In my prior post, I discussed how the IRS has flouted the Administrative Procedure Act in issuing proposed regulations regarding tax-motivated “fee waiver” transactions undertaken by private equity firms. Although the IRS has long disregarded the democratic safeguards otherwise assured by the APA, it has generally faced little consequences for its actions. For example, tax regulations freely announce that the Section 553 notice and comment procedures do not apply to the IRS. Also, until very recently, the IRS’s internal handbook brazenly instructed that when the agency issues regulations, “it is not necessary to justify the rules that are being proposed or adopted or alternatives that were considered.” In short, when it comes to rulemaking, the IRS has long believed that that it is accountable only to itself, and public participation is tolerated reluctantly or only out of benevolence.
A few years ago, in Mayo v. United States, the Supreme Court cast serious doubt on a “tax exceptional” approach to administrative law, but the IRS has been reluctant to accept that decision. Taxpayers, too, have been slow to digest that case, generally forgoing APA-based challenges and preferring to dispute the contents of regulations rather than their procedural infirmities. This approach is understandable, given that whatever the Supreme Court might think, few cases will actually reach One First Street. Taxpayers know that they may have to litigate their disputes in a forum like the Tax Court, which has generally embraced the IRS’s tax-exceptional approach to administrative law.
But a couple weeks ago, the Tax Court issued a stunning decision in Altera v. Commissioner. That case invalidated a major international tax regulation, which by itself would be noteworthy. However, the court’s method of reasoning will establish the case’s legacy. In short, the Tax Court rejected the IRS’s view of every administrative law issue and closed the door on tax exceptionalism. The IRS could not even earn a single vote from the court, which decided the case 15-0 in the taxpayer’s favor. Others have variously described the case as a “huge rebuke” or a “smackdown” of the IRS.
This is a game changer for the IRS’s attack on fee waiver transactions. The IRS has adopted at least three tax-exceptional positions in this context, and each makes the agency’s actions susceptible to challenge in the Tax Court, not merely in hypothetical litigation in front of the Supreme Court.
First, as stated in the regulatory preamble, the IRS believes that the relevant statute, Section 707(a)(2)(A) of the tax code, operates without regulations, even though the statute plainly says that it applies “under regulations.” The Tax Court has sometimes expressed sympathy for so-called “phantom regulations” (that is, applying a statute that calls for regulations but for which none have been issued), but the Supreme Court has flatly rejected that approach in the tax and nontax contexts, as have numerous circuit courts. Altera provides a signal that the Tax Court may conform its approach to the Supreme Court’s and circuit courts’, rather than continue with a tax-exceptional approach. Consequently, the IRS’s attempt to apply phantom regulations to fee waiver transactions faces an even steeper challenge than the ones I previously described.
Second, as I detailed in my prior post, the IRS has jumped the gun and essentially announced that it will apply the proposed regulations prior to their finalization. This approach cannot be reconciled with general administrative law principles and may contaminate the entire rulemaking project in light of the IRS’s apparent “closed mind.” Altera suggests the Tax Court’s willingness to delve into the relevant Supreme Court and circuit court authorities on that issue.
Third, the proposed regulations refer taxpayers to the statute’s legislative history for years prior to the effective date of the final regulations. Under the principles of Petaluma FX v. Commissioner, this may be read as an IRS attempt to apply the regulations to prior tax years. This opens the door to taxpayer challenges regarding the improper retroactive application of administrative regulations.
Had the IRS simply followed the rules, its regulations would be safe from attack. Section 707(a)(2)(A) establishes clear regulatory authority to alter the tax treatment of fee waiver transactions, and all the IRS had to do was observe the democratic safeguards of the APA throughout the rulemaking process. Had it proceeded this way, its regulations would be upheld. However, the IRS’s weaponized approach to rulemaking activities opens the door to taxpayer challenges, and the brutal Altera opinion shows that the Tax Court may be the ideal forum in which to present those challenges.