APA Challenge to Notice of Deficiency: QinetiQ Oral Arguments
On October 26, 2016, the US Court of Appeals for the Fourth Circuit heard oral argument in QinetiQ U.S. Holdings, Inc. v. Commissioner, No. 15-2192. We previously wrote about the case here and here. To refresh, the taxpayer had argued in the US Tax Court (Tax Court) that the notice of deficiency issued by the Internal Revenue Service (IRS), which containing a one-sentence reason for the deficiency determination, violated the Administrative Procedure Act (APA) because it was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The APA provides a general rule that a reviewing court that is subject to the APA must hold unlawful and set aside an agency action unwarranted by the facts to the extent the facts are subject to trial de novo by the reviewing court. The Tax Court disagreed, emphasizing that it was well settled that the court is not subject to the APA and holding that the notice of deficiency adequately notified the taxpayer that a deficiency had been determined under relevant case law. The taxpayer appealed to the Fourth Circuit.
The substance of the oral argument focused on two issues: (1) whether the IRS’s notice of deficiency in this case violated the APA and was invalid; and (2) whether, on the merits, the taxpayer was entitled to a particular deduction. We focus on the former issue here.
The taxpayer argued that, after the Supreme Court’s opinion in Mayo, courts are not free to carve out exceptions to the APA for tax cases. In Mayo, the Supreme Court held that tax regulations are subject to the same deference principles as other federal regulations. Indeed, Mayo emphasized that the Supreme Court had previously expressly recognized the importance of maintaining a uniform approach to judicial review of administrative action.
At oral argument, the taxpayer described the policy rationale for the APA’s requirement to provide a reasoned explanation of the agency’s action. Per the taxpayer, this requirement exists for the benefit of administrative procedure and decisionmaking. It is also imperative that when the IRS arrives at a decision that affects thousands of taxpayers’ lives each year, there is a process in place to ensure that the IRS has engaged in a reasoned—not arbitrary—decisionmaking process. In addition, it would be unfair and unrealistic to force taxpayers to challenge an IRS determination in Tax Court to learn how the IRS determined that they owed more tax. Taxpayers should know that the IRS did not reach a decision by “flipping a coin or throwing a dart.”
The taxpayer further argued that its position is consistent with the Internal Revenue Manual, which at Section 220.127.116.11 instructs the preparer of a notice of deficiency to provide an explanatory paragraph to inform the taxpayer in clear and concise language of the adjustment and to state the position or the positions of the IRS with respect to the adjustments being made.
The court asked how Internal Revenue Code (Code) Section 7522 and the APA should be juxtaposed, since Code Section 7522 was adopted after the APA. Code Section 7522 provides: “Any notice to which this section applies shall describe the basis for, and identify the amounts (if any) of, the tax due, interest, additional amounts, additions to the tax, and assessable penalties included in such notice. An inadequate description under the preceding sentence shall not invalidate such notice.” The taxpayer responded that Code Section 7522 contains “additional description requirements” for a notice of deficiency, but a failure to provide those additional requirements does not, under a literal reading of the statute, provide a basis for invalidating the notice. The second sentence of Code Section 7522 provides that an “inadequate description under the preceding sentence shall not invalidate such notice.” Per the taxpayer, this language demonstrates that the APA is unaffected by Code Section 7522, because the limiting language of the second sentence applies only to the first sentence. The government, however, argued that Code Section 7522 is merely a codification of earlier case law regarding what level of detail the IRS needs to put in notices of deficiency. The government argued that according to that earlier case law, there was no “magical password” that must be included.
Circuit Judge Barbara Keenan was concerned with the lack of substance in the notice of deficiency issued to the taxpayer. She stated that she was concerned specifically with how the average taxpayer would be able to go to Tax Court and hire a lawyer to contest such a notice. She asked the government if it could issue a notice that did not tell the taxpayer anything other than that he or she did not qualify for a deduction. The government responded that in deduction cases, where the taxpayer normally must prove entitlement to a deduction, the IRS does not often have that information until the taxpayer provides it to the IRS. The government responded further that thousands of pro se taxpayers have successfully filed Tax Court petitions, there are provisions in place to award fees where the IRS’s determination is not completely justified, and the burden of proof can shift to the IRS where the notice of deficiency does not provide a basis for its determination. The government also cautioned the court that holding this deficiency notice—and by implication many others—invalid, would result in the loss of money from the public fisc and create a slippery slope regarding the detail deficiency notices must contain.
The government argued that the earlier statutory scheme, which predated the APA, provided for adequate judicial review. The government contended that the APA was intended to only fill in gaps where there was not already a mechanism for adequate judicial review. It would be inappropriate, per the government, to take the APA—which was intended to provide an opportunity for judicial review—and use it as a sword to prevent judicial review. The government also argued that IRS notices of deficiency do not seem to fit within any of the categories of “agency action” specifically addressed in the APA.
The taxpayer agreed that it if the court were to hold the notice of deficiency invalid under the APA, the taxpayer would likely argue that the statute of limitations had not been suspended. In other words, the statute of limitations may have already expired. The government, per the taxpayer, would likely fight this argument.
In its rebuttal, the taxpayer argued that this case is not about money in the public fisc. Rather the case is about whether everyday Americans are entitled to a reasoned explanation when the IRS issues a deficiency notice that can change their lives. The taxpayer cited to the Tax Court’s holding in Greenberg’s Express, that it is inappropriate to “look behind’ a notice of deficiency. Thus, the face of the notice of deficiency should provide sufficient explanation. The taxpayer stated that the court would not be the first court to invalidate IRS agency action, pointing to decisions in the Tenth and Ninth Circuits. Last, the taxpayer noted that this case was an aberration and that the IRS traditionally provides an explanatory notice and paragraph in a notice of deficiency.
The outcome of this case would have far-reaching implications if the Fourth Circuit accepts the taxpayer’s APA argument. Taxpayers should be entitled to some level of notice as to why the IRS determined they owe more tax. It is unknown how many notices of deficiency might be invalidated by a holding that the APA requires more explanation in notices of deficiency on the amount of the additional litigation that would be spawned by such invalidation claims. It is also unknown how many hours of work would be added to an already log-jammed and thin-staffed IRS by such a holding.