In this Ropes & Gray podcast, tax associate Brandon Dunn is joined by tax partners Kat Gregor and David Saltzman to discuss one of the most notable tax decisions from the fourth quarter of 2017 and its implications for taxpayers, particularly multinational corporations. On September 29, 2017, in Chamber of Commerce of the United States of America et al v. Internal Revenue Service et al, the U.S. District Court for the Western District of Texas held that the Internal Revenue Service and the U.S. Treasury Department violated the Administrative Procedures Act by issuing an anti-inversion rule, specifically the “Multiple Domestic Entity Acquisition Rule,” saying it was unlawfully implemented without giving the public enough notice or time to comment.

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Brandon Dunn: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Brandon Dunn, an associate in the tax group, and I’m standing in for Gabrielle Hirz, the regular host of this podcast. Today I’m joined by Kat Gregor, a tax partner and co-founder of the firm’s tax controversy group; and David Saltzman, a partner in the tax group who concentrates on international tax matters. In today's podcast, we are going to discuss a notable court decision from the fourth quarter of 2017, which we've chosen as our case of the quarter. This case, Chamber of Commerce v. Internal Revenue Service, concerned the validity of the Internal Revenue Service’s “Multiple Domestic Entity Acquisition Rule” under the Administrative Procedure Act. The Rule, which was issued by Treasury in April 2016 and had an immediate effective date, was aimed at deterring certain corporate inversions by decreasing the tax benefits of those transactions.

David, let’s start with a little background. I understand that the Internal Revenue Code contains rules designed to deter corporate inversions. Can you tell us a little about corporate inversions and the rules in the Code that govern them?

David Saltzman: Sure, Brandon. Prior to the enactment of the Tax Cuts and Jobs Act, which took effect at the start of this year, the top U.S. tax rate for corporations was 35 percent. That rate was high by world standards, though for many multinationals, the effective rate on earnings could be lower. Unlike many other countries that have territorial tax systems, which exempt earnings from foreign subsidiaries, the U.S. taxed foreign subsidiaries’ active business earnings only when those earnings were repatriated to the U.S. parent, but taxed the foreign passive earnings currently. U.S. multinationals kept their active profits offshore to defer tax and to obtain favorable financial accounting treatment. Foreign multinationals did not have the same issues and could strip earnings from the U.S. and pay less U.S. taxes than a U.S. corporation without a foreign parent. So some companies decided to try to flee the U.S. tax system.

Brandon Dunn: So, did they actually expatriate?

David Saltzman.: Hardly. In early inversion transactions, the companies created a new foreign holding company and flipped the former U.S. company’s shareholders up to become shareholders of the new foreign parent. The foreign company was a shell and its shareholders were identical to the former shareholders of the U.S. company. The U.S. corporation continued to operate in the U.S and typically kept its senior management here too. Through elaborate intercompany planning, the earnings were stripped from the U.S. corporation and landed in its low-tax parent, which also acquired majority control of the foreign subsidiaries out from under the U.S. company. Congress enacted rules hoping to deter these transactions and where the new foreign company was a shell, they treated it as an U.S. corporation when the shareholders before and after were identical or nearly so.

Brandon Dunn: Could you explain to us, David, how those rules work?

David Saltzman: If you have an hour or two, I can do it. To oversimplify, the rules look at whether the former shareholders of the expatriating U.S. corporation hold 60 percent or more of the equity of the foreign acquiring company and no other business was combined. That would always be the case if the Foreign parent was a new holding company. That would also be the case if the foreign company was a real business, but the U.S. company is really the “whale” and its shareholders mainly owned the equity of the combined businesses. Policy wise, Congress was trying to distinguish between the self-inversion transactions involving a corporate shell and a commercially sensible acquisition of a U.S. company by a foreign acquirer with its own equity.;

Brandon Dunn: David, is it true that the Multiple Acquisition Rule, in section 1.7874-8T of the Treasury regulations, the regulation at issue in Chamber of Commerce, changed this framework? Could you explain how the IRS justified this regulation?

David Saltzman: Sure, the Multiple Acquisition Rule was part of a broad set of regulations, which targeted inversions. This rule tried to change the way the ownership percentage I mentioned was calculated. Basically, the concern was that U.S. companies that had staged their own inversions could turn around and acquire another U.S. company. It was like a game of Pacman. The companies would continue on an acquisition binge taking advantage of their superior tax profile and could outbid U.S. competitors for desirable targets. But they could also be the vehicle of companies looking to leave the U.S. while maintaining a large part of their own shareholder base without running afoul of the anti-inversion rules. With each acquisition, an even larger U.S. target could be acquired with the foreign acquirer’s equity. This could be done without the U.S. target’s shareholders acquiring more than 60 percent of the foreign target’s equity. The new regulation tried to slow this process by disregarding the stock of the foreign acquiring company that was issued in an acquisition of a U.S. entity with a three-year period. This regulation was issued without public review during a period when several high profile transactions took place or were being contemplated but had not yet closed. The Chamber of Commerce, one of whose members was a potential party to such a merger, filed a suit in the District Court for the Western District of Texas, challenging the rule.

Brandon Dunn: Taxpayers suing the IRS often face procedural hurdles. In this case, I understand that the IRS challenged the Chamber of Commerce’s suit as prohibited by the Anti-Injunction Act. Kat, can you tell us more about that?

Kat Gregor: Sure, Brandon. The IRS argued that the Anti-Injunction Act barred the plaintiffs’ claims. The Anti-Injunction Act, by way of background, prohibits suits that aim to prevent the collection or assessment of a tax. Generally, a taxpayer seeking to invalidate a tax must sue for a refund after the tax is assessed and collected. The IRS thought that this case fell squarely into the Anti-Injunction Act’s prohibition, but the District Court disagreed. According to the Court, the plaintiffs were not trying to restrain the collection of any tax or the assessment of any tax liability. Rather, the issue was that the regulation deterred plaintiffs’ members from pursuing transactions altogether, so the regulation had never been enforced, and there was no opportunity for a tax to be assessed or collected. This is particularly noteworthy because the Anti-Injunction Act generally has a wide reach. As a recent example, in a different case, CIC Services v. Internal Revenue Service, just this November, another district court found that the Anti-Injunction Act prevented a suit by CIC to challenge the legitimacy of a disclosure requirement. The regulation at issue in CIC provided for a “penalty” for a failure to comply, and the Court concluded that a “penalty” was a tax within the meaning of the Anti-Injunction Act. There, an organization tried to raise a very similar argument, namely that the act of needing to file a document with the IRS would deter transactions, but the court rejected the argument there, effectively requiring a taxpayer to violate the rule, and then challenge any later assertion of a penalty.

Brandon Dunn: After getting over that procedural hurdle, we know that the plaintiffs challenged the Multiple Acquisition Rule under a piece of legislation called the Administrative Procedure Act. What are the noteworthy takeaways from that?

Kat Gregor: Well, the plaintiffs made three broad arguments under the Administrative Procedure Act. First, they said that the Department of the Treasury and the IRS did not have statutory authority to issue this regulation. The APA prohibits agency action that exceeds the “statutory jurisdiction, authority, or limitations” set out by Congress. Section 7874, according to plaintiffs, only granted the Treasury and the IRS the ability to determine whether transactions are a part of a plan to avoid the purposes of Section 7874. This grant of authority, as plaintiffs argued, did not include the ability to disregard stock that was not issued in a plan to circumvent 7874. The District Court disagreed. Because Section 7874 granted broad authority to the Treasury, the code permitted the Treasury to produce “such regulations as may be appropriate” and to “treat stock not as stock.” The Treasury generally has broad rulemaking authority, so this result isn’t necessarily surprising—the court, in essence, held that Treasury had not exceeded its authority.

Second, plaintiffs argued that the Multiple Acquisition Rule was arbitrary and capricious, in violation of the APA. The APA requires federal agencies to give adequate justification for their decisions and regulations. Traditionally, there is a lot of deference to the agency’s justification, as was the case here. The District Court rejected plaintiffs’ argument, stating that the Treasury had issued detailed reasons for its decision, and it appeared rational and reasoned.

Brandon Dunn: Let’s pause there for a second, was it surprising that the Chamber tried to assert that Treasury acted arbitrarily?

Kat Gregor: Maybe five years ago, it would have seemed like more of a long shot, but recently arguments that Treasury has acted in an arbitrary and capricious manner have gotten some traction. While Courts often defer to the Treasury’s reasoning, in another recent IRS loss under the APA, in the Altera case, a Federal Court in California invalidated regulations on a basis very similar to the Chamber’s arguments here. In that case, the regulations involving cost-sharing provisions in a transfer-pricing context, where Treasury had issued regulations requiring that all taxpayers calculate an “arm’s length” payment taking into consideration certain incentive compensation. In that case, a court held that even though Treasury had broad rule-making authority, its decision to require all taxpayers to include such costs in related party provisions, without considering any data on whether arm’s length taxpayers would take those costs into account, was held to be arbitrary and capricious. So, it is not at all surprising that the Chamber raised similar arguments here, even if ultimately not successful. As an aside, it’s worth noting, that the Altera case is presently on appeal to the 9th circuit, and we may hear a decision any day. Perhaps that’ll be our case for the next quarter!

Brandon Dunn: Perhaps! But back to the Chamber of Commerce case, we’ve discussed two losing arguments—so how did the Chamber win in the end?

Kat Gregor: Well, the final argument was the winner and is a traditional argument under the APA—for any lawyers listening, this one will bring you right back to your admin law class—specifically, the Chamber claimed that Treasury did not satisfy the APA’s requirement of a “notice-and-comment period.” Basically, if an agency seeks to issue what are considered “legislative regulations,” the APA requires that interested parties have notice of the contents of an agency’s regulations, and an opportunity to respond to those contents. The APA specifically requires that publication of a regulation must occur at least 30 days before its effective date. This is what the District Court focused on in its decision.

Brandon Dunn: But the APA contains certain exceptions to the notice-and-comment requirement. Did this regulation fall into those exceptions?

Kat Gregor: Well, the IRS argued it did. They first argued that Section 7805(e) of the Internal Revenue Code, which requires that Treasury issue any temporary regulation as a proposed regulation simultaneously, and to finalize that regulation within three years, does not require notice-and-comment for the temporary regulation. But the court rejected this outright, stating that nothing in 7805(e) altered the APA, and that the APA specifically requires that any statute seeking to alter the APA in this regard do so explicitly.

In its final defense, Treasury also argued that the Multiple Acquisition Rule was an interpretative regulation, not a legislative regulation. So-called “interpretive” regulations do not require notice-and-comment periods. This is because, if an agency is merely interpreting a statute, it is not issuing new law, but merely stating its interpretation of existing law. This means that, in theory, a taxpayer was already on notice of the law itself. But the District Court did not agree with the Treasury that the rule was interpretative rather than legislative. It said that the change is substantive in nature, in effect creating new law, because it changes the computation for determining the tax treatment of a corporation. An interpretative regulation merely explains what a statute means, or how it ought apply, it does not, according to the Court, change the way in which it applies or the substantive rights of those to whom it applies. Therefore, the Court held that the Multiple Acquisition Rule violated the APA and had to be set aside.

Brandon Dunn: So, how important is the decision in this case? How far reaching are its effects?

Kat Gregor: I think it’s a really important case for administrative challenges to IRS regulations. The IRS often issues temporary regulations without notice and comment sometimes, also issues other regulations without notice and comment on the basis that such regulations are “interpretative” and therefore can skip notice and comment periods. This decision puts at risk any regulations issued in that manner. Treasury has a habit of putting in, as a default, a statement that a regulation is interpretive—this practice alone will raise questions as other regulations begin to be scrutinized. If Treasury has been arbitrarily declaring regulations to be interpretive to skirt the notice-and-comment period requirement, we can expect a wider backlash in the months and years to come.

That said, the government recently appealed the District Court decision, but if the decision is upheld, it would seriously limit Treasury’s ability to promulgate regulations without going through the notice-and-comment period. That is ultimately going to slow down the pace of bringing new regulations into effective, which may be particularly significant to tax reform, as new regulations are going to be necessary for a variety of new and amended statutory provisions. We could also see the IRS attempt to make greater use of the good cause exception to the notice-and-comment requirement. The APA allows agencies to skip notice-and-comment were it would be “impracticable, unnecessary, or contrary to the public interest.” The IRS does sometimes use the good cause exception, but not that often. For example, it has justified issuing regulations without notice and comment “in order to provide taxpayers with immediate guidance” in situations where no regulations were available.

Brandon Dunn: David, what does this decision mean for taxpayers, particularly multinational corporations considering this kind of transaction, or other kinds of international transactions?

David Saltzman: Well, we shouldn’t lose sight of the fact that the rule only slowed things down. A taxpayer could wait out the three-year holding period or do more modest transactions. The decision only set aside one rule in a much larger body of regulations, all of which were aimed at discouraging inversions. The Tax Cuts and Jobs Act now in effect introduces new sticks that discourage inversions. But the Act also offers carrots for U.S. corporations that choose to stay in the U.S., like a 21 percent tax rate and the ability to repatriate off-shore cash free of tax.

Brandon Dunn: This regulation ultimately targeted base erosion, which has been a serious concern of Congress and the IRS in recent years, as well as in other international jurisdictions with historically high comparative tax rates—which is why the base erosion and profit shifting, or BEPS project, has been such a priority in Europe. How relevant will base erosion measures be under the new Tax Cuts and Jobs Act?

David Saltzman: Well, despite the changes in rates and the move to a territorial system, there are still strong incentives in the U.S. tax code to locate operations overseas. As a result, The Tax Act contains a few new base erosion measures. First, the Act creates a new “tax on a foreign subsidiary’s global intangible low-tax income.” Second, the Act creates a reduced rate of tax on “foreign derived” income for U.S. companies that export from the U.S. and own their intellectual property here. These two measures aim to encourage companies to keep their valuable IP in the U.S. Third, the Act creates anti-hybrid rules that deny U.S. tax deductions in certain situations where there are no taxable inclusions abroad, as well as a “base erosion and anti-abuse tax” which applies to other tax-deductible payments domestic companies make to foreign affiliates. This tax, however, would only apply to companies with annual gross receipts over $500 million, so it would only affect very large businesses.

Brandon Dunn: How about you Kat, would you like to offer any closing observations?

Kat Gregor: Well, certainly, any taxpayers potentially affected directly by this decision should watch how the case unfolds in the Court of Appeals. For others, as Gabby and Rom Watson observed last quarter regarding the Grecian Magnesite Mining case, decisions like this are a positive indication that courts will take the IRS to task if it does not comply with the law. Particularly, if the Court of Appeals upholds this ruling, it could cause a ripple effect, delaying new guidance and putting existing regulations at risk.

Brandon Dunn: Thank you, Kat and David, for joining me in this fascinating discussion. We’ll be back next quarter to discuss one of the major tax decisions of the first quarter of 2018. In the meantime, please visit our tax controversy newsletter webpage at, or of course, for additional news and commentary about other notable tax developments as they arise. Thank you for listening.