While the specific legal issue presented in Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015) has nothing to do with tax-exempt bonds, it is nonetheless instructive to many readers of this blog because it shows how a taxpayer may successfully challenge an IRS regulation in court.
Want to know how? It’s all about understanding the applicability of the Administrative Procedures Act (“APA”), and is worth considering when deciding whether to comment on the newly re-proposed issue price regulations.
Read below, and as an extra bonus learn how the Death Star and taxes are (vaguely) related.
Altera involved a taxpayer who challenged Treas. Reg. § 1.482-7(d)(2) (a transfer pricing regulation). The IRS lost, with one commentator going so far as to call the decision an “APA-Based Smackdown.”
The court concluded that:
- The regulation “lacks a basis in fact”
- “Treasury failed to rationally connect the choice it made with the facts found”
- “Treasury failed to respond to significant comments when it issued the final rule”
- “Treasury’s conclusion . . . is contrary to all of the evidence before it”
Altera. at 69.
APA Review Standards
The court’s authority to overturn the Treasury regulation on those grounds is founded in the requirements of the APA, and the Altera decision nicely outlines the relevant legal precedents. The Supreme Court has made it increasingly clear that it thinks the IRS is an agency subject to all the same rules that apply to other federal government departments and agencies that promulgate regulations. The Supreme Court stated that it is “not inclined to carve out an approach to administrative review good for tax law only,” and that “[t]o the contrary, we have expressly [r]ecogniz[ed] the importance of maintaining a uniform approach to judicial review of administrative action. Mayo Foundation v. U.S., 131 S.Ct. 704, 713 (2011).
Under the APA, judicial review must ensure that the agency “engaged in reasoned decision making.” Altera at 36 (citation omitted). This requires that “the agency must examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.) Motor Veh. Mfrs. Ass’n v. State Farm Ins., 463 US 29, 43 (1983) (emphasis added; internal quotations and citations omitted).
Under the APA, a federal court is permitted to overturn a federal department or agency action that the court finds to be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 U.S.C. 706(2)(A). In Altera, the court noted that “[n]ormally, an agency rule would be arbitrary and capricious if the agency “offered an explanation for its evidence that runs counter to the evidence before the agency”. Altera at 37 (emphasis added; quoting State Farm, 463 U.S. at 43).
A court may also overturn agency regulations where an agency does not respond to significant comments. Under the APA, a “notice and comment” period is generally required, and the courts have held that “the opportunity to comment is meaningless unless the agency responds to significant points raised by the public”. Altera at 35 (emphasis added; quoting Home Box Office, Inc., v. FCC, 567 F.2d 9, 35-36 (D.C. Cir. 1977).
The IRS conceded that Treasury had thought that “it was not obligated to engage in fact finding,” that Treasury files did not contain any evidence in support of its position and did not show any record of Treasury searching for relevant evidence. Altera at 52. By contrast, several accounting firms, law firms, industry associations and others had presented comments to the IRS regarding the regulations at issue, and had offered to provide more information. Altera at 22-24. A key question involved what terms parties entering into arms’ length agreements would agree to, and whether independent parties would agree to share stock compensation costs. The court closely reviewed the preamble to the regulations and found that “Treasury failed to respond directly to any evidence that unrelated parties would not share stock-based compensation costs, other than by asserting that the transactions cited by the commentators did not ‘share enough characteristics . . . to be relevant.’” Altera at 64. The court also took issue with various aspects of Treasury’s reasoning.
So what does this mean to taxpayers generally? Here are a few takeaways:
The IRS and Treasury are generally subject to all the same rules that apply to other federal government departments and agencies;
- IRS regulations that act like laws must generally be promulgated only after providing the public notice and opportunity to comment;
- Treasury must respond to those comments and generally show that “reasoned decisionmaking” was used when promulgating a regulation; and
- Treasury regulations may be overturned for a failure to comply with these requirements.
So what does this mean for readers of this blog?
If you have an interest in what the IRS decides (ahem, issue price regulations), your comments really can make a difference. Well, at least, sometimes.
Of course, a reasoned response is not always the response you want. For instance, when asked in an online petition to build a Death Star, the government said no. In its denial of the petition, “This Isn’t the Petition Response You’re Looking For” (please get the droid joke), the White House gave some APA-esque reasons for denying the petition. The White House said no to the Death Star because of cost ($850,000,000,000,000,000), because “[t]he Administration does not support blowing up planets”, and because of design flaws in the Death Star (“a fundamental flaw that can be exploited by a one-man starship”).