Swallows Decision Renews Questions About Judicial Deference to Tax Regs.

By Eve Elgin, J.D., LL.M., Washington, DC

Editor: Mary Van Leuven, J.D., LL.M.

A recent win for the IRS in Swallows Holding, Ltd., 515 F3d 162 (3d Cir. 2008), rev’g 126 TC 96 (2006), provides an unsettling reminder of the confusing state of the law concerning when courts should defer to federal tax regulations. In Swallows, the Court of Appeals for the Third Circuit reversed the Tax Court and upheld the validity of an “interpretive” Treasury regulation. The Third Circuit applied the high degree of deference to the regulation prescribed by Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 US 837 (1984), finding that Congress intended for the agency action to have the force of law.

The degree of judicial deference to agency action is important, among other reasons, because it can affect the extent to which policy decisions are made by the executive, as opposed to the legislative, branch of government as well as the rights of private persons in relation to agency action. This item summarizes the Tax Court and Third Circuit decisions and considers their potential implications.

Tax Court Weighs In

The taxpayer in Swallows, a Barbados corporation treated as engaged in the trade or business of renting U.S. real property, claimed deductions attributable to its U.S. effectively connected rental income. The IRS disallowed the deductions because the returns were filed late. More specifically, the IRS relied on Regs. Sec. 1.882-4(a)(3)(i), which generally precludes a foreign corporation from claiming deductions attributable to its effectively connected income if the return is filed more than 18 months late. This regulation was issued prospectively.

The Tax Court, in a reviewed decision, held that the regulation was an invalid exercise of Treasury’s general rulemaking authority under Sec. 7805(a) (Swallows Holding, Ltd., 126 TC 96 (2006)). The Tax Court first concluded that the regulation conflicted with an unambiguous statutory provision. Sec. 882(c)(2) requires foreign corporations to file returns in the “manner” prescribed by subtitle F and, according to the court, “manner” does not include a time element. The Tax Court then reasoned that, even if the statute was ambiguous, the regulation was unreasonable under the factors set forth in National Muffler Dealers Ass’n, 440 US 472 (1979) (upholding a regulation determining when organizations could be tax-exempt business leagues under Sec. 501(c)(6)). According to the court, National Muffler is the appropriate standard for reviewing “interpretive” tax regulations issued under Sec. 7805(a), while Chevron (which upheld EPA regulations implementing permit requirements under the Clean Air Act) applies to “legislative” regulations issued under a specific delegation of authority from Congress to Treasury. The National Muffler factors for determining a regulation’s reasonableness include whether the regulation is a contemporaneous construction of the statute and whether the IRS’s position is consistent over time. The court noted, for example, that the regulation was issued more than 60 years after the relevant statutory provision and represented a change in the IRS’s historical position.

Finally, the Tax Court concluded that it would have reached the same result if it had applied a Chevron analysis instead of the National Muffler test. Citing its previous decision in Central Pa. Sav. Assoc. & Subs., 104 TC 384, 392 (1995), the Tax Court stated that it was “inclined to the view that” Chevron had not changed the National Muffler standard but had only restated it as a two-part test “with possibly subtle distinctions as to the role of legislative history and the degree of deference to be accorded to a regulation.”

Third Circuit Reverses

The Third Circuit disagreed with the Tax Court, holding that National Muffler and Chevron imposed different standards of review, that Chevron deference was warranted, and that under Chevron the regulation was valid. According to the Third Circuit, Chevron deference is warranted when Congress intends for agency action to have the force of law, regardless of whether the regulation is interpretive or legislative in nature. The Third Circuit seemed to cautiously avoid inserting itself into the interpretive/legislative quagmire. Instead, the court held that Chevron deference was applicable because the court considered the regulation to have the force of law, as “the Secretary opened the rule to public comment, a move that is indicative of agency action that carries the force of law” (Swallows Holding, Ltd., 515 F3d at 169, citing Mead Corp., 533 US 218 (2001) (a tariff classification ruling by the U.S. Customs Service was not entitled to Chevron deference)).

The Third Circuit in Swallows then applied Chevron’s two-step analysis. According to the court, under step 1, the statutory provision was ambiguous because “manner” could include a time element. Thus, there was an implicit delegation of authority to Treasury to fill the gap with a reasonable regulation. Under step 2, deference to the regulation was warranted because the regulation represented “a permissible construction” of the statute.  The court found that the regulation reasonably balanced the IRS’s interest in tax compliance with the foreign corporation’s interest in claiming tax deductions and that Chevron deference was particularly appropriate in complex and highly technical regulatory programs, such as the tax laws. The court further emphasized that the regulation involved the drawing of a “temporal line” and that the IRS was in a superior position to make judgments about tax law administration.

Where to Go from Here

It is too early to predict the overall impact of the Third Circuit’s decision in Swallows. At a minimum, the decision suggests that foreign corporations seeking a redetermination of tax liability in the Third Circuit may have difficulty claiming effectively connected deductions in the case of late returns caught by Regs. Sec. 1.882-4(a)(3)(i). But note that fewer foreign corporations may appeal to the Third Circuit because Forms 1120-F, U.S. Income Tax Return of a Foreign Corporation, must now be filed in Ogden, Utah (the Tenth Circuit), instead of in Philadelphia (the Third Circuit), where the Swallows taxpayer filed its returns. See also Sec. 7482(b)(1)(B).

Swallows is less likely to provide certainty in the general area of judicial deference to tax regulations. The decision leaves numerous open questions, even in the Third Circuit. For example, what deference might the Third Circuit accord to regulations issued without notice and comment, such as temporary regulations? What deference might apply to regulations with a retroactive effective date? Further, because the Third Circuit stressed the special expertise of the IRS in drawing a temporal line, how might the Tax Court react to a regulation that was more overtly substantive, as opposed to procedural, in character?

It also remains unclear whether the Tax Court will continue to apply National Muffler to cases that are not appealable to the Third Circuit. Under the “Golsen rule,” the Tax Court follows the rule adopted by the court of appeals to which the taxpayer has a right of appeal (Golsen, 54 TC 742 (1970), aff’d on another issue, 445 F2d 985 (10th Cir. 1971)).

The waters may be even more muddied if the Third Circuit, by highlighting the importance of the notice and comment process, is setting the stage for the level of judicial deference to be decided based on whether the IRS complies with the rulemaking provisions of the Administrative Procedure Act (APA) (5 USC Section 553). Although the IRS generally issues its interpretive regulations with notice and comment, the IRS considers these regulations to be interpretive rules within the meaning of the APA and therefore not subject to the APA’s formal notice and comment provisions (see, e.g., Internal Revenue Manual Section

Regardless of whether interpretive regulations are interpretive rules, what level of judicial deference applies if the IRS issues regulations with notice and comment that fall short of the APA’s formal notice and comment provisions? See generally Hickman, “Coloring Outside the Lines: Examining Treasury’s (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements,” 82 Notre Dame L. Rev. (2007): 1727, 1730 (concluding that “Treasury often fails to adhere to APA rulemaking requirements and thus leaves many of its regulations, including some of its most complex and controversial efforts, open to legal challenge on that basis”).

Notwithstanding the Third Circuit’s reliance on Chevron in Swallows, it remains to be seen how the Supreme Court may apply Chevron in tax cases. For example, the Court did not cite Chevron in upholding a tax regulation in the later case of Cottage Savings Ass’n, 499 US 554 (1991). Hopefully the Supreme Court will take up this question at some point. The “force of law” rationale for applying Chevron’s high level of deference to agency determinations may be too blunt for addressing balance of power considerations between branches of government or between the public and private sectors. Of course, even if Chevron applies, it is not clear how the Chevron standard will differ from the National Muffler standard in a particular situation, such as when a regulation is issued contemporaneously with a new statutory provision.

Considerations of judicial deference may be especially important in the tax area. See, for example, Aprill, Galler, and Salem, “ABA Section of Taxation Report of the Task Force on Judicial Deference,” 57 Tax Law. (2004): 717, 719, concluding that the Supreme Court needs to clarify how the concept of deference applies in the tax area, among other reasons, because of “(1) the power and pervasiveness of the IRS, (2) the large number and variety of administrative pronouncements issued by the IRS, and (3) the Supreme Court’s continuing reliance in its tax cases on the traditional test of National Muffler . . . , rather than on Chevron.” The extent of judicial involvement is also important because of the presumption of correctness for IRS deficiency determinations as well as the broad array of penalties for noncompliance, some of which impose strict liability (see, e.g., Sec. 6707A).

Those hoping for Supreme Court intervention should perhaps not hold their breath. A taxpayer recently filed a petition for certiorari, challenging the validity of the IRS check-the-box regulations for entity classification (Regs. Secs. 301.7701-1 through -3). The taxpayer’s petition argued that Chevron deference should apply to legislative but not interpretive tax regulations (see Littriello, 2007 WL 4631293 (12/26/07)). The Supreme Court denied certiorari (S. Ct. Dkt No. 07-851 (U.S. 2/19/08)).


Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC

The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.

©2008 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.



If you would like additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.

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