District Court Holds that Temporary Regulations are Legislative and Thus Fail APA's Notice and Comment Requirement (10/10/16)

In Chamber of Commerce v. U.S. IRS, ________ (W.D. Tex. 10/6/17), here, the Court concluded that the so-called inversion Temporary Regulation was a legislative regulation that could not become effective until there was either the APA required notice and comment because no reasoned good cause statement had been given as required for immediate effectiveness of legislative regulations.   Caveat:  this is a revised opinion.  I have not attempted to locate the differences between the original opinion issued 9/29/17 and this revised opinion.  All of the following discussion relates to the revised opinion issued 10/6/17.

First, I offer the Court's explanation of the Temporary Regulation, which it called the Rule.

The Rule was issued pursuant to statutory authority in the Internal Revenue Code, which provides: 

The Secretary shall prescribe such regulations as may be appropriate to determine whether a corporation is a surrogate foreign corporation, including regulations (A) to treat warrants, options, contracts to acquire stock, convertible debt interests, and other similar interests as stock, and (B) to treat stock as not stock. 

26 U.S.C. § 7874(c)(6). And further, 

The Secretary shall provide such regulations as are necessary to carry out this section, including regulations providing for such adjustments  to the application of this section as are necessary to prevent the avoidance of the purposes of this section, including the avoidance of such purposes through (1) the use of related persons, pass-through or other noncorporate entities, or other intermediaries, or (2) transactions designed to have persons cease to be (or not become) members of expanded affiliated groups or related persons. 

26 U.S.C. § 7874(g). The statute uses terms granting broad authority to the Secretary of the Treasury for example: "such regulations as may be appropriate" and "such regulations as are necessary to carry out this section." The statute does not limit the broad authority granted in the first part of each subsection by identifying regulations that would not be appropriate or providing boundaries to the Secretary's authority under the statute. Instead, the statute gives examples of what the Secretary may employ by using the word "including" several times. Further, the examples given in the statute of regulations the Secretary may issue include significant authorizations, such as the authority to "treat stock as not stock," which could substantially alter a calculation under the statute based on the stock of a corporation.

Based on the broad authority granted by Congress, the court concludes the Rule does not exceed the statutory jurisdiction of the Agencies. The Rule directs that certain stock be disregarded in calculations made under the statute, which falls into the statute's allowance that regulations may "treat stock as not stock." Further, the Rule aims to "prevent the avoidance of the purposes" of the statute, which is specifically named as an authorized function of regulations issued pursuant to the statute. 

The court concludes the Rule does not exceed the statutory jurisdiction of the Agencies.

The Court then holds (pp. 8-10) that the IRS gave a reasoned explanation for the Rule consistent with the broad grant of authority. Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983).

JAT Note: The Court to this point has not distinguished between a legislative regulation and an interpretive regulation.

The Court then holds (pp. 10-13) that the Temporary Regulation, issued without notice and comment, violates the APA requirement for notice and comment.  In this portion of the discussion, the Court does not mention the fact that interpretive regulations are exempted from the APA notice and comment requirement.  So, the assumption must be, for purposes of that discussion, that the Temporary Regulation was a legislative regulation.

The Court then turns (pp. 13-15) to the interpretive regulation exception to the APA notice and comment requirement.  This is the nub of the reason I write this blog entry, so I quote the key part:

Defendants argue the Rule is interpretive because it clarifies terms in the statute and provides additional detail to advise the public how the Treasury Department construes the statute. The court disagrees. The statute authorizing the Treasury Secretary to promulgate the Rule states that the regulations may "provid[e] for ... adjustments to the application of this section." 26 U.S.C. § 7874(g). Permitted regulations under the statute include "regulations to treat stock as not stock." 26 U.S.C. § 7874(c)(6). Adjustments to application and treating stock as if it were not stock are not mere interpretations of the statute, but substantive modifications to the application of the statute. 

The Internal Revenue Code provides that: 

[a] foreign corporation shall be treated as a surrogate foreign corporation if, pursuant to a plan (or a series of related transactions) [inter alia,] after the acquisition at least 60 percent of the stock (by vote or value) of the entity is held
(I) in the case of an acquisition with respect to a domestic corporation, by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation. 

26 U.S.C. § 7874(a)(2)(B)(ii). The Rule provides: 

for purposes of determining the ownership percentage by value (but not vote) described in [the Internal Revenue Code], stock of the foreign acquiring corporation is excluded from the denominator of the ownership fraction in an amount equal to the sum of the excluded amounts computed separately with respect to each prior domestic entity acquisition and each relevant share class. 

26 C.F.R. 1 .7874-8T(b). The Rule therefore 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.

The court concludes the Rule is a substantive or legislative regulation, not an interpretive regulation, and the Agencies are therefore not excused from the notice-and-comment procedure required by the APA.

I don't know whether the court is correct in its bottom-line conclusion that the Rule is a legislative regulation or not.  As noted in Am. Hosp. Ass'n v. Bowen, 834 F.2d 1037, 1045-46 (D.C. Cir. 1987), which is not cited by in Chamber of Commerce:

While the spectrum between a clearly interpretive rule and a clearly substantive one is a hazy continuum, our cases, deploying different verbal tests, have generally sought to distinguish cases in which an agency is merely explicating Congress' desires from those cases in which the agency is adding substantive content of its own. Substantive rules are ones which “grant rights, impose obligations, or produce other significant effects on private interests,” or which "effect a change in existing law or policy.” Interpretive rules, by contrast, “are those which merely clarify or explain existing law or regulations,” are “essentially hortatory and instructional,” and "do not have the full force and effect of a substantive rule but [are] in the form of an explanation of particular terms.”

I do note that the Chamber of Commerce Court avoided any discussion of whether appearance of the Rule in the Temporary Regulation or in the Proposed Regulation might per se entitle it to Chevron deference with the consequence that it would be a legislative regulation even if it were otherwise an interpretive regulation.  The thinking among many scholars seems to be that, once an interpretation is adopted in a regulation, the regulation is a legislative regulation entitled to deference.  I disagree with that thinking and the Chamber of Commerce opinion does not pick sides in that discussion.  (I discuss this disagreement at great length in my Federal Tax Procedure Books; the particular page numbers are Practitioner Edition pp. 48-62 and 95-96, although the entire Chevron discussion (pp. 86-111) is peppered with aspects of the issue (I urge review of only the Practitioner Edition because, as they say, the devil is in the footnotes).)

Additional documents from Pacer:

• U.S. Motion to Dismiss, here.
• Plaintiff's Opposition, here.
• U.S. Response, here.
• Plaintiff's Reply, here.
• Final Judgment, here.

Additional thoughts:

1. I think that, under the traditional distinction between legislative regulations and interpretive regulations, the Temporary Regulation (and the contemporaneous Proposed Regulation) might be considered a legislative regulation.  In the statute (here), there are two "grants" of authority to prescribe regulations -- subsection (c)(6) and (g).  I think a case can be made that the grants are not unlike the grant of authority for the consolidated return regulations -- the universally recognized example of a legislative regulation in the Code.  (On the other hand, I could also argue that they are interpretive regulations, not unlike § 385 (authorizing the IRS to prescribe regulations to distinguish between stock and debt), which I view as a grant of interpretive authority and which, in my mind, could issue under § 7805(a).)

2.  If indeed the Temporary Regulation is legislative as the court held, then the court is right that, in the absence of an appropriate "good cause" justification for immediate effectiveness, the regulation cannot be immediately effective.  5 U.S.C. § 553(b)(3)(B).

3.  I don't view the court as endorsing the notion that, simply because the Rule appeared in a regulation, albeit Temporary, that alone made it a legislative regulation when it would otherwise have been an interpretive regulation.

4.  I think the court was right that the recognition in § 7805 that Temporary Regulations might issue and be immediately effective without advance notice and comment did not trump the requirement that legislative regulations require notice and comment for effectiveness absent the good cause determination.  That is simply to say that regulations authorized under § 7805 are interpretive regulations rather than legislative regulations.  (I don't think anyone has ever supposed that § 7805 was a grant of authority to prescribe legislative regulations.)  A Temporary Regulation issued under the authority of § 7805, which must be an interpretive regulation if authorized under that section, can be valid immediately because interpretive regulations are exempt from the notice and comment requirement.  5 U.S.C. § 553(b)(3)(A).

5.  All of which is to say that, if indeed the Government ultimately prevails on its argument that the regulation is an interpretive regulation (albeit authorized in § 7874 itself), then the Temporary Regulation would be valid for immediate effectiveness.