The IRS Took the Road Less Traveled By, Yet Judges Still Made All the Deference

In 1984, George Orwell famously defined “doublethink” as “holding two contradictory beliefs in one's mind simultaneously, and accepting both of them.” But even Orwell would blush at claims made by the Internal Revenue Service that one can somehow both follow the law and violate it with the same activity. Amazingly, this seems to be the exact argument employed against Duquesne Light Holdings and subsequently upheld by the U.S. Court of Appeals for the Third Circuit.

In the early 2000s, Duquesne filed a series of consolidated tax returns along with its wholly owned subsidiary AquaSource. Despite initially declining to challenge the company’s deductions in a 2004 audit, the IRS later determined that the losses claimed constituted a double deduction. Even though the company painstakingly followed the tax code and regulations to the letter, the IRS relied on a strained interpretation of an 80-year-old case, Charles Ilfeld Co. v. Hernandez (1934), to disallow $199 million in losses, demanding a $36.9 million payment.

The Third Circuit’s endorsement of this odd use of Ilfeld creates a broad new view of federal agency power. Rather than understanding Ilfeld as a background presumption for evaluating ambiguous agency rules, this new doctrine allows agencies to override their own regulations to penalize those who violate some unarticulated, uncodified policy principle. Duquesne followed the rules, which did not prohibit the deductions it claimed. But rather than allowing deductions that were legally authorized, the court imposed a “triple-authorization requirement” mandating an additional okay, specifically stating that the deductions may be taken together. In other words, the court said that it isn’t enough for the law to say “you may take deduction A” and elsewhere “you may take deduction B”; the law must then also explicitly say “you may take deduction A and deduction B at the same time.”

The court’s decision continues the long march toward unrestrained administrative power via judicial abdication. First came Chevron deference, whereby courts must defer to the statutory interpretation of the agency that enforces the relevant statute. Then came Auer deference, requiring that courts defer to an agency’s interpretation of its own ambiguous regulations. But the Third Circuit has now gone a step further, ruling that an agency can reinterpret its own unambiguous regulations to mean whatever it wants. If Auer deference is a jurisprudential black eye, then the Third Court’s decision here is an ocular enucleation.

The ruling against Duquesne amplifies three particular concerns that are endemic to Auer deference. First, both Auer deference and this case implicate separation-of-powers concerns. While Auer deference allows an agency to interpret the regulations that the agency itself promulgated, this new “Duquesne deference” would enable an agency to create, enforce, and adjudicate while at the same time completely ignoring the rules it previously created in its legislative capacity.

Second, both Auer and would-be Duquesne deference undermine the Administrative Procedure Act. By requiring that courts only give deference to agency interpretations of ambiguous regulations, Auer creates the perverse incentive to avoid APA rulemaking procedures by intentionally drafting vague, open-ended regulations that can later be interpreted as the agency sees fit. But this new deference would allow agencies to invoke policy concerns as an easy means of overriding even unambiguous regulations. Under that view, APA rulemaking is not just subject to potential agency abuse, it’s irrelevant.

Third, all this deference deprives regulated entities of fair notice of the rules they must follow. Auer deference at least allows those being regulated to attempt an educated guess about the meaning of an ambiguous regulation, but its expansion to covering even unambiguous regulations would allow agencies to convert regulatory certainty into unpredictability without any warning at all.

Because violations of unwritten rules are not legally punishable and the current deference given to administrative agencies is already bad enough, Cato has filed a brief asking the Supreme Court to review Duquesne Light Holdings v. Commissioner of Internal Revenue. The Court should clarify that no agency may use presumptions to penalize actions that are authorized by the express terms of that agency’s own regulations.