Third Circuit Silences National Muffler, Pumps Chevron Deference

The Third Circuit Court of Appeals recently upheld the validity of Treas. Reg. § 1.882-4(a)(3)(i), which disallows deductions by a foreign corporation that fails to file a U.S. tax return within 18 months of the normal due date. When assessing the validity of the regulation, the Third Circuit applied the Chevron standard and found the language of IRC § 882(c)(2) to be ambiguous and that the related regulation was a reasonable interpretation of that language.

Some Treasury regulations, known as “legislative,” are issued under specific authority granted by Congress in a Code provision with language such as, “The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section.” Other regulations, known as “interpretive,” are issued under the general authority granted in section 7805(a) to fill in gaps in the Code. Courts may invalidate a regulation that exceeds the secretary’s authority to issue it.

In 1979, in National Muffler Dealers Association v. U.S., 43 AFTR2d 79-828 (440 U.S. 472), the Supreme Court outlined six factors for assessing the validity of a regulation: whether the regulation is a substantially contemporaneous construction of the Code, its evolution, how long it has been in effect, the reliance placed on it, its consistency with other interpretations, and the scrutiny it received when Congress re-enacted the related Code section. In 1984 the Supreme Court in Chevron USA Inc. v. Natural Resources Defense Council Inc. (467 U.S. 837) established a two-step analysis: Is the statute unambiguous, and does it directly address the issue? If yes, the plain meaning of the Code should be followed. If not, is the regulation a permissible interpretation of the Code?

Swallows Holdings Ltd., a foreign corporation, owned real estate in California. From 1993 to 1996, the property generated rental income, but the company did not file tax returns for those years until 1999, outside the 18-month filing window allowed by the regulation for deductions. On its late returns, Swallows Holdings deducted its expenses, which the IRS disallowed.

Swallows Holdings asked the Tax Court to invalidate the regulation, claiming IRC § 882(c)(2) contains no explicit time requirement for filing a return in order to deduct expenses. It argued the plain language of section 882(c)(2) only requires a return to be filed in the “manner” prescribed under that subtitle. Furthermore, court decisions from the 1930s and 1940s—before the 1990 issuance of Treas. Reg. § 1.882-4(a)(3)(i)—had generally held that the term “manner” did not mean “time and manner.” In a split decision, the Tax Court ruled the regulation invalid, based on the unambiguous language of section 882(c)(2), and applied the National Muffler factors while examining prior cases, Code re-enactments and the development of the regulation. The majority also stated that a Chevron analysis would have produced the same result and is simply a practical restatement of the National Muffler factors. The court further stated the secretary was attempting “to resurrect a failed litigating position through the issuance of interpretive regulations.”

On appeal, the Third Circuit held that the National Muffler factors are not necessarily consistent with the two-prong test of Chevron. Swallows Holdings argued that interpretative regulations should not be examined under Chevron, but the court, quoting U.S. v. Mead Corp. (533 U.S. 218), said the Chevron standard should be used if “Congress would expect the agency to speak with the force of law.” Since the regulation was open to public comment before it was issued, the court ruled, the regulation had the force of law, thus making it subject to the Chevron standard. The court found the term “manner” used in section 882(c)(2) to be ambiguous and that the regulation was a reasonable interpretation of the statute.

This case illustrates how confusing the legal landscape surrounding the validity of regulations can be. The Tax Court found section 882(c)(2) unambiguous, while the Third Circuit found it ambiguous. The Tax Court believes Chevron is a restatement of National Muffler, but the Third Circuit treats them as different tests. Tax Court Judge Mark V. Holmes’ dissenting opinion in the case listed the circuits’ varied positions on the standards for analyzing the validity of general authority regulations and described the problem those differences create for the Tax Court. It appears as if this case may have raised as many questions as it answered.

n Swallows Holdings Ltd. v. Commissioner, 101 AFTR2d 2008-876

Prepared by Charles J. Reichert, CPA, ­professor of accounting, University of Wisconsin–Superior.