Global Tax Alert | 13 October 2017
US District Court holds US Treasury violated APA’s notice-and-comment requirement in issuing new anti-inversion rule with immediate effective date
In Chamber of Commerce of US. v. IRS, No. 1:16-cv-00944 (W.D. Tex. 29 September 2017), the US District Court for the Western District of Texas (the District Court) held that the Internal Revenue Service (IRS) and the US Treasury Department (collectively, Treasury) violated the Administrative Procedures Act (APA) by issuing Treas. Reg. Section 1.7874-8T with an immediate effective date and without complying with the APA’s 30-day notice-and-comment requirement.
In April 2016, Treasury issued final, temporary and proposed regulations providing new rules addressing inversion transactions (the 2016 Regulations, TD 9761, REG-135734-14; see EY Global Tax Alert, US Treasury issues new regulations modifying application of Section 7874 to inversion transactions and limiting US tax benefits of post-inversion planning, dated 7 April 2016). In general, the 2016 Regulations modified the application of Internal Revenue Code1 Sections 7874 and 367 to inversion transactions, limiting the US tax benefits of certain post-inversion planning.
The 2016 Regulations included temporary regulations with new rules that had not been previously proposed and generally became effective immediately — applying to acquisitions or post-inversion transactions completed on or after 4 April 2016. Specifically, Treas. Reg. Section 1.7874-8T (the Rule) included a new rule that — for purposes of calculating the ownership percentage under Section 7874(a)(2)(B)(ii) — excludes from the denominator of the ownership fraction stock of the foreign acquiring corporation attributable to certain prior domestic entity acquisitions. This Rule applies if, within the 36-month period ending on the signing date with respect to the relevant domestic entity acquisition, the foreign acquiring corporation completed one or more other domestic entity acquisitions that are not excluded under an exception.
The US Chamber of Commerce (Chamber), along with the Texas Association of Business, brought a lawsuit with three separate allegations: (1) Treasury violated its regulatory authority, (2) the Rule was arbitrary and capricious, and (3) Treasury violated the notice-and-comment requirement of the APA in promulgating the Rule. Chamber moved for summary judgment on its claims. Treasury moved to dismiss the case on the grounds that: (1) Chamber lacked standing to challenge the Rule; and (2) the suit was barred by the Anti-Injunction Act.
District Court order
The District Court first addressed Chamber’s standing to bring the suit. Chamber based its standing specifically on the membership in its organization of two companies, and asserted that the Rule eliminated the tax benefits associated with a planned merger between the two companies. Citing relevant case law, the District Court agreed that these companies (and potentially other members of Chamber) would have standing to sue in their own right. Chamber also presented evidence that Treasury specifically targeted the merger of these two companies in promulgating the Rule.
For these reasons, the District Court determined that the requirements for standing and standing-by-association were satisfied, and held that Chamber had standing to challenge the Rule.
Treasury argued that Chamber’s claims were barred by the Anti-Injunction Act, which limits lawsuits challenging a tax before it is assessed or collected. The District Court concluded, however, that Chamber was not seeking to restrain assessment or collection of a tax, but rather to challenge the validity of the Rule that would affect decision-making on potential transactions. The District Court added that the Rule is not itself a tax, but rather a rule regarding who is subject to tax. Accordingly, the District Court held that Chamber’s claims were not barred by the Anti-Injunction Act.
Violation of the APA
Chamber argued that Treasury violated the APA by issuing the Rule because: (1) the Rule exceeded the Treasury’s statutory jurisdiction, (2) Treasury engaged in arbitrary and capricious rulemaking, and (3) Treasury failed to provide adequate notice and opportunity to comment. The District Court addressed each argument.
The District Court concluded that Section 7874 grants Treasury broad authority to issue legislative regulations and that Treasury did not exceed its statutory authority. The District Court noted that the Rule calls for certain stock to be treated as “not stock” for purposes of certain calculations required under the statute — which corresponds to Section 7874(c)(6), which states regulations may “treat stock as not stock” to determine whether a corporation is a surrogate foreign corporation. Further, the Rule aimed to prevent avoidance of the purposes of the statute, which is also specifically authorized in Section 7874(g). Accordingly, the District Court held that Treasury did not exceed its relevant statutory authority by issuing the Rule.
Arbitrary and capricious
The District Court concluded that Treasury did not engage in an arbitrary and capricious rulemaking in issuing the Rule because Treasury: (1) did not rely on factors that Congress did not intend for it to consider, (2) did not fail to consider an important aspect of the issue before it, and (3) offered a reasonable explanation for the Rule.
Finally, Chamber argued that the Treasury violated the APA’s required 30-day notice-and-comment period by issuing the Rule with an immediate effective date. Treasury made two counter-arguments: (1) the APA’s notice-and-comment requirement does not apply to temporary regulations when corresponding proposed regulations that provide a notice-and-comment period are issued simultaneously, and (2) a notice-and-comment period was not required because the Rule was interpretive rather than legislative.
First, the District Court found no exception from the notice-and-comment period requirement for temporary regulations issued with proposed regulations. Specifically, the District Court rejected Treasury’s argument that Section 7805 of the Code allows issuance of temporary regulations without subjecting them to notice and comment before they become effective if the regulation is simultaneously issued as a proposed regulation subject to notice and comment. The District Court dismissed Treasury’s reliance on legislative history to disregard explicit directives of the APA. Accordingly, the District Court held that temporary regulations were not exempt from the APA’s notice-and-comment requirements.
Second, the District Court held that the Rule was a legislative regulation, and thus, subject to the APA’s notice-and-comment requirement. The District Court acknowledged that the APA permits the issuance of “interpretive” regulations without a notice-and-comment period. Treasury argued that the Rule was interpretive — that it merely clarified statutory terms and advised on Treasury’s interpretation of the statute. The District Court disagreed, noting that the statute authorized Treasury to issue regulations modifying the application of the statute and to issue regulations “to treat stock as not stock.” The District Court concluded these rules are not interpretations of the statute but substantive modifications. Specifically, the District Court stated that the Rule changed the calculation for determining whether a corporation is treated as a surrogate foreign corporation by excluding certain stock from the calculation. The District Court held that this makes the Rule legislative, not interpretative, and accordingly subject to the APA’s notice-and-comment requirements.
This opinion is noteworthy as this is the first court to invalidate an IRS temporary regulation solely due to the procedural misstep of not complying with the APA notice-and-comment requirement. The holding, however, does not have any general precedential value and is only potentially persuasive authority. To the extent that another court adopts the same analysis, the holding may imperil other temporary regulations issued with an immediate effective date and without a notice-and-comment period.
Further, the District Court affirmed Treasury’s authority to issue the Rule, which may strengthen Treasury’s ability to regulate the US tax effects of future inversion transactions. The effect of this case on future mergers and acquisitions between US and non-US headquartered companies, however, is unclear. In the near term, taxpayers cannot rely on the holding of this case because the decision is not precedential; in addition, Treasury has the option to finalize the corresponding proposed regulation with an effective date of May 2016.
For future regulations, this case may temper Treasury’s ability to react to the tax market-place without providing a 30-day notice-and-comment period. Tax practitioners should continue to watch Treasury’s reaction to this case, and how the case may change Treasury’s approach to issuing new rules through regulation and notices.
1. All “Section” references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP, International Tax Services
- Jose Murillo, Washington, DC
+1 202 327 6044
- Steven M Surdell, Chicago
+1 312 879 4123
- Trey Whitten, Washington, DC
+1 202 327 7419
Ernst & Young LLP, Tax Controversy and Risk Management Services
- Rob Hanson, Washington, DC
+1 202 327 5696
- Alan Summers, Portland, OR
+1 503 414 7967
- John DiIorio, Washington, DC
+1 202 327 6847
- Matthew S. Cooper, Washington, DC
+1 202 327 7177
EYG no. 05866-171Gbl