Overview
On March 21, 2022, the US District Court for the Eastern District of Tennessee vacated Notice 2016-66 on two grounds: (1) the IRS failed to comply with the Administrative Procedure Act (APA) notice-and-comment requirements,1and (2) the IRS acted arbitrarily and capriciously when issuing the listing notice.2 This decision is the latest ruling in the CIC Services saga, which is on remand from the Supreme Court.3 Notice 2016-66 is the second listing notice to be invalidated last month as part of a transformation in how courts are applying the APA requirements to IRS subregulatory guidance.
Mann Construction
As expected, the Tennessee district court followed the Sixth Circuit's Mann Construction decision, which had invalidated Notice 2007-83 due to the IRS's noncompliance with the APA's notice-and-comment procedures.4 CIC Services rejected the IRS's arguments that Congress had exempted it from the APA's notice-and-comment requirements for issuing listing notices or, alternatively, that the notice constitutes an interpretive rule which does not require notice and comment. Judge Travis McDonough reasoned that "[t]he Sixth Circuit’s analysis in Mann Construction is binding on this Court and applies equally to the arguments advanced by the IRS regarding Notice 2016-66 in this case."5
Arbitrary and Capricious
What was less expected was CIC Services ruling that Notice 2016-66 is arbitrary and capricious. Notice 2016-66 designates "micro-captive transactions" as transactions of interest requiring disclosure by transaction participants and material advisors. Because Notice 2016-66's transaction of interest designation constitutes agency action, the court applied State Farm6 to review whether the IRS's action was arbitrary and capricious under the APA. In State Farm, the Supreme Court announced that the standard for determining whether agency action is arbitrary and capricious evaluates "whether the [agency] examined 'the relevant data' and articulated ‘a satisfactory explanation' for [its] decision, 'including a rational connection between the facts found and the choice made.'"7Applying this standard to the issue at hand, CIC Services explained that it "must review the administrative record to determine whether the IRS 'examined the relevant data' and 'articulated a satisfactory explanation’ for its decision to designate micro-captive transactions as a 'transaction of interest' based on the potential for tax avoidance or evasion."8
After reviewing the notice and administrative record, CIC Services concluded that they failed to include relevant data and facts supporting the IRS's decision to designate microcaptive arrangements as reportable transactions.9 While the IRS stated in Notice 2016-66 that microcaptive transactions have "a potential for tax avoidance or evasion," the court described the contents of the IRS's administrative record and found that it did not identify any facts or data supporting this belief.10 Judge McDonough found the IRS did not explain how its previously issued news releases or the selected statutes and legislative history included in the administrative record provide the facts or data necessary to comply with the APA. While the IRS cited to cases in support of its designation of microcaptive transactions, the court noted that the cases in the administrative record were not limited to microcaptive transactions, and not all of the cases concluded that the taxpayer engaged in an abusive transaction.11Indeed, none of the cases in the administrative record involved microcaptives; instead, the administrative record included cases upholding captive insurance arrangements, such as Amerco, Inc. v. Comm'r, 979 F.2d 162 (9th Cir. 1992) and Rent-A-Center v. Comm'r, 142 T.C. 1 (2014).12The court reasoned: "Simply including cases in the administrative record that suggest certain tax structures could be abusively employed is not synonymous with examining relevant facts and data in connection with issuing the Notice."13 CIC Services ruled that, due to the paucity of underlying facts and data in the administrative record showing microcaptive insurance arrangements have a potential for tax avoidance or evasion, Notice 2016-66 must be set aside as arbitrary and capricious.14
Vacatur and Order to Return Documents Collected
CIC Services considered whether to leave the notice in place while the IRS took action necessary to bring the notice in compliance with the APA, but decided against it, noting "the Sixth Circuit's prior observations that the IRS 'does not have a great history of complying with APA procedures,' and that it does not follow the basic rules of administrative law."15The district court entered judgment vacating Notice 2016-66 in its entirety on a nationwide basis.
The court further ordered the IRS to return to taxpayers and material advisors all documents and information produced pursuant to Notice 2016-66. The order to return all collected information is based on the reasoning that the IRS should not have received such documents and information because it failed to comply with the APA.16 It is unclear whether this order would require the deletion of such information from the IRS’s data systems.
Ramifications of CIC Services
Because Notice 2016-66 has been vacated on a nationwide basis, microcaptive transactions described in Notice 2016-66 no longer need to be reported on Form 8896, Reportable Transaction Disclosure Statement. The IRS will likely appeal the decision, but to what result in the Sixth Circuit? The Sixth Circuit will certainly uphold invalidation of the notice due to the IRS's lack of notice-and-comment procedures under its Mann Construction decision. It is possible that the government will seek to appeal Mann Construction to the Supreme Court, but it is questionable whether the Court would construe the APA requirements differently. At minimum, an appeal of the CIC Services decision to the Sixth Circuit could result in a temporary stay of the vacatur of Notice 2016-66 and the order that the IRS must return to taxpayers all information collected pursuant to the notice.
The part of CIC Services’s decision finding that the notice is arbitrary and capricious is more curious. Does the IRS's failure to include sufficient "facts and data" in the administrative record render the ultimate rule arbitrary and capricious? The IRS and the Treasury Department have not been issuing subregulatory guidance with the intent of meeting the State Farm standard for creating an administrative record. If upheld on appeal, the CIC Services decision could lead to a more searching review of the justification for IRS guidance. Or perhaps there is something distinguishable about microcaptive transactions—that the dearth of facts and data in the administrative record supporting whether the transactions are abusive reflects the IRS's longstanding scrutiny of captive insurance transactions and the opacity of authority on what constitutes insurance for federal income tax purposes.
Irrespective of whether the arbitrary and capricious ruling of CIC Services stands, the invalidation of Notice 2016-66 represents a growing movement to apply the APA requirements to IRS subregulatory guidance, with the outcome that more listing notices and other forms of guidance will meet the same fate.
Endnotes
1 5 U.S.C. § 551, et seq.
2 CIC Servs., LLC v. Internal Revenue Serv.¸ No. 3:17-cv-110, slip op. (E.D. Tenn. Mar. 21, 2022).
3 See CIC Servs., LLC v. Internal Revenue Serv., 141 S. Ct. 1582 (2021).
4 Mann Construction, Inc. v. United States, __F.4th__, 2022 WL 619822 (6th Cir. March 3, 2022). See Sixth Circuit Invalidates IRS Notice for Violation of Administrative Procedure Act in our March newsletter.
5 CIC Servs., No. 3:17-cv-110, slip op. at 8.
6 Motor Vehicle Mfrs. Ass'n of United States, Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983).
7Dep't of Com. v. New York, 139 S.Ct. 2551, 2569 (2019) (quoting Motor Vehicle Mfrs. Ass'n of United States, Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)).
8CIC Servs., No. 3:17-cv-110, slip op. at 9 (quoting Dep't of Com., 139 S.Ct. at 2569).
9 Id. at 10.
10 Id.
11Id. at 12.
12Id.
13Id. at 12-13.
14Id. at 13.
15Id. at 13-14 (quoting CIC Servs., LLC v. I.R.S., 925 F.3d 247, 258 (6th Cir. 2019) and CIC Servs., LLC v. I.R.S., 936 F.3d 501, 507 (6th Cir. 2019) (Thapar, J., dissenting)) (internal citations omitted).
16Id. at 15.
