After months of bitter fighting, the United States Supreme Court vacancy left by the death of Justice Antonin Scalia has finally been filled with the confirmation of Justice Neil Gorsuch on April 7, 2017. What this means for state tax issues that are ripe for Supreme Court review—retroactivity, the death of Quill, etc.—will certainly be the subject of much debate and prognostication. One thing that seems quite clear, based on his record in the Tenth Circuit, is that when given the chance, Justice Gorsuch will likely conclude that the deference standard that currently applies to judicial review of agency regulations is too lenient, and that the power of the administrative state should be curtailed.
For over thirty years, judicial deference to agency regulations has been governed by Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). “Chevron deference,” as it is ubiquitously known, holds that, in certain circumstances, a court will be compelled to grant deference to administrative regulations—in a way, taking the “interpretation of the law” function away from the judiciary and vesting this function in the agency. If it is determined that an agency was statutorily authorized to issue a regulation (i.e., that the agency did not enact a regulation ultra vires), then mandatory deference will be required if both parts of the “Chevron two-step” test are met: (1) Congress must not have directly spoken to the statutory question at issue and (2) the agency’s interpretation must be based on a permissible construction of the statute.
The upshot of Chevron and its progeny is that, when an administrative agency (e.g., the United States Treasury) has duly promulgated a regulation and that regulation is later challenged in court, the court must defer to the regulation if the controlling statute is ambiguous and the agency’s interpretation is reasonable. This is so even if the court finds that the agency’s interpretation is not the best interpretation of the statute. In other words, the court, in the absence of the regulation, may have interpreted the law differently, but because the agency is deemed to have expertise in the specific area of the law that it is tasked with interpreting, the court will defer to the agency’s interpretation. In this way, Chevron clearly requires the court to cede some of its Constitutionally-granted interpretive authority to the agency. Spurred by concerns over the growing power of the administrative state, Congress recently took aim at Chevron, with a bill, the Regulatory Accountability Act of 2017, which passed the House of Representatives and that would explicitly overturn the case.
While Chevron only addresses federal regulations promulgated pursuant to Congressional authority, some states have also applied Chevron to state agency regulations, including tax department regulations. See, e.g., Estate of McVey v. Cabinet, 480 S.W.3d 233 (Ky. 2015). Other states, while not expressly applying Chevron, use a deference standard that is quite similar in effect. See, e.g., Tarrant Appraisal District v. Moore, 845 S.W.2d 820 (Tex. 1993) (“[C]onstruction of a statute by an administrative agency charged with its enforcement is entitled to serious consideration, so long as the construction is reasonable and does not contradict the plain language of the statute.”). Thus, at both the state and federal level, agency interpretations of legislative enactments are entitled to substantial deference by the judiciary.
Enter Justice Gorsuch. In 2016, then-Tenth Circuit Judge Gorsuch authored a concurring opinion in Gutierrez-Brizulea v. Lynch, 834 F.3d 1142 (10th Cir. 2016) (Justice Gorsuch also wrote the majority opinion). Justice Gorsuch’s concurrence roundly criticized Chevron and the expanded role that administrative agencies have played as quasi-legislators in its wake, stating that Chevron (and a subsequent case, Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005)) “permit executive bureaucracies to swallow huge amounts of core judicial and legislative power and concentrate federal power in a way that seems more than a little difficult to square with the Constitution of the framers’ design.” The concurrence went on to describe the ways in which the powerful administrative state—which functions in modern government as executive, legislator and judiciary in one—threatens the very separation of powers upon which our government was founded, and that, for this reason, administrative agencies’ interpretations presumably should “warrant less deference from other branches, not more.” In perhaps the most telling part of his concurring opinion, Judge Gorsuch predicted the consequences of a “world without Chevron.” He opined that
courts could and would consult agency views and apply the agency’s interpretation when it accords with the best reading of a statute. But de novo judicial review of the law’s meaning would limit the ability of an agency to alter and amend existing law. It would avoid the due process and equal protection problems of the kind documented in our decisions. It would promote reliance interests by allowing citizens to organize their affairs with some assurance that the rug will not be pulled from under them tomorrow, the next day, or after the next election.
These words leave little room for doubt that, given the opportunity, Justice Gorsuch will likely conclude that Chevron’s thirty-plus-year reign should come to an end, possibly giving way to de novo judicial review of agency regulations. Whether the addition of Justice Gorsuch to the High Court will be enough to tip the balance in favor of curtailing deference remains to be seen. However, the combination of a Congressional measure to overturn Chevron and a new Supreme Court Justice who has placed Chevron in his crosshairs may foretell a new era of heightened judicial scrutiny to the actions of administrative agencies.
So where does this leave the states? Regardless of what happens at the federal level, states will be free to either continue to follow Chevron, follow whatever new deference standard applies at the federal level, or use their own judicially-created deference standard. However, it is no secret that the well-reasoned opinions of the U.S. Supreme Court carry great weight with state court judicial bodies. Thus, it is likely that state courts will look to any potential new federal deference standard when determining the appropriate level of deference at the state level. Indeed, if a less deferential standard is pronounced, state tax regulations would be an area ripe for challenge.
Often, judges defer to a state tax departments’ reasonable interpretation of an unclear state tax law, giving revenue departments wide latitude to promulgate rules and regulations that interpret the law to their benefit and leaving taxpayers to argue that a revenue department’s actions were either ultra vires or “arbitrary and capricious,” both of which are (quite often impossibly) high standards to meet. However, if the tide turns in favor of de novo review, taxpayers will have the power to persuade judges that their interpretation of the law should prevail even if the department’s interpretation was statutorily authorized and reasonable.
Certain regulations immediately spring to mind when considering potential challenges under a less deferential standard. For example, several states (e.g. Massachusetts, Pennsylvania, California, etc.) have adopted very broad and heavy-handed market-based sourcing regulations and interpretive guidance. While these regulations arguably interpret an ambiguous area of state tax law—i.e., where the “market” is for sales of other than tangible personal property—and while they may be reasonable interpretations, they are not the only way to interpret the law, and taxpayers operating under a de novo standard would at least be permitted to make the legal argument that their interpretation of where, for example, the benefits of their services are received is a superior interpretation to that embodied in the regulations. Another example of a potentially “challenge-worthy” regulation can be found in the draft regulations recently issued by the New York State Department of Taxation and Finance on combined reporting. By statute, taxpayers meeting certain ownership thresholds are permitted to make an election to file a combined report in New York even if they are not engaged in a unitary business. However, in the draft regulations, the Commissioner of Taxation and Finance affords himself the discretion to disregard a commonly owned group election if he finds that it will not have “meaningful continuing application.” Assuming that this regulation could survive an ultra vires challenge (which is questionable), under a de novo review, it would seem clear that a better interpretation of the combined reporting statute is that a commonly owned group election is available for any taxpayer that meets the statutory requirements.
In summary, under the current Chevron deference standard, taxpayers who wish to challenge the application of a regulation or other administrative rule must show that (1) the agency did not have the statutory authority to issue the regulation at all (i.e., that the regulation was ultra vires) (2) the statute is unambiguous and means something other than what the regulation says it does, or (3) the agency’s interpretation of the ambiguous statute is unreasonable. This deference standard leaves taxpayers with limited options for challenging a regulation and affords tax departments great leeway to enact regulations that stretch the boundaries of reasonableness. If the de novo standard, as suggested by Justice Gorsuch, eventually rules the day, the deck will no longer be stacked so heavily in the department’s favor, and taxpayers may have more success in demonstrating that revenue department’s regulations simply aren’t the best way to interpret the law.