Notice & Comment

Using Tax Exceptionalism to Beat Microsoft

In a prior post, “The IRS’s Mercenaries,” I explained how the IRS has taken extraordinary steps to battle Microsoft over the tax consequences of some of the company’s international transactions. In short, the IRS hired a private law firm to perform some audit and litigation related functions, and a federal district court is currently examining the legality of that arrangement. A hearing was held, and the parties recently filed supplemental briefs. U.S. v. Microsoft (W.D. Wash.) (No. 2:15-cv-00102).

The IRS’s brief shows that the agency is quite willing to revive so-called tax exceptionalism to fight Microsoft. (For its brief, see Lexis 2015 TNT 199-17). Under the Administrative Procedure Act, agencies must issue regulations in proposed form before finalizing them, giving the public a chance to comment them. To avoid this requirement, the agency must show good cause for doing so. However, the IRS argues that it does not need to show good cause when issuing interim-final (or “temporary”) regulations, like those that purportedly allowed it to use a private law firm to audit Microsoft. The IRS instead believes that can issue immediately effectively regulations and seek comments after it has already begun enforcement.

The IRS argues that tax exceptionalism validates its practice here. Section 7805(e) of the tax code says that when the IRS issues temporary regulations, those regulations expire after 3 years. The IRS argues that this statute means that the IRS can automatically issue interim-final regulations, with or without good cause, and that Section 7805(e) overrides APA Section 559, under which exceptions to the notice-and-comment requirements are ineffective unless made expressly.

The IRS believes that Section 7805(e) overrides the APA’s good cause requirement because the two statutes inherently conflict, so Section 7805(e), as the later-enacted statute, must control. But that’s simply wrong. It’s quite easy to reconcile the good cause requirement with Section 7805(e). The good cause requirement continues to apply to all agencies that want to issue regulations, including the IRS. However, if and when the IRS has good cause for skipping notice-and-comment, Section 7805(e) prescribes a 3-year shelf-life for the resulting temporary regulations. (For more on the relationship between the APA’s express-statement rule and the tax code, see this article.)

The IRS also asks the court to establish a relatively favorable framework for analyzing which of its regulations are exempted from the APA’s notice and comment requirements. Generally speaking, interpretive rules can be issued without notice and comment, although the Supreme Court has not told us exactly what distinguishes an interpretive rule from a legislative rule. The IRS argues, among other things, that a regulation is interpretive whenever “there would be a statutory basis for an enforcement action.” Under this approach, because the IRS regulation allowing the private law firm to participate in the Microsoft audit was issued under a self-executing statute, the regulation is necessarily interpretive and the IRS did not need to observe notice-and-comment requirements.

If the IRS’s characterization is accepted, this could have major consequences for agency rulemaking. All regulations are enforceable only by virtue of a statute. Otherwise, they are invalid. If a regulation is interpretive whenever the governing statute conceivably supports the interpretation contained in the regulation, then the notice-and-comment requirements become something of a farce. An agency can almost always say the operative statute provides the rule and the implementing regulations are merely an extraneous add on. The APA’s requirements would apply only to regulations issued under a statute whose effect is expressly conditioned on the promulgation of those regulations, or perhaps to regulations that the agency expressly deems legislative.

The IRS’s approach would be more palatable if the agency sought a lower level of deference for regulations issued under self-executing statutes. However, in Mayo, the IRS successfully obtainedChevron deference for a regulation issued under a statute of that type. But now the IRS argues that it need not follow notice-and-comment for regulations issued under self-executing statutes. In other words, the IRS wants to have its cake and eat it too. That, I suppose, is the hallmark of the agency’s tax exceptionalist approach to administrative law.

By Andy Grewal

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