DOJ Argues that 28 U.S.C. § 2401(a) Doesn’t Bar Altera’s APA Challenge to a Tax Regulation Made More Than 6 Years After Adoption

We welcome frequent guest blogger Carl Smith with breaking news about the Altera appeal pending in the 9th Circuit. Today’s news is not dispositive but does provide interesting insight on the Government’s view of a new issue raised by the 9th Circuit as the new panel reviewed the case. Keith

PT readers are no doubt aware of Altera v. Commissioner, 145 T.C. 91 (2015). In the case, the Tax Court invalidated a regulation under § 482 concerning the inclusion of stock option compensation in related-party cost-sharing arrangements. The two Tax Court dockets involved in the case were under the Tax Court’s deficiency jurisdiction in 2012. In those cases, Altera sought to invalidate a 2003 regulation both under the Chevron standard (i.e., not reasonable) and under the Administrative Procedure Act (APA). The Tax Court invalidated the regulation under both theories. The Tax Court found APA violations including the IRS’ (1) failure to respond to significant comments submitted by taxpayers and (2) in light of the administrative record showing otherwise, the IRS’ failure to support its belief that unrelated parties entering into cost sharing arrangement would allocate stock-based compensation costs.

As we blogged here, on July 24, 2018, the Ninth Circuit issued an opinion upholding the regulation. But that opinion was later withdrawn because one of the judges in the majority had died before the opinion was issued. After a new judge was assigned to rehear the case, the parties were invited to (and did) submit supplemental briefs. (Four supplemental amicus briefs were also submitted.) On the day all of these supplemental briefs were submitted, September 28, 2018, the Ninth Circuit panel issued an order inviting further briefing from the parties by October 9 on an issue that had never before been argued in the case. The case is set for reargument before the new Ninth Circuit panel on October 16.

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The recent order stated concerning this additional briefing issue:

The parties should be prepared to discuss at oral argument the question as to whether the six-year statute of limitations applicable to procedural challenges under the Administrative Procedure Act, 28 U.S.C. § 2401(a), applies to this case and, if it does, what the implications are for this appeal. Perez-Guzman v. Lynch, 835 F.3d 1066, 1077-79 (9th Cir. 2016), cert. denied, 138 S. Ct. 737 (2018).

In Perez-Guzman, the Ninth Circuit had held that procedural challenges to regulatory authority (unlike Chevron substantive challenges) must be raised in a court suit within the 6-year catch-all federal statute of limitations at 28 U.S.C. § 2401(a). Since the Altera deficiency cases had been brought more than six years after the pertinent regulation was adopted, the Ninth Circuit was, in effect, wondering whether all APA arguments in the case were time barred.

On October 9, however, the DOJ, rather than file a supplemental brief, filed a 5-page letter disclaiming any reliance on the statute of limitations under 28 U.S.C. § 2401(a). The letter states, in part:

It is the Commissioner’s position that any pre-enforcement challenge to the regulations at issue here – including a purely procedural challenge under the APA, cf. Perez-Guzman, 835 F.3d at 1077-79 – would have been barred by the Anti-Injunction Act. See 26 U.S.C. (“I.R.C.” or “Code”) § 7421(a) (stating that, “[e]xcept as provided in” various Code sections (the most significant of which, I.R.C. § 6213(a), allows the pre-payment filing of a Tax Court petition in response to a statutory notice of deficiency), “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person”) . . . . Thus, Altera properly asserted its challenge to the regulations in two Tax Court actions contesting notices of deficiency that reflected the enforcement of the regulations against it. See Redhouse v. Commissioner, 728 F.2d 1249, 1253 (9th Cir. 1984).

If Altera’s procedural APA challenge to the regulations were nonetheless subject to the six-year statute of limitations set forth in 28 U.S.C. § 2401(a) (which would have started running on the date of issuance of the final regulation, see Perez-Guzman, 835 F.3d at 1077), then Altera would have had to pay the tax and file a refund claim within the six-year window – thereby forfeiting the opportunity to contest the enforcement of the regulations against it in the pre-payment forum of the Tax Court – in order to comply with that time limit. Because the Commissioner has never expressed the view that the six-year statute of limitations applies to a procedural APA challenge to a tax regulation in the context of a Tax Court deficiency proceeding, and because the IRS issued the notices of deficiency in this case outside the six-year APA window, it would have been unfair to argue below that Altera’s procedural APA claims are time-barred. And, given this Court’s holding that the six-year statute of limitations set forth in 28 U.S.C. § 2401(a) is not jurisdictional, Cedars-Sinai Med. Ctr. v. Shalala, 125 F.3d 765, 770 (9th Cir. 1997), the Commissioner waived any defense under that provision by not raising it in the Tax Court.

In sum, it is the Commissioner’s position that the six-year statute of limitations that is generally applicable to procedural challenges to regulations under the APA, see 28 U.S.C. § 2401(a), does not apply to this case.

Observation

Some people wonder why I litigate so much over whether or not filing deadlines are jurisdictional. The Altera case demonstrates again why this can often be a critical issue, since only nonjurisdictional filing deadlines are subject to waiver, forfeiture, estoppel, and equitable tolling.

 

Challenges to Regulations Update: Government Withdraws Appeal in Chamber of Commerce and New Oral Argument Set for Altera

One of the more interesting cases from last year was Chamber of Commerce v IRS, where a federal district court in Texas invalidated temporary regulations that addressed inversion transactions. The case raised a number of interesting procedural issues, including the reach of the Anti-Injunction Act and the relationship between Section 7805(e) and the APA.

Not surprisingly, the government appealed Chamber of Commerce. Over the summer, Treasury issued final regs that were substantively similar to the temporary regs that the district court struck down, and then the government filed a motion with the Fifth Circuit to dismiss its appeal with prejudice.

Last month the Fifth Circuit granted the motion.

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The outcome in Chamber of Commerce illustrates the difficulty that taxpayers face when challenging regulations for process violations (i.e., failing to subject guidance to notice and comment) and in particular challenges to temporary regulations. After all, Treasury can (and did in this case) issue final regs, and Section 7805(b) provides that those regs take effect retroactively upon the earlier of the “date on which any proposed or temporary regulation to which such final regulation relates was filed with the Federal Register” or “the date on which any notice substantially describing the expected contents of any temporary, proposed, or final regulation is issued to the public.”

Chamber of Commerce is to be contrasted with challenges to regs that focus on the substantive way that the regulations interpret a statute; for example, earlier this summer the DC Circuit reversed the Tax Court in Good Fortune Shipping.There, the DC Circuit applied Chevron Step Two and held that Treasury regulations that categorically restricted an exemption to foreign owners of bearer shares unreasonably interpreted the Internal Revenue Code. The taxpayer in Good Fortune challenged the reg the old fashioned way– in a deficiency case as contrasted with the pre-enforcement challenge in Chamber of Commerce.

Probably the most watched procedural case of the year, Altera v Commissioner, also tees up a procedural challenge to regs, and like Good Fortune is also situated in a deficiency case. One of the main arguments that the taxpayer is raising in Altera is a cousin to the challenge in Chamber of Commerce; that is the taxpayer is challenging the way that the reg was promulgated (and the case also involves a Chevron Step Two challenge). In particular, the issue turns on whether the agency action [the regulation] is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 USC 706(2)(A). Altera involves Treasury’s compliance with § 706 of the APA as expanded on in the 1983 Supreme Court State Farm’s “reasoned decisionmaking” understanding of the clause prohibiting “arbitrary” or “capricious” agency action.

As Keith flagged a few weeks ago, after the Ninth Circuit reversed the Tax Court and found that Treasury did enough in its rulemaking and held that the cost-sharing regulation was valid, the Ninth Circuit withdrew the opinion. The Ninth Circuit has now scheduled a new oral argument in Altera for October 16.

Stay tuned.

Review of Stephanie Hunter McMahon’s “The Perfect Process is the Enemy of the Good: Tax’s Exceptional Regulatory Process”

We welcome guest blogger Sonya Watson who teaches at UNLV law school where she is an assistant professor in residence and the director of the Rosenblum Family Foundation Tax Clinic. In the last few weeks, with decisions in Altera and Good Fortune, we have seen major circuit courts of appeal opinions considering whether Treasury’s regulations withstand challenge. Professor Watson returns to provide us with another review of a tax procedure article that directly considers the relationship of Tax regulations and broader administrative law concepts. Keith

Earlier this year I reviewed Professor Kristin Hickman’s article, “Restoring the Lost Anti-Injunction Act,” in which she argued that that a narrow interpretation of the Anti-Injunction Act (“AIA”) is warranted to protect taxpayers’ presumptive right to pre-enforcement judicial review of agency rules and regulations under the Administrative Procedure Act (“APA”).  While the AIA prevents pre-enforcement review of tax laws, the APA allows pre-enforcement review. Hickman argues that it is especially important that taxpayers are able to invoke the APA and hold the IRS to the APA’s standards because of Treasury’s and IRS’ belief than in many instances, the APA does not apply to them. Today I review Professor Stephanie McMahon’s “The Perfect Process is the Enemy of the Good: Tax’s Exceptional Regulatory Process” in which McMahon plays devil’s advocate. McMahon argues that tax is exceptional and as such, Treasury and IRS shouldn’t be bound to the letter of the APA. Rather, Treasury and IRS should follow the spirit of the APA. She argues that this is especially true considering that the APA is not without flaws and that other agencies may not properly adhere to the APA either.

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Because the procedures set out in the APA don’t always accomplish the APA’s goals, rather than focusing on whether agencies strictly adhere to the procedures set out in the APA, we should focus on whether the procedures that the agency does employ are in line with the goals underlying the procedures provided in the APA. The goals underlying the APA’s procedures include: the promotion of public deliberation; reasoned agency decision-making with few errors; and agency accountability to the public and Congress. McMahon argues strict adherence to the APA can thwart accomplishment of these goals. In particular, she takes issue with the APA’s notice and comment process.

The notice and comment process, along with the hard look doctrine, which requires agencies to “consider all comments and to explain why it was not persuaded by all but frivolous comments,” may cause agencies to delay or defer issuing guidance because doing so is too burdensome in terms of resources. Producing guidance costs money:

When not excepted from notice and comment procedures, agencies face significant costs associated with compliance. Although it is impossible to calculate all of the costs of rulemaking because data is unavailable or immeasurable, Professor David Franklin notes, “Congress, the President, and the courts have all taken steps that have made the notice-and-comment rulemaking process increasingly cumbersome and unwieldy. Even critics of tax exceptionalism note that the “procedures are quite burdensome.” Many federal agencies have responded by foregoing notice and comment and issuing interpretative tools, policy statements, and informal guidance. “[B]usy staffs, tight budgets, and a variety of competing priorities” may affect how agencies weight the choice of rulemaking tools.

Further, there is always the risk that that courts may invalidate a rule to which Treasury and IRS have devoted its scare resources.

Aside from being a drain on resources, the notice and comment process creates the potential for agency capture. Agency capture occurs when an interested party influences an agency by dominating it “in ways that are detrimental to the public purpose for which it was created.” There are several ways to capture an agency, one of which is with information. In the context of the IRS, the notice and comment process may lead to information capture if an interested taxpayer inundates the IRS with large amounts of information—evidence and arguments pertaining to a rule—which then may have the effect of drowning out other voices or overcomplicating the issues, making it more difficult for less sophisticated taxpayers to participate. Because the APA’s notice and comment process does not provide a way to effectively filter information so that agencies aren’t overwhelmed by the information received, the process may not achieve its goal of increased public participation in rulemaking. Further, the notice and comment process may be unnecessary considering that “[i]nformal meetings, roundtables, speeches and leaks, advisory committees, and negotiated rulemaking are ways to really get information from the public.”

To the extent that Treasury can promote the goals underlying the APA without following the APA, McMahon believes it makes sense for Treasury to do so. To this end she states that Treasury is justified in availing itself of the good cause exemption to the APA. The good cause exemption allows agencies to issue binding guidance without notice and comment by explaining why notice and comment would be “impracticable, unnecessary, or contrary to the public interest.” Regarding Treasury’s use of the good cause exemption, McMahon writes:

Good arguments can be made for the good cause exemption to apply widely in the tax context. Currently tax provisions are tied to the federal government’s budget and there are restrictions on both deficit spending and the national debt. As a part of the federal fiscal planning, tax provisions are almost always estimated to have immediate effect, and that estimation is necessary in order to accomplish other goals of federal budgeting. In other words, if tax provisions were given delayed effective dates to permit time for notice and comment, this delay would alter the cost calculation of the federal budget.

The foregoing is in addition to the consideration that taxpayers and tax practitioners need Treasury to create guidance quickly in order to be able to better ensure compliance with the ever evolving tax laws.

Courts’ deference to agency rules is another important consideration in the debate over whether Treasury should be required to adhere to the APA. The more likely it is that courts will defer to an agency, the more important it is to make sure that the agency follows proper procedure in creating a rule. Final, legislative regulations enjoy significant deference but interpretative, proposed and, temporary regulations, as well as other types of guidance (revenue rulings, etc.) may enjoy less deference. This is because although agencies theoretically have broad discretion under Chevron, courts often apply tax-specific standards when deciding the extent to which they should defer to tax guidance, making deference harder to secure in the tax arena. Therefore, the idea that courts’ deference to agency rules make it vitally important that agencies follow proper procedure should be tempered with the knowledge that courts often don’t defer to agencies and that this is especially true in the case of Treasury and IRS.

Finally, adherence to the APA might inhibit the use of heuristics. The notice and comment process is meant to provide a means for an agency to receive information it should consider when creating guidance. However, it is unlikely that an agency will receive information regarding all the considerations it should make in creating guidance. So rather than relying on the notice and comment process to receive the information it needs to create good guidance, Treasury should create and rely on heuristics whenever possible. Heuristics are rules of thumb that aid decision making. Using heuristics in the administration of the Internal Revenue Code would allow non-experts to participate by giving them rules that are easier to apply. It also allows Treasury to keep up with changes in the law—because the Code continuously evolves, it is impossible to create guidance that will cover all possible scenarios. Heuristics don’t provide the specificity that regulations do, so using heuristics helps ensure compliance by those who might otherwise plan around the rules. Anyway, taxpayers and practitioners already use heuristics to understand and apply the code:

Developed through common law and now incorporated into practice by the IRS, tax lawyers know that gross income is interpreted broadly while deductions are construed narrowly as a matter of legislative grace, income is to be taxed to earners, substance prevails over form, and (although possibly threatened by codification) transactions need economic substance. These ideas, among others, guide the practice of law and the choices taxpayers make when they report the tax consequences of their activities. Without such guideposts, every new tax provision must be fully and singularly explicated, and any ambiguity litigated from scratch.

McMahon does acknowledge, however, that more detailed guidance may be necessary when heuristics are insufficient.

 

 

The Ninth Circuit Reverses the Tax Court Decision in Altera

We welcome back guest bloggers Professor Susan C. Morse and Stephen E. Shay. Professor Morse teaches at University of Texas Law School and Steve Shay teaches at Harvard. Both are great speakers and writers with a deep knowledge of international taxes honed when they worked together at the Boston law firm of Ropes and Gray. They provided insight on the Altera decision in which the Tax Court decided the case in a fully reviewed 15-0 opinion back in 2015 after the filing of their amicus brief, immediately prior to the oral argument and following the oral argument. The opinion provided perhaps the most important procedural development of 2015 and the reversal is big news as well. The post is a little longer than our normal post but the opinion it discusses is much longer and more important than most of the cases we cover. This is a big win for the IRS. Keith

On July 24, the Ninth Circuit upheld a key IRS transfer pricing regulation, worth billions of dollars in federal revenues, that requires sharing employee stock compensation costs as a condition for a “qualified cost sharing arrangement” or QCSA. In Altera Corp. v. Commissioner, a 2-1 panel reversed the Tax Court’s decision, which had invalidated the regulation under the Administrative Procedure Act (APA).

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The conditions for a qualified cost sharing arrangement are described in U.S. tax regulations. If these are satisfied, the IRS will not make transfer pricing adjustments to the costs shared and will treat the cost sharing subsidiary as the co-owner, for tax purposes, of the intellectual property (IP) rights whose costs were shared. QCSAs benefit U.S. multinationals, since they allow MNCs to allocate to non-U.S. subsidiaries (usually in low-tax countries) income from their ownership of the IP.

The “sharing” of the cost of stock options granted to employees (such as engineers) who develop the intellectual property means that some related tax deductions are shifted to the non-U.S. subsidiary (to match with the shifted profit) rather than all of the deductions reducing the U.S. parent’s taxable income. These amounts are very large in the tech sector in particular and the industry has fought for years to avoid treatment of these expenses as costs to be shared in a QCSA. The failure to allocate the costs supports unjustified income shifting from the U.S. to countries where the foreign subsidiaries are located.

Altera, now part of Intel, claimed that its taxable income would be $80 million less if it were not required to share stock option costs. The Wall Street Journal has reported that the issue is worth at least $3.5 billion to Google alone. If the regulation were invalidated, the U.S. government would lose billions of dollars in tax revenue.

Treasury Regulation 1.482-7A was promulgated in 2003 under the authority of Internal Revenue Code Section 482, after notice and comment. Section 482 charges the Commissioner with reallocating income or deduction items “clearly to reflect” related taxpayers’ taxable income.

Altera argued that Section 482 required application of a narrow version of the “arm’s length” principle that only allowed the IRS to take account of costs if they were found in comparable cost sharing arrangements between unrelated parties. Because the stock option cost sharing regulation took the position that all relevant expenses had to be shared, and did not carve out stock option expenses not shared by unrelated parties, Altera contended – and the Tax Court agreed — that Treasury’s regulation was arbitrary and capricious and therefore invalid under the procedural strictures of the APA for failure to adequately explain its position in response to contrary comments. The Tax Court relied on the 1983 Supreme Court precedent State Farm and held that the reasoning supporting the stock option cost sharing regulation could not be discerned from materials such as the Preamble to the final regulations.

The thorough Ninth Circuit opinion starts with a history lesson on Section 482. The concept of “arm’s length” as primarily a comparable transactions method, which Altera focuses on, stems from 1968 regulations, which the court acknowledges featured a new “focus on comparability” (slip op. at 16). But the court explains that comparable transactions never had a monopoly on Section 482 adjustments. Cases in the 1940s, 1950s and 1960s had rejected the view that Section 482 only turned on comparable transactions. As of 1981, more than ten years after the 1968 regulations, the GAO found that only 3% of IRS adjustments were based on “direct comparables.” (Slip op. at 17)

In 1986, a statutory amendment to Section 482 added a sentence, which requires income allocations “commensurate with the income attributable to the intangible.” In 1994 and 1995, regulations regarding direct and cost sharing intangible transfers were promulgated in response to the statutory change. The cost sharing regulations implemented the commensurate with income standard by conditioning shared ownership of intellectual property under QCSAs on shared allocation of all relevant costs incurred to produce the intangibles. As the Ninth Circuit explained in a footnote, “[c]ontemporary commentators understood that [in the cost sharing regulations], by attempting synthesis between the arm’s length and commensurate with income provisions, Treasury was moving away from a view of the arm’s length standard grounded in comparability.” (slip op. at 21 n. 4) The regulations involving direct transfers of intangibles also adopted some exclusively internal pricing rules using profit splits, which were understood as part of the arm’s length standard. These regulations have not been challenged by taxpayers for failure to rely on (unavailable) comparables. In 2003, Treasury promulgated the regulation at issue in Altera, which explicitly requires the sharing of stock option expense when a firm seeks the protection of a cost-sharing agreement under U.S. regulations.

The Ninth Circuit opinion adheres to general administrative law requirements, consistent with the Supreme Court’s 2011 Mayo decision. The court first evaluated Treasury’s compliance with § 706 of the APA under the State Farm’s “reasoned decisionmaking” understanding of the clause prohibiting “arbitrary” or “capricious” agency action. Then it considered whether the agency’s interpretation of the statute was permissible under Chevron.

Altera’s State Farm argument ran as follows. In the notice-and-comment process, tech industry and other commentators said that requiring related parties to share stock option costs couldn’t be arm’s length because unrelated parties did not share such costs. Commentators contended that nothing could replace comparable transactions, not even if exposure to a contract counterparty’s stock price would be unacceptable for unrelated parties but appropriate for related firms. Altera claimed that Treasury’s response to these comments was inadequate under § 706 of the APA.

Treasury responded, for example in the Preamble to the final regulation, by saying that the comments about comparable transactions were beside the point, because Section 482 does not require comparable transactions. In the regulation’s Preamble, Treasury justified the stock option cost-sharing regulation as consistent with “the legislative intent underlying section 482,” “the commensurate with income standard” and “the arm’s length standard.” Treasury’s view was that “arm’s length” meant a result consistent with what arm’s length parties would have bargained for, not a result that had to be predicated on comparable transactions.

Said the court: “[T]he thrust of Altera’s [State Farm] objection “was that Treasury misinterpreted § 482. But that is a separate question – one properly addressed in the Chevron analysis. That commentators disagreed with Treasury’s interpretation of the law does not make the rulemaking process defective.” (slip op. at 32) The court held that Treasury complied with the State Farm requirement because its regulatory intent could be discerned. It plainly “set forth its understanding that it should not examine comparable transactions when they do not in fact exist and should instead focus on a fair and reasonable allocation of costs and income,” (slip op. at 32). It treated the arm’s length standard as “aspirational, not descriptive.” (slip op. at 43)

The Ninth Circuit followed its State Farm analysis with an analysis of Chevron deference. Here, the question was not whether Treasury had clearly articulated its understanding of its authority under § 482, but rather whether it had stayed within the limits of that authority. As to Chevron step one, the court quickly found that Congress left gaps in transfer pricing law for the Treasury to fill with guidance. It is hard to see a different path. The statute includes broad delegation language, saying that “the Secretary may … allocate gross income, deductions [and other items of commonly controlled organizations] if he determines [it] necessary in order … clearly to reflect … income.”

The court’s Chevron step two analysis was also straightforward. When Congress added the commensurate with income standard to the statute in 1986, it communicated that “the goal of parity is not served by a constant search for comparable transactions” and that “the amendment was intended to hone the definition of the arm’s length standard.” (slip op. at 41) The commensurate with income statutory language directed Treasury to do precisely what it did, which was to promulgate internal standards to address the inadequacy of a narrow, comparable transactions approach to arm’s length. The court rejected the argument that Xilinx Inc. v Commissioner, a 2010 Ninth Circuit case, controlled its decision, in part because Xilinx involved the interpretation of pre-2003 regulations, which did not mention stock options.

Judge O’Malley, a Federal Circuit judge sitting by designation, dissented. On the Chevron issue, she wrote that Xilinx should control. Despite the 1986 addition of the “commensurate with income” standard to the statute and the express mention of stock option costs in the 2003 revisions to Treas. Reg. 1.482-7A, she wrote that the regulations had a “fundamental ‘purpose’” (slip op. at 51) consisting of the narrow, traditional arm’s length standard derived from comparable transactions. On the State Farm issue, she wrote that “Treasury may well have believed that, given the fundamental characteristics of stock-based compensation in QCSAs, it could dispense with arm’s length entirely…. But the APA required Treasury to say that it was taking this position….” (slip op. at 59).

Judge O’Malley also suggested a different interpretation of the text of Section 482, saying that the commensurate with income standard’s reference to a “transfer (or license) of intangible property” was not broad enough to include a qualified cost-sharing agreement. This interpretation, raised in an amicus brief submitted by Cisco Systems, cannot be right. Absent a cost-sharing agreement (or another kind of transfer or license other than a QCSA), intangibles would be owned by the affiliate whose workers created them. For Cisco, this would likely be Cisco Systems, Inc., the parent, publicly traded California-incorporated company that sits atop of the multinational Cisco firm and presumably employs Cisco’s engineers. But because of the cost-sharing agreement, some rights, for instance non-U.S. rights, to the intangibles are owned for tax purposes by a non-U.S. subsidiary, say Cisco Systems Netherlands Holdings B.V., which is apparently the holding company for Cisco’s European, Middle East and Africa business. The only explanation for Cisco Systems Netherlands Holdings B.V.’s tax ownership interest in intangibles created by Cisco Systems, Inc. is that, at least for tax purposes, Cisco’s cost-sharing agreement transferred or licensed intangibles from the U.S. parent to the (low-tax) non-U.S. subsidiary. Also, in practice, in addition to the transfer or license for tax purposes worked by the QCSA, cost sharing arrangements are accompanied by IP licenses to the cost sharing subsidiaries to protect their use of the IP.

A request for panel rehearing is not likely, since one of the panelists in the majority, Judge Stephen Reinhardt, unexpectedly passed away in March 2018. However, the taxpayer might request the Ninth Circuit to review the Altera decision en banc (which would not include Judge O’Malley, the dissenting judge, since she sits on the Federal Circuit). And appeal to the Supreme Court is possible as well.

Altera now involves a remarkable tangle of complex legal issues. It raises federal courts rules, international tax regulations, and intricate administrative case law. How strong is Altera’s hand in the event of appeal?

The federal courts issue is procedural: how should a judge’s vote be recorded when the judge dies before an opinion is issued? A footnote explains that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion before his death.” This is consistent with Ninth Circuit rules and the approach of some other circuits (though not all), giving perhaps little reason to think that the Ninth Circuit would reconsider the issue en banc. If the question is Supreme Court review, Altera might not be the best case for further consideration of this issue. There should be no actual concern that Judge Reinhardt would have changed his mind. Reinhardt voted for the government twice in Xilinx, as he was in the majority in the initial case and in dissent on rehearing. This means that he thought the government properly required the sharing of stock option costs even under the pre-2003 regulations that did not mention them.

The international tax and administrative law questions together raise the issues of compliance with Chevron deference and State Farm APA requirements. Here too, Altera does not hold a strong hand. Despite Judge O’Malley’s efforts, it is impossible to read the statute as limiting Treasury’s authority to the narrow, comparable transactions view of arm’s length analysis that the taxpayer advances. As the history of Section 482 shows, the statute clearly is not limited to traditional arm’s length analysis based on comparable transactions. This validates Treasury’s Preamble disagreement with commentators’ view that comparable transactions had to be used as a starting point.

In other words, the question is not close. Even if Chevron deference were cut back to Skidmore “power to persuade” deference, there would still be room under Section 482 for regulations that did not follow the narrow version of arm’s length based on comparable transactions. Plus, Altera covers an area that is a paradigm of technical tax expertise (unlike, for instance, the issue said to be outside Treasury’s wheelhouse in King v. Burwell). Even if the Supreme Court is inclined to consider limits to Chevron deference, Altera is not a good vehicle for that project.

 

 

 

Quick Takes: Altera, Senate Finance Committee Testimony on IRS Reform

I am trying to meet a deadline before a last gasp of summer vacation in California, and I have had a little less time than usual for blogging.  Tax procedure and tax administration developments wait for no one, however, and much has been happening this week. I will briefly discuss and add some links to two major developments: the Altera case and the Senate Finance Committee Subcommittee on Tax and IRS Oversight hearing.

Altera

As I am sure many readers know, the Ninth Circuit reversed the Tax Court in the heavily anticipated case of Altera v Commissioner, a case we have blogged numerous times. The basic holdings in the Ninth Circuit case all involved the broader question as to whether Treasury exceeded “its authority in requiring Altera’s cost-sharing arrangement to include a particular distribution of employee stock compensation costs.”

The Ninth Circuit, in a divided opinion that included now deceased Judge Stephen Reinhardt in the majority, concluded that the Treasury did not. In so doing, it held that Treasury did not violate the APA in its rulemaking, and under Chevron the court deferred to Treasury’s take on the substantive issue of allocation of employee stock compensation costs.

We will have more on this decision in PT. In the meantime, here are some comments on the decision in the blogosgphere:

Dan Shaviro in Start Making Sense trumpets the 9thCircuit getting to the right outcome

Leandra Lederman in The Surly Subgroup, who like Professor Shaviro wrote an amicus arguing for reversal, succinctly summarizes the holding

Jack Townsend, who in his Federal Tax Procedure blog, in addition to linking to his excellent and free tax procedure book offers his take on the case, including his gloss on Chevron and his forecast that if the Supreme Court gets to this one there is a good chance for the Supremes “screwing it up”

Chris Walker at Notice and Comment who expresses unease about the process, especially the aspect of including as part of the majority a judge who passed away prior to the Court’s issuing the opinion

Alan Horowitz at Miller & Chevalier’s Tax Appellate blog, discussing the holding and likely petition for rehearing by the full circuit

Senate Hearing on Tax Administration

The Senate Finance Committee’s Subcommitte on Taxation and IRS Oversight had a hearing yesterday on improving tax administration.

Here is a link to the audio; witnesses, whose written testimony is linked above, were

  • Caroline Bruckner, Managing Director of the Kogod Tax Policy Center at American University ;
  • Phyllis Jo Kubey, Member of the National Association of Enrolled Agents and the IRS Advisory Council ;
  • Nina Olson, the National Taxpayer Advocate ;
  • John Sapp, the current Chair of the Electronic Tax Administration Advisory Committee advising the Internal Revenue Service, and
  • Rebecca Thompson, the Project Director of the Taxpayer Opportunity

Senator Portman’s introductory statement is here—in it he notes the 20thanniversary of the IRS Restructuring and Reform Act, and how he and Senator Cardin recently introduced the Taxpayer First Act(following the House passing its version of legislation).

The National Taxpayer Advocate blogged on the hearing, including her take encouraging “everyone who cares about improving tax administration to watch the hearing and read the testimony submitted.”

Spotlight on IRS Guidance: A Look at Recent Blog Posts on How Agencies Communicate

Subtitle: And a Nudge to Look at the National Taxpayer Advocate Purple Book’s Proposal to Formalize the NTA in the Rulemaking Process

Last week I attended an outstanding presentation on the recently enacted tax legislation that Tal Tigay, Brian Volz, Cuyler Lovett, Brian Thaler, and Howard Gavin (all from PWC) gave for the Villanova Graduate Tax Program. The Power Point presentation  summarizes the new legislation’s main individual, corporate, and international provisions. The presentation included review of the legislative process that led to a number of substantive decisions in the legislation and covered how any technical changes legislation will not be able to rely on a simple majority in the Senate to pass, but instead will need 60 votes for cloture to avoid a likely filibuster.

There are  numerous areas where the legislation is in need of further clarification. My colleague Professor Ed Liva, Director of the Villanova Graduate Tax program, noted in his introductory remarks that in today’s charged environment in DC, it may be difficult to get the 60 votes in the Senate to get a technical corrections bill passed, putting even greater pressure on IRS and Treasury to get guidance out in the form of regulations or less formal guidance.

The pressing need for tax guidance in light of the legislation leads me to a fascinating series of posts from our blogging colleagues at Notice & Comment, which last week hosted an online symposium on how agencies communicate.

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As part of that series, there are three posts sweeping in IRS: one by Professor Andy Grewal called Involuntary Rulemaking that discusses IRS use of less formal guidance like Chief Counsel Advice, a post by Professors Susan Morse and Leigh Osofsky called How Agencies Communicate: Introduction and an Example, discussing how IRS sometimes fills the gap in regulations and less formal advice by using examples, and Interim-Final or Temporary Regulations: Playing Fast and Loose with the Rules (Sometimes), a post by Professor Kristin Hickman discussing Treasury’s use of temporary regulations. All of the posts are worth a careful read, as does Professor Bryan Camp’s outstanding post a couple of weeks ago in Tax Prof called Treasury Regulations and the APA that looks at the Tax Court’s opinion in SIH Partners v Commissioner involving an APA challenge to longstanding regulations under Section 965. (Bryan’s post is part of a series of posts he regularly places on Tax Prof called Lessons from the Tax Court; for tax procedure types the series is a must read).

Today I will focus on Professor Hickman’s Notice & Comment post. In her post she notes how Treasury has skirted pre-promulgation APA notice and comment requirements with what she believes is an excessive use of temporary regulations (an issue we have discussed on PT in the context of the Chamber of Commerce challenge to the temporary anti-inversion regs). Calling the practice short-sighted, Professor Hickman laments that “post-promulgation notice and comment are an inadequate substitute for pre-promulgation procedures that themselves are already a second-best proxy for the legislative process.” Adding to the concern, Professor Hickman notes that social science research suggests that once a decision has been made and Treasury is administering a regulation it is less likely to change gears and respond to comments.

Professor Hickman’s comments have broad appeal, especially among  administrative law scholars who might find Treasury’s use of temporary regulations (or interim final regulations in admin law speak) to be an outlier agency practice. The argument also finds a soft landing spot among those who may not like the IRS, for both legitimate and perhaps less legitimate reasons.

Perhaps because I come at the issue more from the perspective of thinking about agency rulemaking as it applies to individual taxpayers, and especially lower income taxpayers, when reading Professor Hickman’s post I thought of the recent National Taxpayer Advocate (NTA) Report and its Purple Book. The Purple Book is a concise summary of suggestions that the NTA believes will strengthen taxpayer rights and improve tax administration. One of the NTA’s recommendations is that Congress should amend Section 7805 to require that IRS/Treasury should be required to solicit comments from the NTA when it promulgates regulations. And for good measure, the NTA proposes that Treasury should have to address those comments in the preamble to the final rules.

This mirrors a proposal I made when I last wrote a longish article about Treasury’s rulemaking process, in the 2012 Florida Tax Review’s A New Paradigm for IRS Guidance: Ensuring Input and Enhancing Participation.  I made a similar suggestion to amend Section 7805, drawing on Section 7805(f), which requires Treasury to solicit input from the Small Business Administration when proposed rules were likely to have an impact on small business taxpayers. I noted that the absence of participation is particularly troubling for rules that have a likely impact on those the agency is less likely or able to consider in the first instance (such as low income taxpayers or other taxpayers without much voice), and that the tax system would be better if there were a more formalized role for proxies like the NTA that could ensure all voices and views are before the agency.

The NTA proposal is a bit more nuanced than mine, as in my article I pegged the requirement to Treasury promulgation of final regs, while the Purple Book proposal adds that the requirement should also apply when Treasury is contemplating issuing temporary regulations.

The increasing attention around IRS’s rulemakng practice is likely to be intensified given the pressing need for guidance following the passage of the sweeping tax legislation. While it seems unlikely that Congress can in a bipartisan way approach the issue from an agency best practices perspective, perhaps the tax legislation’s passage will nudge the IRS to reflect further not just on the public’s need for guidance but also think about the process it uses get that guidance to the public.

 

 

Tax Court Decides Scope and Standard of Review in Whistleblower Cases

In a fully reviewed Tax Court opinion, Kasper v Commissioner, the Tax Court held that the scope of review in whistleblower cases is subject to the record rule and that the standard of review is abuse of discretion. The opinion is an important development in the progression of treating tax cases as a subset of cases within the mainstream of administrative law generally and the Administrative Procedure Act.

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The opinion concerns whistleblower claim relating to a former employee’s allegations that his employer had a longstanding pattern of uncompensated overtime for its employees. The whistleblower claim connected to taxes because it claimed that the millions of dollars in unpaid overtime would have led to substantial employment tax on the compensation.

The IRS rejected the claim in 2011, and in so doing sent a boilerplate rejection that was not really responsive to the particulars of the claim. In a bankruptcy proceeding involving Kasper’s former employer, IRS collected over $37 million in taxes relating to unpaid withholdings. Kasper wanted some of that, connecting his whistleblower claim to the IRS actions in the bankruptcy proceeding.

The opinion notes that the parties tried the case to “establish the contents of the administrative record and ordered the parties to brief the issues of the scope and standard of review in whistleblower cases to help us figure out both what we can look at and how to look at the IRS’s work in whistleblower cases.”

The opinion clears the fog on the scope and standard of review in whistleblower cases. In so doing, it explores an issue we have covered in PT and an area that I have discussed extensively in IRS Practice and Procedure, especially in revised Chapter 1.7, namely the precise relationship between the APA and the workings of the IRS.

The importance of Kasper is that it establishes that whistleblower cases, unlike deficiency cases which predate the APA and which have a defined set of procedures establishing a clear legislative exception to the path of judicial review of agency action, are subject to the same rules as applied to court review of other agency adjudications. There are there main aspects of that principle:

  • Scope of Review: Tax Court review of whistleblower determinations are subject to the record rule, meaning that the parties are generally bound to the record that the agency and party made prior to the agency determination
  • Standard of Review: the Tax Court will review whisitleblower determinations on an abuse of discretion basis; and
  • Chenery Rule Applies: The Tax Court can uphold the Whistleblower Office determination only on the grounds it actually relied on when making its determination.

What makes Kasper one of the most significant tax procedure cases of the new year is that in reaching those conclusions it walks us through and synthesizes scope and standard of review and Chenery principles in other areas, such as spousal relief under Section 6015 and CDP cases under Section 6220 and 6330.

In what I believe is potentially even more significant is its discussion of exceptions within the record rule that allow parties to supplement the record at trial.   To that end the opinion lists DC Circuit (which it notes in an early footnote would likely be the venue for an appeal even though the whistleblower lived in AZ ) summary of those exceptions:

  • when agency action is not adequately explained in the record;
  • when the agency failed to consider relevant factors;
  • when the agency considered evidence which it failed to include in the record;
  • when a case is so complex that a court needs more evidence to enable it to understand the issues clearly;
  • where there is evidence that arose after the agency action showing whether the decision was correct or not; and
  • where the agency’s failure to take action is under review

As I observe in IRS Practice and Procedure, the clarity so to speak of cases such as Kasper in bringing categories of tax cases within the confines of administrative law is belied by the complexity and at times uncertainty surrounding basic administrative law principles. As  Kasper notes, there can be (and often are) disputes about what is the agency record, and nontax cases establish that the agency itself does not have the final word on what constitutes the record.

On the merits, the Tax Court concluded that the information that Kasper provided did not lead to the collection of the employment taxes in the bankruptcy case. Even though the whistleblower office did not consider the evidence pertaining to the bankruptcy court proceedings, the opinion notes that the IRS would have filed its proof of claim in the ordinary course, so its error in note considering the information was harmless.

Ninth Circuit Hears Altera Tomorrow

We welcome back guest bloggers Professor Susan C. Morse from University of Texas School of Law and my colleague Senior Lecturer on Law Stephen E. Shay from Harvard.  Professors Morse and Shay, building on an earlier post as well as their amicus brief, explain that the Tax Court went too far in striking down Treasury regulations requiring the sharing of stock-based compensation costs in Altera.  The underlying issue as well as the procedural issue make this a case to watch. We have previously blogged about Altera here and here.   Keith

On Wednesday of this week, October 11, the Ninth Circuit will hear argument in Altera, a case about transfer pricing and administrative law. Politically, Altera is a case about big multinational technology companies and under-resourced government regulators. Technically, it is about the transfer of intellectual property rights from U.S. affiliates of a multinational firm (a “U.S. group”) to one or more non-U.S. offshore subsidiaries under a qualified cost sharing arrangement (QCSA).

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Firms from Google and Apple to Altera, a semiconductor company owned by Intel, use the QCSA “cost sharing” strategy to support the attribution of intellectual property for tax purposes to low-tax offshore subsidiaries and thereby justify allocation of substantial taxable income to those subsidiaries. The smaller the amount of U.S. group costs included in the pool, the more tax revenue the U.S. loses with respect to the cost-shared IP. Billions of dollars are at stake. Two amicus briefs prepared pro bono by academics and former tax practitioners support the government and multiple amicus briefs on behalf of interested business groups support the taxpayer in this important litigation.

Altera challenged a final Treasury regulation that requires multinationals who enter into QCSAs with offshore affiliates to include the cost of stock options granted to employees who develop the IP (among other expenses) in the pool of costs to be shared. Under cost sharing, if net costs are borne by the U.S. group the non-U.S. affiliates must reimburse the U.S. group for that amount. Prior regulations did not specifically address the issue of stock option cost allocation in a QCSA. In a prior case, Xilinx, the Tax Court and Ninth Circuit held that the government could not make offshore affiliates pay a share of stock option expense under these earlier regulations.

The revised final regulation requires taxpayers to include stock option costs in the pool of expenses for determining cost sharing payments. They provide that this is required under the arm’s length standard and, consistent with the directive of Section 482 of the Internal Revenue Code, is necessary clearly to reflect the income of the U.S. group.

Taxpayers challenged the final regulation and won in Tax Court in a reviewed decision that was unanimous among the judges that participated. The Court held that the regulations departed from the historic understanding of “arm’s length standard” which required the use of data about unrelated party transactions. The Tax Court proceeded to conclude, under a review based on State Farm (US 1983), that the regulatory change was arbitrary and capricious under § 706(2)(A) of the Administrative Procedure Act.

The misconception in the Tax Court’s decision is fundamental. One reason is that the historic understanding of “arm’s length standard” does not require the starting point of data about unrelated party transactions. Sometimes an application of the arm’s length standard uses unrelated party data. For example, if a taxpayer sells a commodity to related affiliates and unrelated firms, the unrelated firm price is the right starting point for the related affiliate price, because it is sufficiently comparable. But in other cases, unrelated party transactions are not comparable enough to serve as good starting points.

The arm’s length standard has always been a counterfactual inquiry. It has always asked how a related party transaction would be treated if, contrary to fact, the same transaction (including the actual relationships presented in fact) were conducted by unrelated parties (i..e, as though the relationship did not exist). This does not mean insisting that the reasoning begin with an unrelated party transaction if that transaction has sufficiently different facts and is not comparable.

Several transfer pricing methods, including the comparable and residual profit split methods, do not require use of unrelated party prices as starting points.   Moreover, large chunks of the 482 rules prove that the arm’s length standard is not a brittle instruction to use whatever unrelated party information is available. The 482 regs include many pages of comparability adjustments which at every turn show that a starting unrelated party price, even if available, often needs a lot of work before it can be considered a comparable.

Altera and other multinational tech companies want to avoid paying for the stock option cost component of technology by arguing that unrelated firms that share technology do not require payment for stock option costs. They say that the arm’s length standard requires a starting unrelated party data point, and further that any departure from the unrelated party data point requirement is a significant regulatory change.

One reason that Altera should lose in the Ninth Circuit is because the arm’s length standard does not, and never has, required a starting unrelated party data point in all cases. Government briefs include this argument. They show that uncontrolled joint development agreements were not relevant to the question of whether to include stock option costs in QCSAs because clear reflection of income for high-profit intangibles cannot succeed if it relies on uncontrolled party data.  One amicus brief points out that Section 482’s reference to pricing “commensurate with income” only makes sense if the arm’s length standard embraces transfer pricing that is not bound to unrelated party pricing.

Another amicus brief (ours, with coauthors) explains that unrelated party data points cannot be starting points for an arm’s length analysis if the unrelated information is wholly incomparable to the related party situation. This is the case for the evidence that Altera points to, which consists of technology sharing deals among unrelated parties that do not mention stock option costs. This evidence is not relevant for QCSAs because it is not comparable.

The facts of Example 2 in our brief illustrate the lack of comparability between unrelated party joint ventures and related party technology transfer agreements:

Assume that Company C and Company D are unrelated and want to share the R&D costs and benefits for a new innovation on a 50/50 basis.

Company C pays cash compensation of 80 and grants stock options with an expected cost of 20 for its R&D employees. Company D pays cash compensation of 20 and grants stock options with an expected cost of 80 for its R&D employees. There are two possible ways of looking at the R&D costs in this deal:

Option 1: If stock option expenses are included, the pool of expenses is 200, and each company pays 100. No transfer between C and D is required to achieve a 50/50 split of expenses.

Option 2: If stock option expenses are not included, the pool of expenses is 100: 80 contributed by Company C and 20 contributed by Company D. D would transfer 30 to C to achieve a 50/50 split of expenses.

The correct answer is Option 1. Any rational economic actor would estimate and incorporate the stock option expense cost. Note that Company C and Company D do not need to mention stock option costs in order to consider and incorporate them into their transaction. The lack of a specific mention of stock options in the unrelated party deal document does not mean that stock option costs are priced at zero or intentionally disregarded.

The arm’s length standard has always recognized the absence of comparable third-party transactions in some areas of transfer pricing, including the large-scale licensing of IP among related parties. Thus the revised regulation at issue in Altera does not revolutionize the meaning of arm’s length. Instead it stays true to the meaning of clear reflection of income.

Tune in again after October 11 to hear how the taxpayer, the government and the judges of the Ninth Circuit approached this case at oral argument.