Notice & Comment

The Sixth Circuit Conjures Phantom Regulations

A few decades ago, various federal trial and appellate courts adopted an odd approach towards tax statutes that call for Treasury regulations but for which no regulations had been issued. These courts decided that they would not wait for the Treasury to act. Instead, they would apply the statutes without regulations. In doing so, they would conjure the regulations that they thought the agency might have adopted. “Phantom regulations” were thus born. See Grewal, Substance Over Form? Phantom Regulations and the Internal Revenue Code, 7 Houston Bus. & Tax J. 42 (2006).

A recent and significant case, Whirlpool v. Commissioner, 19 F.4th 944 (6th Cir. 2021), illustrates the serious problems with phantom regulations. Whirlpool involves a complex taxation scheme, inaccessible to most readers. Yet for administrative law purposes, the issues can be greatly simplified. Under one rule in the tax code, a U.S. company faces immediate taxation on some income earned by its foreign subsidiaries. Under a second rule, Congress granted the Treasury the authority, “under regulations,” to expand the income subject to immediate taxation. See 26 U.S.C. 954(d)(2).

At the Tax Court level, Whirlpool argued that the Section 954(d)(2) regulations should not apply. Whirlpool claimed that the regulations, on their own terms, did not reach the company’s arrangement. Alternatively, Whirlpool claimed that the regulations impermissibly interpreted the governing statute. The IRS, of course, disagreed with those contentions. The Tax Court, in a detailed opinion, held for the IRS. The court concluded that the regulations’ language allowed for Whirlpool’s expanded immediate taxation. The court also found that the regulations validly interpreted the statute. See Whirlpool v. Commissioner, 154 T.C. 142 (2020).

On appeal, something very strange happened. In an opinion by Judge Kethledge, the Sixth Circuit ignored the regulations. The court decided that it could do so because Section 954(d)(2) sets forth highly detailed conditions and consequences. Thus, the court believed, the taxpayer lost “under the text of the statute alone.” 19 F.4th at 953. See also Whirlpool v. Commissioner, 154 T.C. at 165. To the Sixth Circuit, when “Section 954(d)(2)’s conditions are met, the consequences that follow are clear from the statute itself.” Id. at 954 (punctuation modified).

The court acknowledged that the statute’s text contemplated rules that would apply “under regulations.” But the court could not accept that the Treasury enjoyed “unfettered discretion to determine whether” expanded immediate taxation would arise. 19 F.4th at 953. Thus, the statute’s reference to regulations did not govern the analysis. The court would look at the statute alone. The dissent, by contrast, believed that the statutory language (“under regulations”) meant that “Congress gave Treasury a role in defining when” expanded immediate taxation would occur. 19 F.4th at 957 (Nalbandian, J., dissenting).

Whirlpool shows how phantom regulations can thwart the congressional intent reflected in statutory language. The Sixth Circuit said that it applied the text adopted by Congress. But its nominally textual approach applies some statutory words and ignores others (“under regulations”). The Sixth Circuit should have given effect to all words found in Section 954(d)(2).

The Sixth Circuit’s approach might earn some sympathy. The court plainly wanted to resolve the case without wading into the highly complicated Section 954(d)(2) regulations. Ignoring the statute’s reference to regulations provided a convenient way to do so.

But Congress acts deliberately when it decides that a statutory rule will apply “under regulations.” Through that language, Congress decides that agencies, as experts, should examine tradeoffs and determine whether and how a potential rule should apply. Section 954(d)(2) itself addresses highly complicated matters. Thus, it’s easy to see why, as Judge Nalbandian’s dissent observed, Congress would want expanded immediate taxation to arise only after the Treasury followed the notice-and-comment-process.

Sometimes, Congress leaves agencies with no discretion. A statute may announce that an agency “shall issue regulations.” But even in that context, courts usually recognize their limited role. Courts can order an agency to act but they cannot apply the rules that they think the agency must implement. See Norton v. S. Utah Wilderness All., 542 U.S. 55, 65 (2004) (Section 706 of the APA permits “a judicial decree … requiring the prompt issuance of regulations, but not a judicial decree setting forth the content of those regulations”). Cf. also Dunlap v. United States, 173 U.S. 65 (1899) (a tax statute that contemplated rules provided “under regulations” could not apply until regulations were issued).  

Nominally, Whirlpool reflects a loss for taxpayers. But the Sixth Circuit’s approach, which swept aside the “under regulations” language, hurts taxpayers only because Section 954(d)(2) contemplates adverse results (expanded immediate taxation). Numerous other statutes say that tax benefits will follow “under regulations” prescribed by the Treasury. In the Sixth Circuit, at least, taxpayers might thus seize on Whirlpool. They can immediately claim tax benefits even when a statute conditions those benefits on subsequently issued Treasury regulations. Also, even if the Treasury issues regulations denying benefits, that might not be effective. Taxpayers can follow Whirlpool’s approach and claim that the Treasury simply lacks “discretion” to deny them the claimed benefits, regardless of what any regulations say.

Whirlpool thus sows severe confusion into an already-confusing area of tax law. Of course, the Sixth Circuit hardly bears sole blame. Phantom regulations have created interpretive difficulties for decades. But recently, judges have grown increasingly cautious over those regulations. The Supreme Court largely killed tax exceptionalism in Mayo v. United States, 562 U.S. 44 (2011), providing a wake-up call to the tax community. The Tax Court often adopts a more sensitive approach to phantom regulations. See, e.g., 15 W. 17th St. LLC v. Commissioner of Internal Revenue, 147 T.C. 557 (2016). See also Grewal, Mixing Management Fee Waivers with Mayo, 16 Fla. Tax Rev. 1, 31-38 (2014) (explaining why phantom regulations must evaporate after Mayo). Whirlpool may thus be an outlier. Nonetheless, even one circuit court’s mistake can wreak havoc on the tax system.

The taxpayer in Whirlpool has now petitioned the Sixth Circuit for a rehearing en banc. The government, in response, has doubled down on its view that regulations are unnecessary to implement Section 954(d)(2). If the court grants the taxpayer’s petition, it should correct the panel’s mistake. The Sixth Circuit should follow the Supreme Court’s approach and hold that phantom regulations can never be conjured by courts.


(This was post last updated on 10/20/22.)

Follow or contact me on Twitter: @AndyGrewal

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