Tax Court in Reviewed Opinion Rejects Chevron and State Farm Attack on § 482 Blocked Income Regulation (2/10/23; 2/15/23)

In 3M Companies v. Commissioner, 160 T.C. ___ No. 3 (2/9/23) (reviewed), TA here and GS here, the Court sustained the IRS so-called blocked income regulations. The opinions (opinion of the court and concurring and dissenting opinions) cover 346 pages. The following is the page breakdown.

• Opinion of the court by Morrison, joined by Kerrigan, Gale, Gustafson, Nega, Ashford, and Marshall): pp. 1-273, with 208 footnotes
• Kerrigan concurring (joined by Gale, Paris, Ashford and Copeland): pp. 275-280, no footnotes
• Copeland concurring in the result joined by Kerrigan, Gale and Paris: pp. 281-286, 1 footnote
• Buch dissenting joined by Urda, Jones, Toro, and Greaves: pp. 287-305, 9 footnotes
• Pugh dissenting, joined by Foley, Buch, Urda, and Toro: p. 306, 1 footnote
• Toro dissenting, joined by Buch, Urda, Jones, Greaves, and Weiler (307-346, 33 footnotes

Judge Toro offers (p. 309 n. 2) this helpful and short statement describing the function of the opinion of the court: “Following the Court’s tradition, I refer to the opinion by Judge Morrison, which received 7 votes (out of 17) from active judges, as the opinion of the Court.” The opinion of the court is not a majority opinion, so what gives? For more on this phenomenon, see Kandyce Korotky, All for One, and Five for Sixteen? When the Tax Court’s “Majority” Opinion Isn’t (Procedurally Taxing Blog 4/10/18), here. [Note: in a subsequent Order in Coca-Cola v. Commissioner (Dkt. No. 31183-15 Order dated 2/14/23), a case on hold pending the outcome of 3M, Judge Lauber asked the Coca-Cola parties to file briefs addressing some issues remaining open after the 3M opinions and describing the 3M split among the judges as follows: "On February 9, 2023, a Court-reviewed opinion was issued in the 3M case, rejecting by a 9-8 vote the taxpayer's Chevron and APA arguments and upholding the validity of the “blocked income” regulation. See 160 T.C. No. 3 (2023)."]

I think it will be most helpful to readers just to offer the Syllabus at the beginning of all the opinion of the court. The Syllabus summarizes the opinion of the court (not the concurring and dissenting opinions): 

11th Cir. Invalidates Proportionate Sharing Regulations As Procedurally Arbitrary and Capricious for Failing to Address a Significant Comment (12/30/21; 12/31/21)

Subsequent blog entry adding some procedural nuance:  Regulations Interpreting Pre-1996 Code provisions; Fixing Hewitt (Federal Tax Procedure Blog 1/6/22), here.

In Hewitt v. Commissioner, 21 F.4th 1336 (11th Cir. 2021), 11^th Cir. here and GS here, the Court invalidated regulation § 1.170A-14(g)(6)(ii) denying charitable donations of partial interests (such as easements) for conservation purposes if the deed requires that, upon extinguishment, the proceeds be shared between donor and charitable donee ratably to the value between the conservation easement and the donor’s retained property rights as of the time of the donation.  Specifically, the regulations did not permit in that sharing calculation, the subtraction of value of post-donation improvements incurred by the donor.  Such subtraction, if allowed, would allocate that portion of the value exclusively to the donor rather than sharing with the charitable donee according to the date of donation values).  The Regulation interpreted the § 170(h)(5)(A) requirement that:

(A) Conservation purpose must be protected
A contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.

Two issues are potentially implicated.

(i)              Was the regulation properly promulgated under the procedural requirements for regulations in the Administrative Procedure Act (“APA”)?  Those requirements include a statement of purpose addressing significant comments in the Notice and Comment process (sometimes called Reasoned Decisionmaking) which may be tested under the APA’s arbitrary and capricious standard under 5 USC 706(2)(A).  This is sometimes referred to as the State Farm test.  Motor Vehicles Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983).  This test is a procedural regularity test only and, as to interpretations in the regulation, do not test the validity of the interpretation.  (Thomas Merrill, a noted scholar, has suggested that Reasoned Decisionmaking or some variation including a reasoning concept is better called “process review,” to avoid confusing it with the ambiguous requirement of “reasonableness,” which is the deference test for an interpretation. Thomas W. Merrill, Re-Reading Chevron, 70 Duke L. J. 1153, 1171-1172 (2021); process review seems to focus better on the inquiry into the procedural validity of the regulation.).

(ii)            Was the interpretation in the regulation a valid interpretation either because it is the best interpretation of the statute (regardless of deference) or, if not the best interpretation, subject to Chevron deference?  Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984).  In this regard, a Notice and Comment regulation interpretation adopted in a procedurally invalid way is not entitled to Chevron deference but should still carry the day if it is the best interpretation of the statute.  BTW, this is why an interpretive regulation differs from a legislative regulation; if a legislative regulation is procedurally defective or even does not exist, there is no law in the statute to apply; if an interpretive regulation is procedurally defective or does not exist, there is still the statute a court can apply based on its best interpretation.  For example, the quintessential tax legislative regulations are the consolidated return regulations; if there are no consolidated return regulations or they are procedurally invalid, there is no law for consolidated returns; by contrast, most tax regulations are interpretive regulations where if there were no interpretive regulations or if the interpretation in the regulations were not valid (qua interpretation), there would still be the statute which the court could interpret to resolve the dispute.

The 11^th Circuit held in Hewitt that the regulation failed the procedural regularity test in (i) above because, in adopting the Final Rule, Treasury failed to consider and discuss a material significant comment regarding the extinguishment formula as to whether the value of post-donation improvements by the donor must be shared with the charitable donee.  Failing the procedural regularity test, the regulation was invalid thus precluding any Chevron deference.  Had the regulation passed the procedural regularity test in (i), Chevron deference might have been an issue.

Distinction Between APA Arbitrary and Capricious Review and Chevron Interpretive Reasonableness Review (6/19/20; 7/24/20)

In DHS v. Regents of the University of California, ___ U.S. ___, 140 S.Ct. 1891 (6/18/20), Sup. Ct. here and GS here, the Court held that the DHS rescission of DACA was procedurally defective (arbitrary and capricious) for failure to satisfy the reasoned decisionmaking requirement of the APA, as interpreted.  (Also often referred to as the State Farm standard.)  DHS v. Regents has created quite a stir in the national political discussion (most of the stir being rhetoric).

I have not dealt much with the State Farm standard on this blog.  But,  I have noted, for example, that failure to satisfy the arbitrary and capricious/ State Farm standard is Altera’s principal argument on petition for certiorari in Altera Corp. v. Commissioner, 145 T.C. 91 (2015), rev’d 926 F.3d 1061 (9th Cir. 2019), reh. en banc den. 941 F.3d 1200 (9th Cir. 2019), petition for cert. pending, No. 19-1009 (filed 2/10/20).  See Altera Reply Brief on Petition for Certiorari (Federal Tax Procedure Blog 6/7/20; 6/11/20), here.

I won’t get further into either DHS v. Regents or Altera today (except as an aside at the end), but I did pick up a new case, that  makes a nice (and correct) distinction between Chevron review for interpretive regulations and arbitrary and capricious review applicable to both legislative and interpretive regulations.  The case is:  Natural Resources Defense Council, Inc. v. U.S. EPA, 961 F. 3d 160 (2d Cir. 2020), GS here.  The relevant excerpt is (pp. 169-171) (cleaned up). I bold face parts that I think require particular attention):

II. Legal Standard 

            "We evaluate challenges to an agency's interpretation of a statute that it administers within the two-step Chevron deference framework." Catskill Mountains Chapter of Trout Unlimited, Inc. v. EPA, 846 F.3d 492, 507 (2d Cir. 2017).  At Chevron Step One, we ask "whether Congress has directly spoken to the precise question at issue." If Congress's directive is unambiguous, both the agency and the courts are bound by that mandate. If, instead, "the statute if silent or ambiguous with respect to the specific issue," the analysis proceeds to Chevron Step Two. At that step, "the question for the court is whether the agency's answer is based on a permissible construction of the statute."  

            In evaluating reasonableness at Chevron Step Two, "we will accord deference to the agency's interpretation of the statute so long as it is supported by a reasoned explanation, and `so long as the construction is a reasonable policy choice for the agency to make.'" Catskill Mountains, 846 F.3d at 507. Because "a statute's ambiguity constitutes an implicit delegation from Congress to the agency to fill in the statutory gaps," the agency's interpretation must only be reasonable, and need not be the sole permissible or even most reasonable interpretation of the statute.

Tax Court Conflates Standards for Testing Interpretive and Legislative Regulations (5/7/20; 5/11/20)

In Whirlpool Financial Corp. v. Commissioner, 154 T.C. ___ No. 9 (2020), here, the Tax Court (Judge Lauber) held that income from a foreign manufacturing and sales structure was foreign base company sales income (FBCSI) under § 954(d).  Whirlpool’s tax shenanigans to avoid that result failed.  I won’t get into the details of the underlying tax issues.  I focus here on the Court’s explanation of how it applied Chevron to approve a regulation interpretation that was important to the result.

The Court discusses the Chevron analysis at Slip Op. pp. 54-62.  The regulation in question interpreted § 954(d)(2).  Although the Court did not state whether the regulations were interpretive or legislative regulations, it seemed to treat the regulations as interpretive regulations, testing the regulations under “the familiar two-step test of Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984).”  (Slip Op. p. 54.)  As I have noted before, Chevron applies to an interpretive regulation, ultimately testing the reasonableness of an agency interpretation of ambiguous statutory text.  The questions are (i) is the interpretation within the scope of the statutory ambiguity and (ii) is the interpretation reasonable (sometimes called permissible).  By contrast, legislative regulations (such as the consolidated return regulations) are the law within the scope of the delegation and are not interpretations of the law, so testing a legislative regulation for reasonableness of the interpretation is an oxymoron.  Rather, legislative regulations are tested under the arbitrary, capricious or manifestly contrary to the statute standard under 5 U.S.C. § 706(2)(A); and Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983), focusing on the procedural regularity of the regulations promulgation process.  Questions I sometimes ask to those I engage on the subject are:  Do courts defer to statutes (deference being meaningful only to interpretations of statutes)? Since legislative regulations within the scope of the authority granted are the law just as if they were statutes and are not interpretations of the law, how exactly does a court defer to the legislative regulation?

As other courts have misread Chevron and subsequent cases, the Court conflated the two standards.  But, they are not the same standard, and the two standards do not apply to the same type of regulation.  I cite readers to my article, John A. Townsend, The Report of the Death of the Interpretive Regulation Is an Exaggeration (SSRN 1/25/20), here.  (Caveat, the main theme of the article and the points I make in this blog are rejected by many, if not most, scholars addressing the issue, as I note in setting up the discussion in the article; if error there be in my view, I still stick with it.)

These are the parts of Judge Lauber’s opinion that I think improperly conflate (or at least confuse) the two standards:

Altera Petition for Certiorari (2/12/20; 2/13/20)

Readers of this blog will know that the Altera drama has been the topic of many of my thoughts. See Altera Corp. v. Commissioner, 145 T.C. 91 (2015), rev’d 926 F.3d 1061(9th Cir. 2019), reh. en banc den. 941 F.3d 1200 (9th Cir. 2019), cert. pending (2/10/20).  Just search on the word Altera and pull up all blog entries mentioning Altera.  And, if you followed the citation to the end, you see that Altera just filed a petition for certiorari.  That petition is here.

The petition states the questions presented as:

1. Whether the Treasury Department’s regulation is arbitrary and capricious and thus invalid under the Administrative Procedure Act, 5 U.S.C. 551 et seq.  

2. Whether, under SEC v. Chenery Corp., 332 U.S. 194 (1947), the regulation may be upheld on a rationale the agency never advanced during rulemaking. 

3. Whether a procedurally defective regulation may be upheld under Chevron on the ground that the agency has offered a “permissible” interpretation of the statute in litigation.

I think there is less to those issues than presented by Altera in its petition.  I will think about it more and present my ideas when I have time to think them through and articulate them.  At the inception of my thought process, I do think that there are some conceptual threshold issues that the petition just assumes away.  I will deal with that in later comments.

In the meantime, I do note that Chevron was a key basis for the Ninth Circuit decision, the petition does not make a frontal assault the concept of Chevron deference.  Rather, based on the questions presented, Altera attacks on procedural regularity grounds (even if the interpretation in the regulation is a reasonable interpretation of the statute, the regulation failed procedural regularity).

Added 2/13/20 11:00 am:

Ninth Circuit Reverses Unanimous Tax Court in Altera (6/7/19; 6/20/19; 7/2/19)

I have blogged on the Ninth Circuit's prior opinion reversing the unanimous Tax Court in Altera Corp. v. Commissioner, 145 T.C. 91 (2015) (reviewed opinion), here. Developments - Federal Tax Procedure Book 2018 Editions and Altera (7/25/18; 7/27/18), here. That opinion was reversed because it was rendered after one of the panelist died.  Ninth Circuit Withdraws Altera Opinions (8/7/18; 8/13/18), here.  Another judge was substituted for the deceased judge and oral argument was heard by the reconstituted panel.

The Ninth Circuit reconstituted panel, with all members apparently still alive, issued its opinion reversing the unanimous Tax Court.  Altera Corp. v. Commissioner, ___ F.3d ___, 2019 U.S. App. LEXIS 17143 (9th Cir. 2019), here.

Altera has been quite a saga, including the strange concept of a dead judge joining a majority opinion.  At the outset, it might be worth doing a tally of the judges on the merits.  In just the win-lose category.  There are two judges giving the win to the IRS, but they are the most important judges -- two of the three judges on the reconstituted panel.  All the other judges (other than the deceased Ninth Circuit judge who apparently voted before his death) who voted on merits held against the IRS.  Those judges are the dissenting judge on the reconstituted panel and all of the judges (15 in number) who voted on the reviewed opinion in the Tax Court.  So, just counting heads, two judges thought the IRS should win; 16 thought the IRS should lose.  (And this is not counting the dead judge's vote for the original panel opinion, which, if counted, would have been 3 for the IRS and 16 for the taxpayer.)  For those with the time to review an anecdote from my earlier appellate career at DOJ Tax for a Government appeal, like Altera, from a reviewed Tax Court opinion with most of the judges voting for the taxpayer, see Developments - Federal Tax Procedure Book 2018 Editions and Altera (7/25/18; 7/27/18), here.

Now to the current opinions from the reconstituted panel with living panel members.  The split is as it was in the withdrawn opinion.  Judge Thomas was for the IRS; Judge O'Malley from the Federal Circuit (by designation for the original and reconstituted panel) was for the taxpayer.  The swing judge was Judge Graber from the Ninth Circuit, designated to the panel to replace the deceased Judge Reinhardt.  Like Judge Reinhardt, the swing judge voted with Thomas whose opinion thereby became the majority just as with the withdrawn opinion.

I am focusing here only on the new panel majority and dissenting opinions.  I make no attempt to compare the differences between the withdrawn opinions and reconstituted panel current opinions; I just assume that, in broad strokes, the positions are the same (with some interim tweaking) since the same judges wrote the panel majority and dissenting opinions. (Readers interested in the withdrawn panel majority and dissenting opinions can look at my prior blog or Google any other comment on them.)  Readers interested in a discussion of the differences between the withdrawn and the current opinions might watch the Miller & Chevalier Tax Appellate Blog, here, because, in a quick posting on the blog on Friday, there the author said:  "Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison."  Steve Dixon, Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera (Tax Appellate Blog 6/7/19), here.

In broad outline, the panel majority opinion holds:

1.  Chevron Analysis.

   a.  Chevron Step One. Section 482 is ambiguous on the issue presented (whether the qualified cost sharing arrangement ("QCSA") must include employee stock option costs in allocating income from the intangible ).  Accordingly, Chevron Step One is passed.

   b.  Chevron Step Two.  The regulations' requirement that employee stock option costs be included in the QCSA costs is reasonable and therefore the interpretation that the court applies, by Chevron deference, in Chevron Step Two.

2.  State Farm Analysis.  The promulgation of the regulation requirement met the reasoned decisionmaking requirement and was not procedurally defective.