “an abundance of caution,” suggesting that it did not believe it was raising a new matter.
From Qinetiq, Ax and numerous other cases, it is well established that although the IRS is subject to the APA, the Tax Court does not believe it is subject to the APA. Ax is noteworthy for taxpayers because it provides further guidance on how the Tax Court interprets the APA, an issue that has become increasingly popular in tax litigation. It will be interesting to see how Qinetiq (and possibly Ax) is decided on appeal.