I. Overview
The Sixth Circuit's decision in Whirlpool Financial Corp. v. Comm'r1 can be criticized for its substantive analysis of Code Sec. 954(d)(2). It concluded that Code Sec. 954(d)(2) unambiguously required foreign base company sales income (FBCSI) if the two conditions in the statute were met, with no requirement to then test the income under Code Sec. 954(d)(1). This conclusion conflicts with a longstanding rule in Treasury regulations2 that prohibits FBCSI under Code Sec. 954(d)(2)'s branch rule unless there would be FBCSI under Code Sec. 954(d)(1) if the branch were actually a subsidiary.3 The circuit court misread the Tax Court as reaching the same holding based on the statute, when in fact the Tax Court found Code Sec. 954(d)(2) ambiguous on that point, analyzed Code Sec. 954(d)(2) under the regulations, and then returned to Code Sec. 954(d)(1) before holding that FBCSI must be recognized.4
The most remarkable aspect, however, of the Sixth Circuit's Whirlpool decision was the court's disregard of both the express delegation of authority to Treasury in Code Sec. 954(d)(2), and the rule in Reg. §1.954-3(b)(2)(ii)(e) that implemented this delegation. Believing that the statute clearly commanded FBSCI under Code Sec. 954(d)(2) after the provision's two conditions were met, the court dismissed whatever Treasury might have said differently in the regulations, stating "the agency's regulations can only implement the statute's commands, not vary from them."5 The court's "go it alone" approach to interpreting Code Sec. 954(c)(2), as if it were unaware that Treasury had long ago reached a different interpretation, violates a Supreme Court mandate for judicial deference to agency regulations. For that reason alone, the Sixth Circuit's Whirlpool opinion—to the extent of its holding that FBCSI automatically results under Code Sec. 954(d)(2) if the two conditions are met with no requirement to apply Code Sec. 954(d)(1)—should not have any precedential value outside the Sixth Circuit, including in the Court of Federal Claims. And given the strong dissent to the majority's Sixth Circuit opinion, the persuasive effects of that opinion should be minimal.
Far from a clean victory, the Whirlpool opinion has created a veritable mess for the government. The rule in Reg. §1.954-3(b)(2)(ii)(e) was not invalidated, even though it cannot be reconciled with the court's primary holding on Code Sec. 954(d)(2). And, because the Sixth Circuit's opinion was based solely on its interpretation of the statute, the validity of the manufacturing branch regulations—which were upheld as valid in the Tax Court—was not addressed. What does that mean for Treasury and the Internal Revenue Service (IRS)? If they treat Whirlpool as "the law," then they need to withdraw Reg. §1.954-3(b)(2)(ii)(e) from the regulations, because otherwise the government is bound to apply those regulations.6 That is, it cannot apply the Whirlpool holding and Reg. §1.954-3(b)(2)(ii)(e) at the same time—one has to go. Given the weak precedential value of Whirlpool, does the government risk facing a validity challenge in another circuit if it incorporates the Whirlpool holding into its regulations? And does it dare make those revisions retroactively?
A victory is not always a victory in the world of tax administration.
It is frustrating to know how different things could have been had the Sixth Circuit analyzed Reg. §1.954- 3(b)(2)(ii)(e) under established principles of judicial deference. It is inconceivable that the court would have invalidated—or even analyzed—this provision under Chevron Step One,7 particularly when both parties respected the validity of that provision. The Chevron analysis likely would have been limited to the manufacturing branch rule that was challenged by the taxpayer in the Tax Court. Based on what the Sixth Circuit said about the statute being unambiguous, it likely would have upheld the manufacturing branch rule in Chevron Step One. Then, having laid that groundwork, the Sixth Circuit could have focused on the Tax Court's holding that the controlled foreign corporation's (CFC's) sale income was FBCSI because its sales were made on behalf of a related person under Code Sec. 954(d)(1) (i.e., the branch that is treated as a subsidiary under Code Sec. 954(d)(2)'s branch rule). That, in turn, might have caused the Sixth Circuit to focus on a major flaw in the Tax Court's opinion, which was the failure to articulate why the CFC could not have benefited from the manufacturing exception in the Code Sec. 954(d)(1) regulations.8 Unfortunately, there is still no answer to that question.
II. Court's Statutory Interpretation Exceeded its Authority
This judicial deference analysis is being approached with some amount of hesitation. In sum, the Sixth Circuit was required by Supreme Court precedent to analyze the issues before it through the lens of the applicable Treasury regulations, and its failure to do so was a judicial error. However, to arrive at that conclusion one must tread through a complex web of Supreme Court and lower court opinions that ebb and flow with varying degrees of uncertainty and clarity, as the judiciary changes and the precedent evolves. Concepts that were once important in tax, such as the distinction between legislative and interpretative regulations, now seem less important.9 However, other similar concepts, such as the distinction between an express delegation and an implied delegation, have continuing importance.10
While a deeper analysis of this issue is better suited for a constitutional scholar than a busy tax attorney, it is clear that Code Sec. 954(d)(2) contains an express delegation of authority from Congress to Treasury.11 Code Sec. 954(d)(2) first describes the conditions for its application: (i) that a CFC has carried on activities through a branch outside the country of the CFC's incorporation and (ii) such carrying on of activities has substantially the same effect as if the branch were a wholly owned subsidiary of the CFC. Then, following those conditions it has the following command: "... under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch or similar establishment shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and shall constitute foreign base company sales income of the controlled foreign corporation." (emphasis added).
Whenever Congress has made an express delegation of authority to an agency, and the agency has issued regulations pursuant to the delegation, a court must consider how the issue before it has been addressed by those regulations.12 It does not have the privilege to indulge in an independent analysis of what the statute means, if the regulations have already addressed the issue in the case.13 It does not matter that the court has a different view than the agency.14 The court must defer to the agency's regulations unless it finds that the regulations are arbitrary, capricious, or manifestly contrary to the statute.15 Effectively, in the case of an express delegation, the court bypasses Chevron Step One and goes directly to Step Two. If a court makes such a finding in its Step Two analysis, it must "set aside" the regulations as invalid.16
Footnotes
1 19 F.4th 944 (6th Cir. 2021).
2 All references to Treasury regulations are to the Reg. §1.954-3 regulations that were last amended in T.D. 9008, 2002-2 CB 335 (Jul. 7, 2002), and were at issue in Whirlpool. These regulations were originally issued in 1964. T.D. 6734, 1964-1 CB (Part 1) 237 (May 14, 1964). Subsequent versions of these regulations in 2008 and 2011 were not at issue. T.D. 9438, IRB 2009-5, 387 (Dec. 24, 2008); T.D. 9563, IRB 2012- 6, 354 (Dec. 15, 2011).
3 Reg. §1.954-3(b)(2)(ii)(e), entitled "Comparison with ordinary treatment," provides: "Income derived by the branch or similar establishment, or by the remainder of the controlled foreign corporation, shall not be considered foreign base company sales income if the income would not be so considered if it were derived by a separate controlled foreign corporation under like circumstances."
4 See Whirlpool Financial Corp., 154 TC 142, Dec. 61,661, 154 TC No. 9 (2020).
5 19 F.4th at 952-53.
6 United States ex. rel. Accardi v. Shaughnessy, 347 US 260, 74 SCt 499 (1954) (Agency must abide by its own valid and applicable regulations); Mutual Savings Life Insurance, CA-5, 74-1 ustc ¶9208, 488 F2d 1142, 1145 (1974) ("A taxpayer has the right to rely upon the Government's Regulations ... Treasury Regulations having the force and effect of law are binding on tax officials, as well as taxpayers ... [T]he Government cannot just abandon ... the regulation[ ] and direct it into some type of obscurity oblivion as if it never existed"); Notice CC-2003-014 (May 8, 2003) ("Chief Counsel attorneys may not rely on case law to take a position that is less favorable to the taxpayer in a particular case than the position set forth in published guidance"). See also Rauenhorst, 119 TC 157, 171, Dec. 54,899 (2002) ("However, we cannot agree that the Commissioner is not bound to follow his revenue rulings in Tax Court proceedings"); Dover Corp. and Subsidiaries, 122 TC 324, 350, Dec. 55,630 (2004) (same).
7 The reference to Chevron deference, Step One and Step Two are derived from the twostep framework for judicial review of agency regulations set forth by the Supreme Court in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 US 837, 104 SCt 2778 (1984).
8 To compound the frustration, Judge Nalbandian's dissenting opinion sets forth a compelling analysis of why the CFC's sales income should not have been treated as FBSCI due to the manufacturing exception in Reg. §1.954-3(a)(4), or why, at a minimum, the taxpayer should have had an opportunity to present evidence at trial on its ability to qualify for that exception. Unlike the majority's narrow focus on the "shall constitute" language in the final clause of Code Sec. 954(d)(2), the dissent looks more broadly at the structure and purpose of Code Secs. 954(d)(1) and (d)(2) to conclude "that it only makes sense if (d)(2) transactions filter back through (d)(1)'s framework, including its Manufacturing Exception." Whirlpool, 19 F.4th at 956 (J. Nalbandian, dissenting). Unlike the majority's disregard of Reg. §1.954-3(b)(2)(ii)(e) in its analysis of Code Sec. 954(d)(2), the dissent recognized that "Congress gave Treasury a role in defining when branch transactions generate FBCSI," and concluded that this regulation "explicitly tells us to apply the (d)(1) exceptions to the (d)(2) transaction." Id. at 956-59.
9 The Supreme Court's opinion in Mayo Found. for Medical Educ. and Research, SCt, 2011-1 ustc ¶50,143, 562 US 44, 57–58, 131 SCt 704 (2011) confirmed that regulations issued under Code Sec. 7805(a)'s general grant of authority are entitled to the same Chevron deference as regulations issued under a specific grant of authority, if issued pursuant to the notice and comment process of the Administrative Procedure Act. That does not mean, however, that any regulation issued under Code Sec. 7805(a)—which is nearly every tax regulation other than regulations issued under a specific grant of authority—has an automatic path to Chevron's Step Two. E.g., Wisconsin Central Ltd., SCt, 2018-1 ustc ¶50,291, 138 SCt 2067, 2074 (2018) (Reg. §31.3231(e)-1, promulgated pursuant to Code Sec. 7805(a), held invalid; insufficient statutory ambiguity to move to Chevron Step Two). Any Code Sec. 7805(a) regulation hoping for Chevron deference must still point to a gap in the statute that needs to be filled, in order to have the requisite authority to fill that gap. E.g., Sea-Land Serv., Inc. v. Dept. of Trans., 137 F3d 640, 645 (D.C. Cir. 1998) ("[Chevron] deference comes into play, of course, only as a consequence of statutory ambiguity, and then only if the reviewing court finds an implicit delegation of authority to an agency").
10 In Chevron the Court described two different deference standards—the arbitrary and capricious standard and the permissible construction standard—with the former applying where the delegation of authority from Congress is explicit and the latter applying where the delegation is only implicit as a result of ambiguity or silence. 467 US at 843-44.
11 See, e.g., E.I. du Pont de Nemours & Co., CA-3, 94-2 ustc ¶50,620, 41 F3d 130, 135 (1994) ("Code Sec. 58(h) provided that the 'Secretary shall prescribe regulations ...,' which appears to be precisely the type of 'express delegation of authority to the agency' that Chevron contemplates"); Mohamed, 103 TCM 1814, Dec. 59,074(M), TC Memo. 2012-152 (2012) (Regarding Code Sec. 170(a)(1) which provided that "[A] charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the Secretary," the Tax Court stated: "This language is an 'express delegation of authority' to create rules about how a donation will be verified .... We can't invalidate regulations unless they are arbitrary, capricious, or manifestly contrary to the statute"). See also Berg, Judicial Deference to Tax Regulations: Reconsideration in Light of National Cable, Swallows Holding, and Other Developments, 61 Tax Lawyer, 61(2), 485–490 (author explores the various types of delegations of regulation-writing authority).
12 The Supreme Court's command in Chevron is unequivocal: "If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute." 467 US at 843-44. The opinions cited as authority for this statement include Morton, 467 US 822, 834, 104 SCt 2769 (1984) ("As part of the 1977 amendment, Congress authorized the promulgation of 'regulations for the implementation of the provisions of section 659' .... Because Congress explicitly delegated authority to construe the statute by regulation, in this case we must give the regulations legislative and hence controlling weight unless they are arbitrary, capricious, or plainly contrary to the statute"); Schweiker v. Gray Panthers, 453 US 34, 101 SCt 2633 (1981) (Referring to regulations issued under the Social Security Act, the Court stated: "Congress conferred on the Secretary exceptionally broad authority to prescribe standards for applying certain sections of the Act .... Of special relevance in the present case is the delegation of authority in §1902(a)(17)(B) of the Act .... In view of this explicit delegation of substantive authority, the Secretary's definition of the term 'available' is 'entitled to more than mere deference or weight.' .... Rather, the Secretary's definition is entitled to 'legislative effect' because, '[i]n a situation of this kind, Congress entrusts to the Secretary, rather than to the courts, the primary responsibility for interpreting the statutory term'"); Batteron v. Francis, 432 US 416, 424–426, 97 SCt 2399 (1977) ("Congress in §407(a) expressly delegated to the Secretary the power to prescribe standards for determining what constitutes 'unemployment' for purposes of AFDC-UF eligibility .... In exercising that responsibility, the Secretary adopts regulations with legislative effect. A reviewing court is not free to set aside those regulations simply because it would have interpreted the statute in a different manner .... The regulation at issue in this case is therefore entitled to more than mere deference or weight. It can be set aside only if the Secretary exceeded his statutory authority or if the regulation is 'arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.' 5 USC 706(2)(A), (C)").
13 E.g., Thorne v. U.S. Dep't of Defense, 916 FSupp. 1358, 1366 (E.D. Va. 1996) ("Considered in isolation, then, the statute on its face imposes a restriction on speech. But this does not end the matter for the statute should not be read apart from the Department of Defense's implementing regulations, as Congress explicitly provided that the 'Don't Ask, Don't Tell' plan embodied in §654 was to be implemented 'under regulations prescribed by the Secretary of Defense,' 10 USC §654(b)"); Barnhart v. Walton, 535 US 212, 222, 122 SCt 1265 (2002) ("Chevron provides the appropriate legal lens through which to view the legality of the Agency interpretation here at issue").
14 National Cable & Telecommunications Ass'n v. Brand X Internet Services, 545 US 967, 980, 125 SCt 2688 (2005) ("Chevron requires a federal court to accept the agency's construction of the statute, even if the agency's reading differs from what the court believes is the best statutory interpretation").
15 Id.
16 Mead Corp., 533 US 218, 229, 121 SCt 2164 (2001) (citing the Administrative Procedure Act, 5 USC §706(2), stating that "a reviewing court shall set aside agency action, findings, and conclusions found to be 'arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law'").
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Originally Published by International Tax Journal
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