The Sixth Circuit's Ultra Vires Opinion In Whirlpool'What Now?

• Published date: 18 April 2022
• Subject Matter: Tax, Income Tax, Tax Authorities
• Law Firm: Mayer Brown
• Author: Mr Gary Wilcox

I. Overview

The Sixth Circuit's decision in Whirlpool Financial Corp. v. Comm'r¹ can be criticized for its substantive analysis of Code Sec. 954(d)(2). It concluded that Code Sec. 954(d)(2) unambiguously required foreign base company sales income (FBCSI) if the two conditions in the statute were met, with no requirement to then test the income under Code Sec. 954(d)(1). This conclusion conflicts with a longstanding rule in Treasury regulations² that prohibits FBCSI under Code Sec. 954(d)(2)'s branch rule unless there would be FBCSI under Code Sec. 954(d)(1) if the branch were actually a subsidiary.³ The circuit court misread the Tax Court as reaching the same holding based on the statute, when in fact the Tax Court found Code Sec. 954(d)(2) ambiguous on that point, analyzed Code Sec. 954(d)(2) under the regulations, and then returned to Code Sec. 954(d)(1) before holding that FBCSI must be recognized.⁴

The most remarkable aspect, however, of the Sixth Circuit's Whirlpool decision was the court's disregard of both the express delegation of authority to Treasury in Code Sec. 954(d)(2), and the rule in Reg. §1.954-3(b)(2)(ii)(e) that implemented this delegation. Believing that the statute clearly commanded FBSCI under Code Sec. 954(d)(2) after the provision's two conditions were met, the court dismissed whatever Treasury might have said differently in the regulations, stating "the agency's regulations can only implement the statute's commands, not vary from them."⁵ The court's "go it alone" approach to interpreting Code Sec. 954(c)(2), as if it were unaware that Treasury had long ago reached a different interpretation, violates a Supreme Court mandate for judicial deference to agency regulations. For that reason alone, the Sixth Circuit's Whirlpool opinion—to the extent of its holding that FBCSI automatically results under Code Sec. 954(d)(2) if the two conditions are met with no requirement to apply Code Sec. 954(d)(1)—should not have any precedential value outside the Sixth Circuit, including in the Court of Federal Claims. And given the strong dissent to the majority's Sixth Circuit opinion, the persuasive effects of that opinion should be minimal.

Far from a clean victory, the Whirlpool opinion has created a veritable mess for the government. The rule in Reg. §1.954-3(b)(2)(ii)(e) was not invalidated, even though it cannot be reconciled with the court's primary holding on Code Sec. 954(d)(2). And, because the Sixth Circuit's opinion was based solely on its interpretation of the statute, the validity of the manufacturing branch regulations—which were upheld as valid in the Tax Court—was not addressed. What does that mean for Treasury and the Internal Revenue Service (IRS)? If they treat Whirlpool as "the law," then they need to withdraw Reg. §1.954-3(b)(2)(ii)(e) from the regulations, because otherwise the government is bound to apply those regulations.⁶ That is, it cannot apply the Whirlpool holding and Reg. §1.954-3(b)(2)(ii)(e) at the same time—one has to go. Given the weak precedential value of Whirlpool, does the government risk facing a validity challenge in another circuit if it incorporates the Whirlpool holding into its regulations? And does it dare make those revisions retroactively?

A victory is not always a victory in the world of tax administration.

It is frustrating to know how different things could have been had the Sixth Circuit analyzed Reg. §1.954- 3(b)(2)(ii)(e) under established principles of judicial deference. It is inconceivable that the court would have invalidated—or even analyzed—this provision under Chevron Step One,⁷ particularly when both parties respected the validity of that provision. The Chevron analysis likely would have been limited to the manufacturing branch rule that was challenged by the taxpayer in the Tax Court. Based on what the Sixth Circuit said about the statute being unambiguous, it likely would have upheld the manufacturing branch rule in Chevron Step One. Then, having laid that groundwork, the Sixth Circuit could have focused on the Tax Court's holding that the...