2d Circuit Defers to the IRS's Litigating Position (9/9/12)

In Union Carbide Corporation v. Commissioner, ___ F.3d ___, 2012 U.S. App. LEXIS 18876 (2012), here, sustains the IRS's interpretation on brief of an ambiguous IRS regulation of an ambiguous statute.  In Chevron, the Supreme Court held that an IRS regulation interpretation of an ambiguous statute is entitled to deference.  However, what if an ambiguous regulation interprets the ambiguous statute?  Well, the IRS can in its brief interpret the regulation and that interpretation of the ambiguous interpretation of the ambiguous statute is entitled to deference.  Here is the Second Circuit's analysis:

We agree with the Tax Court that the costs for which UCC seeks a research credit are "at best, indirect research costs excluded from the definition of [qualified research expenses] under section 1.41-2(b)(2) [of the Treasury Regulations]." Id. The Tax Court's reference to the Treasury Regulations is consistent with the principle that "if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute." Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 843 (1984). The Treasury Regulations explain section 41(b) by stating that "[e]xpenditures for supplies or for the use of personal property that are indirect research expenditures or general and administrative expenses do not qualify as inhouse research expenses." Treas. Reg. § 1.41-2(b)(1) (as amended in 2004). This regulation, however, does not clearly resolve whether the supplies at issue here were "used in the conduct of qualified research" because it is not clear how one distinguishes between direct and indirect research expenses. 

Nevertheless, the Commissioner argues in his brief that "[s]upply costs are 'indirect research expenditures' if they would have been incurred regardless of any research activities." We ordinarily give deference to an agency's interpretation of its own ambiguous regulations, even if that interpretation appears in a legal brief. Auer v. Robbins, 519 U.S. 452, 461-62 (1997). The interpretation advanced here does not fall into any of the enunciated categories where we would withhold such deference as it is not "plainly erroneous or inconsistent with the regulation," does not "conflict with prior interpretation" of the same regulation, and is not merely a "convenient litigating position" or a "post hoc rationalization advanced by an agency seeking to defend past agency action against attack." Christopher v. SmithKline Beecham Corp., 132 S. Ct. 2156, 2166 (2012) (internal quotation marks and citation omitted).

On the contrary, the Commissioner's interpretation is entirely consistent with the purpose of the research tax credit, which is to provide a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur. Indeed, the House Ways and Means Committee explained that this "substantial tax credit for incremental research and experimentation expenditures will overcome the resistance of many businesses to bear the significant costs of staffing, supplies, and certain computer charges which must be incurred in initiating or expanding research programs." H.R. Rep. No. 97-201, at 111 (1981). The purpose of overcoming "the resistance of many businesses to bear the significant costs of," among other things, "supplies . . . which must be incurred in initiating or expanding research programs" is served by affording the taxpayer the credit for the substantial costs that it would not otherwise have incurred to conduct qualified research. Affording a credit for the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting simply creates an unintended windfall. Even if the latter interpretation may be encompassed within the language of section 41(b)(2)(A)(ii), the Commissioner is hardly compelled to adopt the construction that would not necessarily be consistent with the purpose of the credit for increasing research activities. See Cabell, 148 F.2d at 739 ("[S]tatutes always have some purpose or object to accomplish, whose sympathetic and imaginative discovery is the surest guide to their meaning.") (Hand, L., J.) (quoted with approval in Pub. Citizen v. United States Dep't of Justice, 491 U.S. 440, 455 (1989)). 

In sum, as Judge Katzmann has observed, "Agencies are charged with implementing legislation  that is often unclear and the product of an often-messy legislative process. Trying to make sense of the statute with the aid of reliable legislative history is rational and prudent." Robert A. Katzmann, Madison Lecture: Statutes, 87 N.Y.U. L. Rev. 637, 659 (2012). We are satisfied that in formulating and construing Treasury Regulation § 1.41-2(b)(1), the Commissioner reached a result that is rational, prudent, and consistent with the legislative history and congressional purpose.

I will add this case to a citation in a footnote in the text, but the point is already made by citing Auer.