On July 23, 2024, the United States Court of Appeals for the District of Columbia Circuit (Court of Appeals) released a decision in Rawat v. Commissioner (available here). The case considers whether the portion of a non-US person’s gain on the sale of an interest in a US partnership attributable to “inventory gain” was US-source income. Although the opinion issued less than a month after the Supreme Court’s decision in Loper Bright, which overruled the long-standing but often questioned Chevron rule, the Rawat court did not discuss either case. It did not have to because it extended no deference to the IRS’s views on the construction of the Code and regulations. In this way, the Court of Appeals’ approach to construing the Code provisions and Treasury Regulation at issue provides a useful example of how courts may approach such issues in our new, post-Chevron world.1
The case stemmed from the sale by Indu Rawat, a nonresident alien individual, of her interest in a US partnership. Rawat sold the partnership stake for $438 million, approximately $6.5 million of which represented Rawat’s share of the appreciation in the partnership’s inventory, determined under section 751(a) of the Internal Revenue Code (Code). Rawat argued that the “inventory gain” was attributable to her disposition of the partnership interest and sourced outside the US. The government argued that an exception for the sale of inventory in Sections 741 and 751 applied to re-characterize a portion of her gain as from the sale of inventory: i.e., US-source income. The Tax Court ruled against the taxpayer, and an appeal to the Court of Appeals ensued.
The dispute turned on whether Sections 741 and 751 re-characterized a portion of Rawat’s sales proceeds as from the sale of inventory such that a portion of her gain was US source income under the rules of Sections 861, 862, and 865. The sourcing rules applicable during the year at issue, 2008, stated that the income from the sale of personal property (such as a partnership interest) of a non-US person was generally foreign-source and not taxable in the United States. However, there was an exception for the sale of inventory, which could be US-source income.2
To resolve this dispute, the Court of Appeals focused on the meaning of Sections 741 and 751 of the Code. Section 741 provides generally that gain (or loss) from the sale or exchange of a partnership interest is considered to be gain (or loss) from the sale or exchange of a “capital asset.” However, it provides an exception to the general rule: “except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).” Section 751(a), in turn, provides that an amount realized by a transferor-partner attributable to, inter alia, inventory items of the partnership “shall be considered as an amount realized from the sale or exchange of property other than a capital asset.”
Both parties in Rawat agreed that section 751(a) required inventory gain to be characterized as ordinary income. The government went a step further, however, and argued that the gain on the sale of a partnership interest attributable to “inventory gain” was treated as if there were an actual sale of the inventory. This would have changed the source of those gains from foreign to US-source under the sourcing provisions mentioned above. The taxpayer in Rawat interpreted section 751(a) more narrowly, arguing that the statute merely subjected inventory gain to taxation as ordinary income if the gain was otherwise taxable. Rawat argued the inventory gain she realized was foreign-source because it arose from the sale of a partnership interest and not from the sale of inventory.
The Analysis by the Court of Appeals
The Court of Appeals agreed with the taxpayer, reversed the Tax Court and held that her income was foreign-source. In reaching this decision, the Court of Appeals focused first and foremost on a close reading of the words in Sections 741 and 751 and their relationship to one another. Although the Court of Appeals did not cite the Supreme Court’s decision in Loper Bright, its reliance on ordinary principles of statutory construction was consistent with Chief Justice Robert’s admonition that “Courts interpret statutes, no matter the context, based on the traditional tools of statutory construction . . . .” 3
The pivotal words of section 751(a) were “shall be considered an amount realized from the sale or exchange of property other than a capital asset.” Looking solely to principles of statutory interpretation, the Court of Appeals determined that this clause should effectively be read as “shall be considered as ordinary income.” The government argued that section 751(a) changed the character of the asset being sold from a partnership interest to the inventory itself. The Court of Appeals rejected the government’s argument as inconsistent with the court’s interpretation with the statutory text. The court applied traditional canons of construction, including parsing the words of the statute, relying on a statutory definition (i.e., ordinary income), considering Section 751’s context (i.e., its interaction with Section 741), and reviewing the legislative history.4 Based on these tools, the Court of Appeals held that, although Section 751 mandates ordinary income treatment, it does not re-characterize proceeds from the sale of a partnership interest as proceeds from the sale of inventory.
The government also advanced an argument based on Treas. Reg. § 1.751-1, which states that if a partner sells a partnership interest and section 751(a) applies, “the money or fair market value of the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset” to the extent attributable to unrealized receivables or inventory. The government argued that the regulation required the income to be treated for all purposes as though it were the product of the sale of inventory. Notwithstanding that Treasury and IRS authored the regulation, the Court of Appeals gave no deference to the IRS’ view of the regulation. The court observed that the regulation, although “amenable” to the government’s interpretation, could be interpreted consistently with the Court’s construction.5
The Court of Appeals closed by noting that the taxpayer’s interpretation of section 751(a) was consistent with the approach the government unsuccessfully put forward in the Tax Court in Grecian Magnesite. Despite the government’s losing before the Tax Court in that case, the Court of Appeals found it “notable that our construction of section 751(a) is consistent with a basic approach the Commissioner himself once viewed as interpretively correct and workable in practice.”
As noted above, the Rawat opinion did not cite the Supreme Court’s recent decision in Loper Bright, which was decided less than a month before Rawat. The Supreme Court in Loper Bright set forth a number of considerations for courts when reviewing agency regulations, including whether the agency adopted its interpretation of a statute “roughly contemporaneously” with the statute’s enactment and has been “consistent over time,” and whether Congress expressly delegated to the Agency discretionary authority to write regulations.6 Future litigation will be necessary to define the scope of these interpretive considerations.
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1 See Chevron U.S.A. Inc. v. Nat. Res. Def. Council, 467 U.S. 837 (1984), overruled, Loper Bright Enterprises v. Raimondo, 603 U.S. ___, 144 S. Ct. 2244 (June 28, 2024) (available here).
2 Subsequent to the year at issue, the Tax Cuts and Jobs Act of 2017 (TCJA) amended the sourcing rules to provide that gain (or loss) on the disposition by a non-resident alien individual of an interest in a partnership that is engaged in a trade or business within the US is treated as effectively connected with the conduct of the US trade or business. See Code section 864(c)(8).
3 Loper Bright, 144 S. Ct. at 2268.
4 The Court of Appeals’ approach to the legislative history was to look for confirmation of the court’s interpretation of the statute, which it treated as paramount. See Rawat v. Commissioner, No. 23-1142, slip op. at 13 (D.C. Cir. July 23, 2024) (“Not only does the Commissioner's reliance on legislative history run aground in the face of the statutory definition of ordinary income, but the sentences quoted by the Commissioner also do less work than he supposes.”).
5 In making this argument, the government’s briefs did not raise so-called Auer deference, which could call for a court to defer to the agency’s interpretation of its own regulations. See Auer v. Robbins, 519 U.S. 452 (1997). Auer deference was significantly limited in Kisor v. Wilkie, 588 U.S. 558 (2019), and Treasury subsequently instructed that it should not be invoked in defending any Treasury regulation. Department of the Treasury, “Policy Statement on the Tax Regulatory Process,” (Mar. 5, 2019) (available at https://home.treasury.gov/system/files/131/Policy-Statement-on-the-Tax-Regulatory-Process-3-4-19.pdf). Nor did it raise any other deference argument. It is hard to see how a court could invoke Auer deference today given Justice Robert’s analysis of the relationship of the courts to administrative agencies in Loper Bright and, in any event, the Court of Appeals would have needed to consider this sua sponte.
6 Chief Justice Roberts was careful to point out that there are constitutional limits on Congress’ ability to delegate discretionary rulemaking powers to agencies. See Loper Bright, 144 S. Ct. at 2263, 2268, 2273. This may signal a willingness to review overly broad delegations of discretion to agencies, including Treasury and IRS, to write regulations according to their own predilections.
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