CIC Services: Micro-captive Notice Vacated Based on the APA
After five long years of litigation that went all the way to the U.S. Supreme Court and back, a federal district court in Tennessee has ruled in favor of CIC Services, LLC and determined that the IRS failed to comply with the Administrative Procedure Act (APA) when it issued Notice 2016-66. CIC Servs., LLC v. IRS, No. 3:17-cv-110 (E.D. Tenn. Mar. 21, 2022). Back in 2017, the same court denied the taxpayer's motion for a preliminary injunction to prohibit the IRS from enforcing Notice 2016-66 and instead granted the government's motion to dismiss the suit for lack of subject matter jurisdiction based on its finding that CIC Services was unlikely to succeed on the merits of its claims because the suit was foreclosed by the Anti-Injunction Act (AIA). CIC Servs, LLC. v. IRS, No. 3:17-cv-110, 2017 US Dist. Lexis 181482 (E.D. Tenn. Nov. 2, 2017). CIC Services appealed and the Court of Appeals for the Sixth Circuit upheld the dismissal. CIC Servs., LLC v. IRS, 925 F.3d 247 (6th Cir. 2019). Eventually, the Supreme Court held that the AIA did not deprive the district court of jurisdiction over CIC Services' claim. See CIC Servs., LLC v. IRS, 141 S. Ct. 1582 (2021). Once the case was remanded to the district court, the parties filed cross motions for summary judgment and supplemented their briefing following the Sixth Circuit's recent decision in Mann Construction, Inc. v. United States. As we previously reported, Mann Construction concluded that a similar IRS notice was a legislative rule and, thus, subject to the APA's notice and comment requirement. No. 21-1500, 2022 WL 619822 (6th Cir. Mar. 14, 2022).
At the outset of the CIC opinion, the district court explained that its role in this case was limited to a review of the administrative record to determine whether the agency complied with the APA. Relying on Mann Construction, the court found that Notice 2016-66 was also an example of a legislative rule to which the tenets of the APA applied. After examining this instance of rulemaking through the lens of the APA, the court held that Notice 2016-66 was invalid because the IRS (1) failed to comply with the notice and comment requirement, and (2) acted arbitrarily and capriciously when it issued the notice.
The IRS's failure to comply with the APA notice and comment requirement was evidenced by the fact that Notice 2016-66 was issued with immediate effect, the agency having failed to solicit commentary from taxpayers regarding the impact of the Notice's designation of micro-captive transactions as reportable transactions. When turning its attention to the determination of whether the IRS action was arbitrary and capricious, the court noted that its inquiry would be limited to whether "the agency examined the relevant data and articulated a satisfactory explanation for the decision, including a rational connection between the facts found and the choice made." CIC Servs, at 8 (quoting Dep't of Com. v. New York, 139 S. Ct. 2551, 2569 (2019). In doing so, the court held that it "may not substitute its judgment for that of the agency, but instead must confine itself to ensuring that the agency remained within the bounds of reasoned decisionmaking." Id. Under this standard, the court found that "the administrative record fails to include relevant data and facts supporting the IRS's decision to designate micro-captive arrangements as transactions of interest, and, thus, reportable transactions." While the notice stated that the IRS was aware of micro-captive transactions and believed that they had "a potential for tax avoidance or evasion," the court found that the IRS had failed to identify any facts or data supporting its belief that the transactions had the potential for tax avoidance or evasion. The court did not find facts or data in support of the Notice in the administrative record, which included internal IRS and [Treasury] emails, prior IRS notices, statutes and legislative history, and captive insurance cases. In particular, the court held that including cases, statutes, legislative history, or previous notices without explanation "is not synonymous with examining relevant facts and data in connection with issuing the Notice." The court noted that the APA requirement "that the IRS examine relevant facts and data supporting [its] conclusion" applies regardless of whether the IRS is ultimately correct that micro-captive transactions have a potential for tax avoidance. Because the administrative record did not include the facts and data underlying the IRS's conclusion, the court held that the Notice must be set aside as an arbitrary and capricious agency action.
The court next turned to the appropriate relief to be granted. It noted that the Sixth Circuit in Mann Construction followed the plain language of the APA, which provides that a reviewing court shall "hold unlawful and set aside" agency actions that are "arbitrary, capricious, and abuse of discretion, or otherwise not in accordance with law." CIC Servs., at 14 (emphasis in original). But the court also recognized that the U.S. Court of Appeals for the District of Columbia has found that vacating a rule is not always necessary and the decision to do so depends on "the seriousness of the order's deficiencies . . . and the disruptive consequences of an interim change that itself may be challenged." Id. at 14 (citing Allied-Signal, Inc. v. Nuclear Regul. Comm'n, 988 F.2d 146, 150 (D.C. Cir. 1993)).
In this case, the court decided that vacating Notice 2016-66 with respect to all taxpayers was the appropriate remedy. The court cited the IRS's historic failure to comply with APA requirements and "the basic rules of administrative law" in support of vacatur of the Notice. CIC Servs., at 14-15. In doing so, however, the court recognized that the IRS is not prevented from promulgating a new rule that satisfies APA requirements.
In addition to vacating the notice, the court also partially granted the taxpayer's request for injunctive relief. Because taxpayers cannot recoup the time and resources they spent complying with the Notice since its issuance, the court concluded that it is "entirely reasonable and equitable to require the IRS to return to the taxpayers and material advisors information and documents it collected pursuant to the Notice." But the court refused to enjoin the IRS from offering documents produced in response to the Notice in any judicial or administrative proceedings. The court noted that the IRS can lawfully obtain much of the same information from other sources and that it may try to issue a new APA-compliant rule. Ostensibly, the court did not want to risk setting up future litigation over whether the IRS lawfully obtained the information sought to be used.
This decision, which comes on the heels of the Sixth Circuit's decision in Mann Construction, leaves us all wondering what's next. How many IRS notices that identify listed transactions and transactions-of-interest are susceptible to an APA challenge? And what is the appropriate remedy? Taxpayers considering a reportable transaction may want to rethink their future disclosure obligations and will certainly have a new argument to use when defending against penalties for failures to disclose. In addition, taxpayers that paid penalties for failure to disclose a reportable transaction in prior years may want to consider filing amended returns before the statute expires.
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