By Abraham Gross

Law360 (June 14, 2021, 4:32 PM EDT ) Ohio's challenge of a federal law prohibiting states from using pandemic aid to offset tax cuts should be tossed because the first stop for such disputes is a proceeding to recoup aid, the U.S. Treasury Department told a federal court.

In a reply brief filed Friday, the Treasury told the Southern District Court of Ohio that the state's challenge to the American Rescue Plan Act 's provision that bars states from using federal aid to offset net revenue reductions, or risk having to return the funds, lacked standing.

Since Ohio certified to Treasury on May 13 that it would abide by the conditions of accepting the federal funds — including the offset provision and any related regulations or guidance — Treasury told the court that it should dismiss the state's case and its request for a permanent injunction.

"Instead, recoupment proceedings, should they ever occur, would be the proper context for addressing a state's challenge to this grant condition," Treasury said. "Unless and until that happens, Ohio cannot overcome the standing, mootness and ripeness problems with its current claims."

Treasury had asked the court this month to dismiss Ohio's request for a permanent injunction against the federal law's clawback provision, saying the state's claims were moot because Ohio certified it would accept the funds and follow the law. But Ohio responded that the law remains unconstitutionally ambiguous and coercive because that state's officials still have no clear guidance on how they can alter tax laws without triggering a clawback.

U.S. District Judge Douglas R. Cole previously denied Ohio's bid for a preliminary injunction but said that the state "established a substantial likelihood of success" on the merits and that it was suffering irreparable harm. Ohio suggested this meant that a permanent injunction would provide more adequate relief, and the state refiled its claims that the law violates the 10th Amendment and the spending clause, which allows Congress to attach certain conditions for use of federal funds.

The Treasury Department has issued an interim final rule on the provision, laying out how states should determine whether a net revenue reduction would prompt a clawback and the procedures for tracking and reporting their tax changes to the federal government through 2024, when funds must be spent.

The rule, Treasury said in its brief last week, provided clear instructions for how states could avoid running afoul of the clawback provision. The agency also reiterated its stance that the law isn't unconstitutionally coercive or commandeering.

But in a response, Ohio — represented by Republican Attorney General Dave Yost's office — said Treasury's proposed regulation further injures the state by compelling it to "allocate scarce resources to a task" that Ohio claims is unconstitutional.

The rule stated that if net tax revenue hasn't been cut, states fall under a safe harbor rule and the clawback provision doesn't apply. The rule also set up a de minimis standard when the total value of revenue reductions by a government is below 1% of the reporting year's baseline. If revenue reductions were below that amount, no clawback would occur.

Additionally, the rule sets the baseline to measure reductions in net tax revenue to 2019 fiscal year tax revenue, indexed for inflation in each year of the covered period.

In its reply, Treasury reiterated its arguments that Ohio's claims were moot while adding that the state's challenge was premature before any recoupment proceeding for federal funds commenced.

Treasury also pushed back against Ohio's argument that the agency's position would foreclose all declaratory and injunctive relief for spending clause claims, saying the state's suit was unusual because it sought to challenge the law on its face before implementation or enforcement rather than challenging the law as it is applied.

Buckeye State lawmakers are negotiating a budget with a mix of tax cuts and expanded deductions. Since the rule won't be finalized before the state's June 30 budget deadline, Ohio has argued that the interim regulation doesn't address the state's concerns of not knowing what tax policy can pass muster under the clawback provision.

Ohio's case is one of several that mostly Republican attorneys general from around the country have filed against the clawback provision. The litigation is at various stages. A federal judge dismissed a complaint from Missouri, although the state appealed that ruling. District court rulings in the other cases are pending.

Representatives of Yost's office and the U.S. Department of Justice, which is representing Treasury, did not immediately respond to requests for comment.

Ohio is represented by Attorney General Dave Yost and by Benjamin M. Flowers, Zachery P. Keller and Sylvia May Davis of the Ohio Attorney General's Office.

Treasury is represented by Brian M. Boynton, Brian D. Netter, Alexander K. Haas, Brigham J. Bowen, Stephen Ehrlich, Michael P. Clendenen and Charles E.T. Roberts of the U.S. Department of Justice.

The case is Ohio v. Janet Yellen et al., case number 1:21-cv-00181, in the U.S. District Court for the Southern District of Ohio.

--Additional reporting by James Nani and Paul Williams. Editing by Roy LeBlanc.

For a reprint of this article, please contact reprints@law360.com.