Challenging the Rulemaking Process: Three Lessons for Tax Lawyers

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By Carolina Vargas

A recent Tax Court opinion shows that challenging tax regulations under the rulemaking process isn’t one-size-fits-all.

The Jan. 18 division opinion in SIH Partners LLLP v. Commissioner found that foreign corporation guaranties of margin loans are taxable income. Taxpayers had challenged Internal Revenue Service regulations under the Administrative Procedure Act (APA), which defines the rulemaking process for administrative agencies and polices agencies for improper behavior. Usually, an agency must give notice and have a comment period as part of the process. Noncompliance with the rulemaking process can trigger lawsuits.

SIH Partners LLLP sought to invalidate regulations under tax code Section 956 for failing to meet APA requirements—including whether the agency was “arbitrary and capricious” in how it conducted the notice and comment period—in its argument that controlled foreign corporations’ guaranties of Merrill Lynch margin loans shouldn’t be included in the parent corporation’s U.S. income.

Tax lawyers expected the court to rely on a more standard application of Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto Ins. Co.a 1983 case that held that the same arbitrary and capricious standard for reviewing agency actions applied for both enacting and rescinding regulations.

For tax lawyers, SIH Partners offers some lessons in how to challenge tax laws under the APA.

1. It’s Hard to Challenge Old Regulations

Taxpayers looking to make challenges under the APA need to be aware of a regulation’s history. SIH Partners shows that the Tax Court will be looking at the comments made during a regulation’s notice and comment period—even if it’s decades old. The older a regulation, the more inclined judges are to go along with it, Steve Johnson, a tax law professor at Florida State University College of Law, told Bloomberg Tax.

In SIH Partners, the court said the failure to meet the notice and comment requirement was invalid because no substantive comments had been received.

“Nobody filed comments regarding the specific issue raised in the case when the regulation was proposed in 1963. It is difficult to fault Treasury for failing to address an alternative approach when that alternative is first raised more than 50 years after the regulation was finalized,” Robert Kovacev, a tax partner with Steptoe & Johnson LLP, told Bloomberg Tax.

Taxpayers anticipating a challenge to proposed regulations should submit comments to the Treasury Department about their concerns, Kovacev said. That didn’t occur 50 years ago with the Section 956 regulations at issue in SIH Partners.

“This regulation was around for 45 years, and it’s pretty hard to paint such a long-standing guidance as ‘arbitrary,’ which is the APA standard they have to meet,” Bryan Camp, George H. Mahon professor of law at the Texas Tech University School of Law, told Bloomberg Tax.

“I think the attack might have had more traction against a recent regulation,” Camp said.

2. ‘State Farm’ Application May Not Always Prevail

In trying to invalidate the Section 956 regulations, the taxpayers argued that the IRS and Treasury had violated the APA’s arbitrary and capricious standard. One of the landmark cases used in SIH Partners for determining whether the agency’s action was arbitrary and capricious is State Farm, which dealt with regulations for passive restraints in vehicles.

Patrick Smith, a partner at Ivins, Phillips & Barker, Chartered in Washington, said he was disappointed in the application of State Farm.

“The court incorrectly seemed to think that by distinguishing the case factually from the facts in the State Farm decision, that this was a sufficient application of the State Farm analysis,” Smith said.

Johnson disagreed, saying that “a duty of explanation was far more imperative in State Farm than it was in this case.”

The court ultimately determined the agency didn’t act arbitrarily or capriciously because no substantive comments were received during the notice and comment period.

“Arbitrary and capricious review is narrow and deferential,” Johnson said. The court’s bias is in favor of upholding the regulation unless there is a serious problem with it, he said.

3. Taxpayers Shouldn’t Be Discouraged

This one application of State Farm is just that—one application. Practitioners told Bloomberg Tax that they think State Farm will continue to be used, but might vary in its application.

The SIH Partners opinion pointed out that the issue of income inclusions had been brought up twice before in the Tax Court but that neither case had challenged the regulations themselves.

Because the application was the first, some tax practitioners said they fear the court has narrowed the State Farm analysis so much that it won’t be useful for those trying to bring challenges against the IRS under the APA.

People are concerned that a significant amount of reasoned explanation won’t be required for a transfer pricing case, said Andy Grewal, a professor at the University of Iowa College of Law.

Grewal said that while he understands that reasoning, he doesn’t share that concern because transfer pricing cases can vary greatly in their analysis.

Camp also said he doesn’t see the SIH Partners decision discouraging taxpayers from challenging regulations. The Tax Court appropriately applied the State Farm analysis with consideration of the different context of the case, he said.

“That’s the mark of a good court: actual facts drive the case, not abstract Weberian ideal-types,” Camp said.

To contact the reporter on this story: Carolina Vargas in Washington at

To contact the editor responsible for this story: Meg Shreve at

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