Andy Grewal (Iowa; Google Scholar), The Sixth Circuit Conjures Phantom Regulations:
A few decades ago, various federal trial and appellate courts adopted an odd approach towards tax statutes that call for Treasury regulations but for which no regulations had been issued. These courts decided that they would not wait for the Treasury to act. Instead, they would apply the statute without regulations. In doing so, they would conjure the regulations that they thought the agency might have adopted. “Phantom regulations” were thus born. See Grewal, Substance Over Form? Phantom Regulations and the Internal Revenue Code, 7 Houston Bus. & Tax J. 42 (2006).
A recent and significant case, Whirlpool v. Commissioner, 19 F.4th 944 (6th Cir. 2021), illustrates the serious problems with phantom regulations.
Whirlpool involves a complex taxation scheme, inaccessible to most readers. Yet for administrative law purposes, the issues can be greatly simplified. Under one rule in the tax code, a U.S. company faces immediate taxation on some income derived from its foreign subsidiaries. Under a second rule, Congress granted the Treasury the authority, “under regulations,” to expand the income subject to immediate taxation. See 26 U.S.C. 954(d)(2).
At the Tax Court level, Whirlpool argued that the Section 954(d)(2) regulations should not apply. Whirlpool claimed that the regulations, on their own terms, did not reach the company’s arrangement. Alternatively, Whirlpool claimed that the regulations impermissibly interpreted the governing statute. The IRS, of course, disagreed with those contentions. The Tax Court, in a detailed opinion, held for the IRS. The court concluded that the regulations’ language allowed for Whirlpool’s expanded immediate taxation. The court also found that the regulations validly interpreted the statute. See Whirlpool v. Commissioner, 154 T.C. 142 (2020).
On appeal, something very strange happened. The Sixth Circuit, in an opinion by Judge Kethledge, ignored the regulations. The court decided that it could do so because Section 954(d)(2) sets forth highly detailed conditions and consequences. Thus, the court believed, the taxpayer lost “under the text of the statute alone.” 19 F.4th at 953. To the court, when “Section 954(d)(2)’s conditions are met, the consequences that follow are clear from the statute itself.” Id. at 954 (punctuation modified). ...
Whirlpool shows how phantom regulations can thwart the congressional intent reflected in statutory language. The Sixth Circuit said that it applied the text adopted by Congress. But its nominally textual approach applies some statutory words and ignores others (“under regulations”). The Sixth Circuit should have given effect to all words found in Section 954(d)(2), like the Tax Court did below. ...
The taxpayer in Whirlpool has now petitioned the Sixth Circuit for a rehearing en banc. The government, in response, has doubled down on its view that regulations are unnecessary to implement Section 954(d)(2). If the court grants the taxpayer’s petition, it should correct the panel’s mistake. The Sixth Circuit should follow the Supreme Court’s approach and hold that phantom regulations can never be conjured by courts.