May 1998
Test for Validity of Interpretive Regulations
Tax lawyers have traditionally subscribed to the notion that interpretive regulations must be consistent with the law they are interpreting. The degree of consistency is usually the battleground. And, in this battleground, merely formulating the legal test to apply is important because of subtle nuances.
A recent decision of the Seventh Circuit has highlighted these nuances. In Bankers Life v. Commissioner, ___ F.3d ___ (7th Cir. 4/17/98), unofficially reported at 98 TNT 76-8 (4/21/98), the issue was the proper interpretation of insurance tax regulations. The insurance tax scheme is quite complicated, so we will spare the reader an exegesis of the technical legal background. It boiled down to whether the law imposing a special tax on distribution of assets would be based upon the distributing insurance company's basis in the assets distributed or fair market value of the assets distributed. (It sounds somewhat like General Utilities, but it is not.) The long-standing regulations required that the base for the tax be the amount distributed. The taxpayer stood to avoid substantial taxes if the test were basis rather than fair market value. The taxpayer argued that the statutory language properly interpreted required basis; the IRS argued fair market value. With the positions thus staked out, the Court was forced to determine whether the regulation requiring fair market value was controlling. The Court started its analysis with the following:
Essentially, we must determine the degree of deference owed to a Treasury Regulation issued under I.R.C. section 7805(a) with notice and comment procedures. This seemingly simple inquiry leads us into a free-fire zone of judicial debate over the proper level of judicial deference to various IRS interpretations of the revenue laws. The basic question is whether Chevron deference (from Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), and its progeny) applies to tax regulations. See, e.g., Central Pa. Sav. Ass'n v. Commissioner, 104 T.C. 384, 390-91 (1995) (discussing the "checkered career" of Chevron deference in the tax arena), supplemented by, 71 T.C.M. (CCH), 1996 WL 165489 (Apr. 10, 1996). In addition to the debate in the case law, the topic has generated heated scholarly commentary. See Ellen P. Aprill, Muffled Chevron: Judicial Review of Tax Regulations, 3 Fl. Tax Rev. 51 (1996) (describing and advocating a fusion of Chevron and National Muffler, 440 U.S. 472 (1979)); Paul L. Caron, Tax Myopia Meets Tax Hyperopia: The Unproven Case of Increased Judicial Deference to Revenue Rulings, 57 Ohio St. L.J. 637 (1996) (critiquing attempts to apply discrete levels of deference to tax interpretations); John F. Coverdale, Court Review of Tax Regulations and Revenue Rulings in the Chevron Era, 34 Geo. Wash. L. Rev. 35 (1995) (arguing for distinct levels of non-Chevron deference for each type of tax interpretation); Linda Galler, Judicial Deference to Revenue Rulings: Reconciling Divergent Standards, 56 Ohio St. L.J. 1037 (1995) (attempting to provide a hierarchy of uniformly applied levels of deference for tax interpretations).
Forced into this thicket, the Court found little help in the traditional distinction between legislative and interpretive regulations, finding that in the tax world these classifications offer "more confusion than clarity." The Court thus found that even interpretive regulations were issued under a general congressional directive (Section 7805(a)) and were entitled to great deference because they were not just interpretations, but interpretations adopted under the full administrative procedures of notice and comment. (The Court noted that agency interpretations issued without such formalities were entitled to only moderate deference.) Once so issued, they are entitled to deference under the Chevron standard rather than under the standard historically articulated for tax regulations. The Seventh Circuit articulated the difference between the two standards as follows:
Chevron upholds a regulation if the agency based its interpretation on a permissible construction of a statute, see 467 U.S. at 843, while the traditional rule validates the regulation if the agency reasonably implemented Congress's mandate.
The Court noted that, in practice, these two tests might reach the same result, but noted that the test that applies is the Chevron test. Trying to treat the difference between the two standards as "a ‘negligible' difference between the approaches might overstate the true extent of the divergence." The Court thus adopted the Chevron test, even though other courts, most importantly for us the Fifth Circuit had rejected it. In adopting Chevron, the Court said:
We also favor Chevron because many courts contend that the traditional rule accords less than Chevron deference to tax regulations. The Sixth Circuit, for instance, characterizes National Muffler as allowing "plenary review" contrasted with Chevron deference. [Citation omitted]. The Third and Fifth Circuits believe that the traditional rule entitles a regulation to "less deference" than under Chevron. [Citations omitted] As Atchison explains, we owe full Chevron deference to a regulation issued with the full deliberative procedures. Although we acknowledge the gulf between the idealized Chevron and the realized one, we do believe that the structure of Chevron encourages a court to defer rather than to interpret. We, therefore, prefer it.
The Court then noted that Chevron requires a two step analysis: (1) is there a plain meaning of the statute which forecloses further inquiry and (2) if the first question is not answered affirmatively, then whether the regulations is reasonable. In describing this test, the Court said (emphasis supplied):
In the second step, the court determines whether the regulation harmonizes with the language, origins, and purpose of the statute. While not dispositive, a court may find various considerations informative -- these considerations might include the consistency of the agency's interpretation, the contemporaneousness of the interpretation, and the robustness of the regulation following congressional re-enactment of the underlying statute. Although we sometimes describe Chevron as a "rubber stamp," see [citation omitted], we know that agencies occasionally act unreasonably. Given the scope of the permissible inquiry under Chevron's second step, we believe that courts can rein in the excesses of unreasonable administrative rule-making. With that said, however, we reiterate Chevron's fundamental dictate that a court must not "substitute its own construction of a statutory provision for a reasonable interpretation" by the agency in question. [Cite to Chevron omitted.]
On the substantive life insurance issue involved, the Court sustained the IRS regulation because "the government offers a reasonable explanation for the regulation given the origin and purpose of the three-phase taxation scheme."
T&J Comment: As articulated, the Chevron test seems harder to overcome that the test traditionally applied. Fortunately, the Fifth Circuit has not yet bought into this notion.