Sixth Circuit favors Tennessee in split ARPA tax mandate decisions

On Nov. 18, 2022, the U.S. Court of Appeals for the Sixth Circuit issued two separate decisions regarding state challenges to the spending restriction on COVID-19 relief funds provided to the states under the American Rescue Plan Act (ARPA), reaching different conclusions for each state.¹ Finding that Tennessee presented a justiciable challenge to the ARPA provision, the court affirmed a lower court permanent injunction on the basis that the provision is impermissibly vague under the Spending Clause of the U.S. Constitution. In the same case, the court found that Kentucky lacked standing to challenge the provision because it failed to establish that the federal government would imminently seek to recoup the ARPA funds. In a separate decision, the court dismissed Ohio’s challenge, concluding that the case became moot once the state accepted the funds.

Background

Approved by President Biden in March 2021, ARPA was enacted to address the economic effects of the COVID-19 pandemic.² In particular, Congress allocated over $350 billion for state and local governments to either use the funds for a wide variety of pandemic-related purposes or to make infrastructure investments.³ Notably, states are prohibited from using the funds to “directly or indirectly” offset a reduction in state net tax revenue resulting from a change in law, regulation or administrative interpretation during a “covered period” that reduces any tax (known as the offset provision or the tax mandate).⁴ The “covered period” began on March 3, 2021, and ends on the last day of the fiscal year in which the funds are used or returned to the federal government.⁵ States must comply with various certification and reporting requirements in order to receive the ARPA funds.⁶ The federal government has the right to recoup the funds if the states are found to violate the offset provision.⁷

In response to requests for clarity regarding the scope of the offset provision, the U.S. Treasury Department (Treasury) adopted an interim rule to provide further guidance to states on the implementation of the provision.⁸ In January 2022, Treasury issued a final rule in substantially the same form as the interim rule, which became effective in April 2022.⁹ The final rule generally provides that states are considered to impermissibly use ARPA funds to offset a reduction in net tax revenue when they fail to offset the reduction through means unrelated to ARPA funds.¹⁰ The final rule confirms that a reduction in net tax revenue could result from any “covered change,” including a change in law, regulation or administrative interpretation that reduces any tax.¹¹ However, the final rule clarifies that a covered change does not include changes that the state cannot control, or income tax changes simply conforming to changes in federal law.¹²

Since the enactment of ARPA, approximately 20 states have filed six lawsuits challenging the constitutionality of the offset provision. As the first state to challenge the tax mandate, Ohio filed a lawsuit in Ohio federal court, arguing that that the tax mandate violates the Spending Clause in addition to the Tenth Amendment to the U.S. Constitution. In July 2021, the U.S. district court granted Ohio’s motion for a permanent injunction, finding that the offset provision was unconstitutionally vague, falling short of the clarity needed to meet the dictates of the Spending Clause regarding conditional grants to states.¹³

Kentucky and Tennessee filed a similar lawsuit in a Kentucky federal court, arguing that the ARPA tax mandate was a coercive grant of federal money in violation of the Spending Clause. Ruling in favor of the states, the U.S. district court agreed, granting the states’ motion for a permanent injunction in a September 2021 decision.¹⁴ Treasury appealed both rulings to the Sixth Circuit Court of Appeals.

Ohio v. Yellen

In vacating the U.S. district court’s permanent injunction, the appellate court concluded that the injury asserted by Ohio became moot once Ohio accepted the funds. In its initial complaint, Ohio argued that it was forced to decide whether to accept the ARPA funds under ambiguous conditions, but the alleged injury was no longer a live harm once it accepted the funds. The court further reasoned that Treasury’s final regulations established parameters for states to determine whether tax reductions would violate the offset provision. According to the court, the final regulations disavowed Ohio’s interpretation of the tax mandate and sufficiently explained that Treasury would not enforce the provision to bar all tax cuts.

In the court’s view, Ohio did not provide concrete evidence that Treasury would imminently pursue a recoupment action against Ohio in response to any past, present or future tax policy to warrant a permanent injunction. The court noted that its decision would not prevent Ohio from raising other challenges to the offset provision if a justiciable dispute arose. In vacating the permanent injunction, however, the court concluded Ohio “did not establish that this challenge is justiciable.”

Kentucky et al. v. Yellen

In a separate decision, the appellate court likewise found that Treasury’s final regulation established “safe harbors” permitting states to cut taxes in certain instances. Because Kentucky and Tennessee offered no evidence of a concrete plan to violate the rule, the court reasoned, both states failed to establish that Treasury would imminently seek recoupment of the funds. In Kentucky’s case, the court found that the state offered no evidence of any other theory of injury, and therefore the final regulation mooted its challenge to the offset provision. Accordingly, the court concluded that Kentucky lacked standing to bring the lawsuit and vacated the permanent injunction issued by the lower court.

The court came to a different conclusion for Tennessee, finding that the state presented sufficient evidence that it was harmed by Treasury’s final rule and the underlying offset provision because of the compliance costs the state incurred to ensure that its tax cut legislation did not violate the tax mandate, manifested in the form of additional labor and other expenses. Under the “compliance-costs” theory of injury, the court found that the final rule “exacerbated” the harm to Tennessee with its more detailed explanation of the measures required to comply with the offset provision. For these reasons, the court held that Tennessee presented a justiciable challenge that was not moot.

Reaching the merits of the case, the court determined that the offset provision is impermissibly vague because it lacked the clarity required by the Spending Clause when states accept federal funds under certain conditions. In the court’s view, the open-ended ARPA statute gave Treasury “expansive discretion to construe its terms in the particular way Treasury saw fit,” thus failing to provide states with “clear notice of a purported funding condition.” Short of declaring the offset provision unconstitutional under the Spending Clause, the court concluded that the offset provision “does not clearly explain (1) how to calculate a ‘reduction’ in net tax revenue, (2) how to determine whether such a reduction resulted from a tax cut, or (3) how to tell what particular conduct constitutes an ‘indirect’ offset.” The Court further concluded that Treasury’s final rule did not clearly follow from the text of the offset provision, meaning that Treasury lacked the authority to impose compliance requirements on Tennessee. For these reasons, the court upheld the permanent injunction granted by the lower court as applied to Tennessee.

Commentary

With these decisions, the Sixth Circuit became the first federal appeals court to rule on the substantive merits of the ARPA offset provision. Once it determined that Tennessee had standing to challenge the tax mandate and Treasury’s interpretive regulation on the basis that they burdened the state with compliance costs, the court proceeded to an analysis of the underlying offset provision, finding that it is impermissibly vague under the Spending Clause of the U.S. Constitution. At the same time, the Sixth Circuit was the third federal appeals court to rule on the issue of whether the states have standing to challenge the offset provision, ruling in the same decision that Kentucky lacked standing to challenge the tax mandate. Rather than ruling that Ohio lacked standing to bring its lawsuit, the court instead ruled that Ohio’s challenge to the offset provision became moot when Treasury finalized a regulation disavowing Ohio’s broad interpretation of the provision.

The split rulings issued by the Sixth Circuit are indicative of a deepening divide among the federal appellate courts on the issue of whether states have standing to challenge the ARPA offset provision. In May 2022, the Ninth Circuit Court of Appeals ruled that Arizona had standing to challenge the offset provision and remanded the case to a lower district court to consider the state’s claims.¹⁵ The Eighth Circuit Court of Appeals reached the opposite conclusion in July 2022, holding that Missouri lacked standing to challenge the provision because it alleged merely hypothetical harms that would result from the offset provision based on its consideration of tax reduction policies.¹⁶ In response, Missouri filed a request in October 2022 for the U.S. Supreme Court to consider the case.¹⁷ The Sixth Circuit rulings and the expanding circuit split over standing to challenge the offset provision, coupled with any potential conflicting rulings on the constitutionality of the tax mandate, increase the chances that the U.S. Supreme Court will have an opportunity to consider these issues if the cases are appealed, given the continuing impact on the ability of states to set their own tax policy.

1 Kentucky et al. v. Yellen, U.S. Court of Appeals for the Sixth Circuit, No. 21-6108, Nov. 18, 2022; Ohio v. Yellen, U.S. Court of Appeals for the Sixth Circuit, No. 21-3787, Nov. 18, 2022.
2 P.L. 117-2 (2021).
3 42 U.S.C. § 802(c)(1).
4 42 U.S.C. § 802(c)(2).
5 42 U.S.C. § 802(g)(1). As the funds must be spent by Dec. 31, 2024, the ending date of the covered period could extend for several years.
6 42 U.S.C. § 802(d)(2).
7 42 U.S.C. § 802(e).
8 31 C.F.R. Part 35, RIN 1505-AC77, Coronavirus State and Local Fiscal Recovery Funds.
9 31 C.F.R. §§ 35.1 et seq.
10 C.F.R. § 35.8(b).
11 31 C.F.R. § 35.3.
12 Id.
13 Ohio v. Yellen, 547 F. Supp. 3d 713 (S.D. Ohio 2021). For further discussion of this decision, see GT SALT Alert: Ohio granted injunction from ARPA tax cut provision.
14 Kentucky et al. v. Yellen, 563 F. Supp. 3d 647 (E.D. Ky. 2021). For further discussion, see GT SALT Alert: Kentucky and Tennessee succeed in ARPA challenge.
15 Arizona v. Yellen, 34 F.4th 841 (9th Cir. 2022).
16 Missouri v. Yellen, 39 F.4th 1063 (8th Cir. 2022). For further discussion of this case, see GT SALT Alert: Missouri barred from challenging ARPA offset restriction.
17 Missouri v. Yellen, petition for cert. filed (U.S. Oct. 14, 2022) (No. 22-352).