Administrative Law - Judicial Review of Treasury Regulations - Federal Circuit Invalidates a Treasury Regulation under State Farm for Lack of Contemporaneous Statement of Justification

Article excerpt

For years, generally applicable administrative law was not applied to taxation under the doctrine of tax exceptionalism. (1) Essentially, while cases like Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc. (2) and Motor Vehicle Manufacturers Ass'n v. State Farm Mutual Automobile Insurance Co. (3) controlled review of most agency action, Treasury regulations (4) were reviewed under different standards -- most recently, those developed in National Muffler Dealers Ass'n v. United States. (5) Some circuit courts started applying Chevron to Treasury regulations beginning in 1989, but the circuits did not reach a consensus regarding which standard should apply. (6) The Supreme Court finally put the issue to rest in Mayo Foundation for Medical Education & Research v. United States, (7) holding that Chevron was the applicable standard for review of Treasury regulations. (8) Though some in the tax community feared that Mayo would usher in an era of unprecedented deference to the Treasury, (9) Mayo was soon followed by United States v. Home Concrete & Supply, (10) in which the Court, for the first time, upheld the invalidation of a Treasury regulation under general administrative law principles, holding that the regulation was an invalid interpretation of an unambiguous statute under Chevron step one. (11) Recently, in Dominion Resources, Inc. v. United States, (12) the Federal Circuit took another leap forward in applying administrative law to tax cases by invalidating a Treasury regulation that lacked reasoned contemporaneous justification as required under State Farm. (13) In applying State Farm to invalidate a Treasury regulation for what appears to be the first time at the appeals court level (14) the Federal Circuit has exposed many technically faulty but nonetheless substantively valid and important Treasury regulations to the risk of invalidation. However, the potential applicability of a developing administrative law doctrine -- remand without vacatur, under which faulty rules may remain temporarily in effect while agencies remedy defects -- suggests that Dominion is unlikely to trigger large-scale invalidation of Treasury regulations.

Dominion Resources, Inc. is a Virginia corporation in the business of generating and selling electric power. (15) In 1996, a Dominion subsidiary performed renovations on two of its generating plants and was forced to take the plants out of service temporarily. (16) At the time, Dominion was paying interest on debt unrelated to the renovations, (17) an expense ordinarily deductible from income in the year incurred. (18) However, [section] 263A of the Internal Revenue Code (I.R.C. or Tax Code) provides that, in addition to capitalizing the direct costs of an improvement, a taxpayer must also capitalize -- and therefore may not presently deduct -- indirect costs allocable to the improved property, including interest that would otherwise be presently deductible under [section] 163, to the extent that the cost of the tax-payer's then-existing debt could have been reduced had he not spent money on "production expenditures" for the improvement. (19) The effect of [section] 263A is thus to deny the taxpayer a present deduction, in the amount of his weighted-average interest rate on debt during the time of production, multiplied by accumulated production expenditures. (20) To give color to the term "production expenditures," the Treasury promulgated, inter alia, the "associated-property rule," which required that the adjusted basis of property taken out of service during the course of the improvement be included in accumulated production expenditures. (21) For Dominion, this rule meant that the bases of two entire generation units were included and that thus a total of $3.3 million of present interest deductions were disallowed. (22) Dominion disputed the amount of interest that needed to be capitalized as related to property taken out of service, and in August 2007 reached a settlement agreement with the Internal Revenue Service (IRS) to capitalize half of the amount in dispute and deduct the other half. …