screenshot-2016-12-13-at-7-08-36-am

The Section 385 Debt-Equity Regulations and The Separation of Powers

by Andy Grewal — Friday, July 29, 2016

The IRS recently proposed some highly controversial regulations related to debt-equity classifications. A challenge to the regulations seems likely, and a recent news article discusses how some pending legislation might affect the controversy. See Bloomberg BNA, “Debt-Equity Rules Could Be Easier to Strike With Pending Bill” (7/25/16). That legislation, The Separation of Powers Restoration Act of 2016 (SPRA) , would purportedly kill judicial deference doctrines (like Chevron ) and require courts to “decide de novo all relevant questions of law, including the interpretation . . . of statutory provisions.”

SPRA, if passed, would seemingly limit the interpretive force of IRS rules and regulations. However, its effects may be limited for regulations issued under statutes that provide specific grants of regulatory authority.

To understand this point, consider a highly-simplified version of Section 385, under which “The IRS may prescribe regulations treating an interest in a corporation as either debt or equity.” Assume that the IRS issues detailed regulations under this statute, classifying various interests one way or another. Assume also that a taxpayer challenges the validity of one of the regulation’s classifications. Under SPRA, would a court determine the classification of the interest under a de novo standard?

I don’t think so. Although SPRA tells courts to interpret statutes under a de novo standard, the interpretive question for the simplified version of Section 385 is limited: “Does the IRS have authority to classify interests as either debt or equity?” Deciding whether an interest should be classified one way or another is not a question of statutory interpretation, because the statute says nothing on that topic — it simply grants the IRS the authority to make debt-equity classifications. A court would decide, de novo, whether the regulations relate to debt-equity issues (because the scope of the granted authority is a question of statutory interpretation), but it would not decide, de novo, whether any particular interest should be treated as debt or equity.

In reality, Section 385 is far more detailed than the stylized version presented above, and commenters have strenuously argued that various aspects of the regulations exceed the statute’s scope. For this type of challenge, SPRA would play an important role because it would displace the Chevron deference otherwise afforded to the IRS on questions related to its rulemaking authority. However, many parts of the regulations relate to exercises of policy discretion (within the ambit of the statute), and SPRA would be irrelevant.

If Congress wanted to change this, it could make Section 385 self-executing, in which case SPRA would have profound effects. For example, if Section 385 stated that “interests that exhibit the fundamental characteristics of indebtedness shall be treated as indebtedness” then, under SPRA, a court would decide de novo the best interpretation of “fundamental characteristics,” “indebtedness,” and so on. But as Section 385 is currently drafted, a large chunk of the IRS’s policy decisions related to debt-equity classifications would be shielded from SPRA.

More generally, if the drafters of SPRA want to eliminate deference for all regulations, they will need to expand the Act to better address statutes that provide specific grants of regulatory authority. However, eliminating deference for regulations issued under such statutes borders on the nonsensical. Why would Congress pass a statute asking an agency to create rules in an area and then pass another statute telling courts to pretend like those rules do not exist, and to create their own? If Congress believes that agencies wield too much power under specific grants, the analytically coherent approach would involve repealing or limiting the grant, not removing deference doctrines. It will be interesting to see if a later version of SPRA addresses these issues.

This entry was tagged .

About Andy Grewal

Law Professor, University of Iowa

Cite As: Author Name, Title, Yale J. on Reg.: Notice & Comment (date), URL.

Leave a Reply

Your email address will not be published. Required fields are marked *