On September 29, 2017, the United States District Court for the Western District of Texas struck down Temporary Treasury Regulations § 1.7874-8T (the “Multiple Domestic Entity Acquisition Rule” or “Rule”) on the basis that those regulations were unlawfully issued without adherence to the notice-and-comment requirements of the Administrative Procedures Act (the “APA”). Chamber of Commerce of the U.S. v. Internal Revenue Service, case number 1:16-cv-00944-LY (W.D. Tex. 2017).
The Multiple Domestic Entity Acquisition Rule was issued in both temporary and proposed form by the Internal Revenue Service (the “IRS”) and the Department of the Treasury (the “Treasury Department” together with the IRS, the “Agencies”) as part of a package of regulations issued in April 2016 pursuant to section 7874 of the Internal Revenue Code (the “Code”). Section 7874 was added to the Code in 2004 to counteract certain transactions commonly referred to as inversions whereby a foreign corporation directly or indirectly acquires the properties of a domestic corporation or a domestic partnership and the former shareholders of the domestic entity become shareholders of the acquiring foreign corporation. Section 7874 is applicable when, among other requirements, former shareholders or partners of the domestic entity acquire 60 percent or more of the stock of the foreign corporation by reason of their former equity interest in the domestic entity. The Multiple Domestic Entity Acquisition Rule, issued in both temporary and proposed form in April 2016, disregards stock of a foreign acquiring corporation for purposes of determining that ownership percentage if such foreign stock is attributable to a prior domestic entity acquisition by the foreign acquiring corporation occurring within the 36-month period ending on the signing date of the relevant later domestic entity acquisition. Disregarding foreign corporation stock increases the ownership percentage and increases the likelihood that the later domestic entity acquisition will reach the ownership percentage threshold.
It is generally acknowledged that the Multiple Domestic Entity Acquisition Rule was issued at least in part to prevent an announced merger between pharmaceutical giants Pfizer Inc. and Allergan Plc, which was called off just a day after the regulations were published. The U.S. Chamber of Commerce, of which Allergan Plc is a member, and the Texas Association of Business (together, the “Plaintiffs”) filed suit in August 2016 seeking to overturn the Multiple Domestic Entity Acquisition Rule.
Although the court found that the Agencies had statutory authority to issue the Multiple Domestic Entity Acquisition Rule and that the Agencies did not engage in arbitrary and capricious rulemaking in issuing the Rule, it concluded that the Agencies violated the APA because the Agencies failed to provide affected parties with notice and opportunity to comment. The Multiple Domestic Entity Acquisition Rule was simultaneously issued (1) as a temporary regulation under Temporary Treasury Regulations § 1.7874-8T, effective immediately, and (2) as a proposed regulation under Proposed Treasury Regulations § 1.7874-8, subject to notice-and-comment. The Plaintiffs asserted that issuance of the temporary regulation effective without a 30-day notice period or opportunity for comment violated the APA.1 In response, the Agencies argued that temporary regulations do not require notice-and-comment under the APA. The court held that, although Section 7805(e) of the Code allows the Treasury Department to issue a temporary regulation if it is also issued as a proposed regulation, the court found that nothing in the language of Code Section 7805(e) expressly exempted temporary regulations from the APA’s requirement that publication be made not less than 30 days before a rule’s effective date.
The Agencies further argued that the Multiple Domestic Entity Acquisition Rule is an interpretive regulation rather than a legislative regulation and, as such, meets an exception to the generally required notice-and-comment requirements of the APA. Unlike “interpretive rules,” which generally advise the public of an agency’s construction and interpretation of the statutes and rules which it administers, a “legislative rule” affects individual rights and obligations and creates law (usually implementary to an existing law). The Agencies argued that the Multiple Domestic Entity Acquisition Rule was interpretive because it clarified terms within Code Section 7874, was pursuant to a purported grant of authority in Code Sections 7874(c)(6) and 7874(g), and provided additional detail advising taxpayers on how the Agencies construed the statute. The court held, however, that “[a]djustments to application and treating stock as if were not stock are not mere interpretations of the statute, but substantive modifications to the application of the statute” because the Multiple Domestic Entity Acquisition Rule changes “the computation for determining whether a corporation shall be treated as a surrogate foreign corporation by directing that certain stock that would otherwise be included in the calculation is excluded.” Accordingly, the court concluded that the Multiple Domestic Entity Acquisition Rule is a legislative regulation and is not excused from the notice and comment procedure required by the APA. As such, the court granted the Plaintiffs’ motion for summary judgment with respect to their claim that the Agencies violated the APA.
It remains to be seen how the government will respond to the invalidation of the Multiple Domestic Entity Acquisition Rule by the federal district court. It could appeal the decision to the Fifth Circuit Court of Appeals or it could take corrective action by reissuing the regulation (in either current or modified form) after an appropriate notice and comment period. Likewise, the Plaintiffs might cross-appeal on the claim that the regulations are arbitrary and capricious and exceeded the Agencies’ statutory authority. Accordingly, the decision creates some uncertainty for taxpayers engaging in transactions that could fall within the scope of the Rule. The decision also opens the door for challenges of other non-interpretive temporary regulations that have been issued without satisfying the notice-and-comment requirements of the APA.
The decision also opens the door for challenges of other non-interpretive temporary regulations that have been issued without satisfying the notice-and-comment requirements of the APA. Pursuant to Code Section 7805(e), temporary regulations issued after November 20, 1988, expire 3 years after issuance; thus, the only temporary regulations still outstanding are those issued on or prior to that date or in the last 3 years.