Ninth Circuit Reconsideration in Altera v. Commissioner

We welcome back guest blogger Stu Bassin. Stu has blogged with us on several occasions. He is a practitioner based in DC with an extensive controversy practice and provided a discussion of the Altera case earlier here. Les

Last week bought the latest twist in the saga of a challenge to a critical transfer pricing regulation—a rehearing by the Ninth Circuit of a since-vacated ruling upholding the regulation. The original unanimous reviewed decision by the Tax Court in Altera Corp. v. Commissioner, 145 T.C., No. 3 (2015), invalidated the regulation. A divided panel in the Ninth Circuit reversed, upholding the validity of the regulation over a strong dissent. The majority opinion was soon vacated and the case was reargued on October 16, 2018. Given the importance of the specific regulation at issue in transfer pricing cases, as well as the continuing discussion regarding questions concerning Administrative Procedure Act challenges to IRS regulations, the reargument has generated substantial attention in the tax community.

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The underlying dispute involves a cost-sharing agreement governing allocation of stock-based compensation costs between entities related to the taxpayer and invocation by the IRS of Section 482 to recharacterize the terms of that agreement. Section 482 provides:

In any case of two or more organizations . . . owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

The taxpayer relied upon the undisputed fact that the terms of its cost-sharing agreement were consistent with the prices which unrelated parties would employ in comparable arms-length agreements, thereby satisfying the legal standard historically applied in evaluating cost-sharing agreements under Section 482. The IRS recharacterized the terms of the agreement, relying upon a regulation which specifically required affiliates to share stock-based compensation costs in a manner “commensurate with the income attributable to the intangible.” The taxpayer disagreed, contending that the regulation was invalid under the APA because it deviated from the comparable arms-length transaction test.

The Tax Court unanimously ruled in favor of the taxpayer, invalidating the regulation and rejecting the proposed Section 482 adjustment, focusing upon the second stage of the regulation validity inquiry mandated by Mayo Foundation v. United States, 562 U.S. 44 (2011) — whether the determinations reflected in the regulation were arbitrary and capricious. The opinion concluded that the regulation was invalid because the IRS failed to engage in actual fact-finding, failed to provide factual support for its determination that unrelated parties would share compensation costs in their cost-sharing agreements, failed to respond to significant comments, and acted contrary to the factual evidence before Treasury.

The IRS appeal to the Ninth Circuit was initially heard by a panel consisting of Chief Judge Thomas, Senior Judge Reinhardt, and Judge O’Malley of the Federal Circuit. Judge Thomas, joined by Judge Reinhardt, wrote the opinion for the court reversing the Tax Court opinion and upholding the validity of the regulation. He reasoned that the 1986 amendment of Section 482 (which added the language containing the “commensurate with income” standard) mandated that the IRS adopt regulations employing the commensurate with income standard in addition to the comparable arms-length transaction standard. Judge O’Malley dissented, urging invalidation of the regulation because it deviated from the arms-length standard.

Because the decisive vote was cast by Judge Reinhardt, who died after the argument and roughly 100 days before the opinion was issued. A footnote to the opinion states that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion prior to his death.” A procedural issue arose when Altera petitioned for rehearing. The remaining members of the panel were deadlocked, so the court withdrew the original opinion, assigned Circuit Judge Susan Graber (a Clinton appointee) to replace Judge Reinhardt on the panel, and scheduled the case for reargument last week.

At the argument, Judge Thomas was silent and Judge O’Malley appeared to reiterate the position stated in her dissent. So, all eyes focused upon Judge Graber, who was new to the panel and the likely decisive vote on the merits. She focused her inquiry upon statutory construction issues and the relationship between the historic standard of “comparable arms-length transactions” embodied in the first sentence of Section 482 and the “commensurate with income” standard embodied in the second sentence of Section 482. Noting that the statutory language of the second sentence applies only to “the income with respect to such transfer or license [of intangible property],” she questioned whether the cost sharing agreement was a “transfer or license” within the meaning of the statute. The taxpayer argued that its cost-sharing agreement was not a narrow “transfer or license” and that the second sentence’s “commensurate with income” standard was therefore inapplicable. In contrast, the government contended that the indirect role of the cost-sharing agreement in establishing the pricing on the arrangement between the two subsidiaries was sufficient to render the “commensurate with income” standard applicable and controlling.

Judge Graber also asked a series of questions focused upon reconciling the commensurate with income standard with the general requirement under Section 482 that the IRS must allocate costs in a manner consistent with the arms- length standard. The government argued that the legislative history reflects a congressional policy judgment and determination that, in those cases involving transfers of intangible property, only an allocation based upon the “commensurate with income” standard would satisfy the arms-length standard. The taxpayer countered by stating that the legislative history did not support such a construction and observed that, if the government’s construction were adopted, relatively few transactions would remain governed by the traditional arms-length standard.

Finally, Judge Graber inquired whether there was a factual basis or economic theory which supported the regulation’s finding that stock-based compensation costs must be allocated in a manner   commensurate with income to satisfy the arms-length standard. The taxpayer noted the absence of a factual record or economic theory supporting the IRS findings, arguing that the only evidence before the agency supported a finding that comparable arms-length transactions did not allocate stock-based compensation costs in the manner required by the IRS. In contrast, the government stated that such evidentiary support was not required to support the IRS determination.

Interestingly, the argument gave relatively little attention to the second stage of the Mayo analysis—the arbitrariness of the IRS determination. The degree of deference accorded regulations under Chevron was hardly discussed. Both sides and the court focused upon the statutory authority for the regulation. They all seemed to agree that, if the statute authorized the IRS to deviate from the arms-length standard, the regulation would survive.   Otherwise, the regulation was invalid.

The panel gave no indication of when it would render its decision. Full opinions on appeals to the Ninth Circuit tend to take a long time and the initial panel decision was not released until nine months after the argument. So, it seems likely that a decision will not be issued until early 2019.

 

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.

White House Oversight of Tax Regulations

One of the more significant tax procedure developments of the past year is the new centralized OMB review  that applies to some tax regulations. In this post, Professor Clint Wallace from the University of South Carolina School of Law describes the new framework and notes the many areas that await further clarification. Clint discusses this in greater detail in Centralized Review of Tax Regulations, forthcoming in the Alabama Law Review. Clint is an important voice in the academy on tax administration and tax procedure. His article Congressional Control of Tax Rulemaking appeared this past year in the Tax Law Review. In that piece Clint discussed the special institutional capacity that the Joint Committee on Taxation plays in tax legislation, situating the JCT in the context of administrative law and principles of statutory interpretation. Les

Earlier this month, the Treasury Department and the Office of Management and Budget announced a “new framework” that appears likely require many more tax regulations to undergo OMB review.  In other contexts—for example, environmental or workplace rules—this sort of consultation between agency regulation-writers and OMB is commonplace.  Dating back to the Reagan administration, centralized review has been mandated for many regulations.  (The fountainhead of OMB’s authority to impose this review is Executive Order 12,866, which has been modified in some minor respects by subsequent EOs, but remains in effect).  When OMB reviews a “significant” regulation, it requires the drafting agency to quantify the costs and benefits of the rule, and it facilitates a process whereby other departments can weigh in on the proposals.  But OMB has never before required tax regulations to be subjected to this sort of review.

Some political commentators saw the framework as OMB winning a turf war against Treasury, and some tax professionals reacted with dismay that additional layers of analysis will delay new regulations.  Delays are a particular concern in the tax community right now because Treasury is scrambling to produce reams of important regulations to fill in the many blanks that Congress left when it hastily enacted the Tax Cuts and Jobs Act at the end of 2017.

But treating this as either an issue of shifting political power or simply a matter of stretching out a bureaucratic process both undersells and oversells the potential import of this move.  As of now, no one really knows what it means for the implementation of the Tax Cuts and Jobs Act, nor for the development of regulatory tax policy more generally.

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The framework has three major components.  First, it requires Treasury to keep the Office of Information and Regulatory Affairs (the office within OMB charged with central authority to review regulations)abreast of its agenda by submitting quarterly “notices” of all “planned tax regulatory actions.”  This, of course, does not mark a significant change from current Treasury and IRS practices: Treasury and the IRS already produce an annual “Priority Guidance Plan,” with quarterly updates.  Further, these documents are already robust and useful versions of the sort of regulatory agenda-setting prescribed under Executive Order 12,866: Treasury does a good job of soliciting public input on agenda items, makes fairly accurate predictions of its capacity, and follows through on the items it places on the agenda. It looks like the new framework does not change anything about this agenda-setting process, but rather simply mandates that Treasury should provide the (already publicly available) agenda and updates directly to OIRA.  The framework specifies that “[a]t the election of the OIRA administrator, Treasury will engage in substantive consultation with OIRA regarding any” regulatory action that appears on the agenda.  It is not clear from the memorandum what such engagement might consist of; regardless, such engagement was not prohibited previously.

The second component of the framework is that it provides that OIRA will review any regulatory actions that “create a serious inconsistency or otherwise interfere with an action taken or planned by another agency,” or that “raise novel legal or policy issues, such as by prescribing a rule of conduct backed by an assessable payment.”  The treatment of this category of tax regulatory actions corresponds with the treatment of “significant” rules under E.O. 12,866.  Along similar lines, the third element of the framework requires that regulatory actions that have “an annual non-revenue effect on the economy of $100 million or more,” be subject to the comprehensive review that is required for “economically significant” regulations under E.O. 12,866.  This review calls for the drafting agency (i.e., Treasury) to produce quantified cost-benefit analysis of the proposed regulation and alternatives.   The framework provides OIRA with 45 days to review each rule, with additional time provided as necessary, and allows Treasury to request an “expedited” 10-business-day review—this is notably shorter than the standard 90-day review period provided for regulations from other agencies, which suggests Treasury and OIRA were mindful of timing concerns expressed from the tax community.

These changes potentially mark a sea-change in the process for producing tax regulations.  However, many important details—which could impact the effectiveness and significance of this new world of centralized review—remain to be determined.  Most prominently, the categories of tax regulatory actions subject to review are ill-defined:

  • The first category of tax regulations that OIRA plans to review—i.e., the category that aligns with “significant” regulations under Executive Order 12,866—applies if a proposed regulation presents a “serious inconsistency” with action taken by another agency. But it is unclear how OIRA will distinguish between serious and minor potential inconsistencies.  The other definitional prong is similarly vague: a “novel legal or policy issue” appears straightforward, but is then exemplified as a “rule of conduct backed by an assessable payment.”  In tax administration, such a rule is not novel; it is a tax or a penalty.  It is unclear whether OIRA intends to (or believes it is authorized to require) review of any rule that can affect the amount of tax or penalty owed, or if this is more limited.
  • The second category of tax regulations includes no explanation of how the “non-revenue effect on the economy of $100 million or more” will be calculated. The first descriptor, “non-revenue effect” makes clear that revenue estimates are not relevant.  Presumably this means that Treasury will be focused on the costs and benefits of compliance and behavioral changes.  If Treasury relies on its existing compliance cost estimates, this requirement will simply weight review towards regulations that affect more taxpayers.
  • Further, the $100 million amount is measured again a “no action” baseline, but it is unclear what sort of action that refers to—Does that mean a state of the world where Congress has not enacted a provision that requires regulatory action?Or where Congress has acted but Treasury provides no further guidance?  If it is the latter, then the baseline will often be defined by partial compliance with a law as enacted.

Additionally, a central feature of centralized review is quantified cost-benefit analysis.  But for most tax regulations, current CBA practices will not yield any benefits—a tax creates deadweight loss, and imposes compliance and administrative costs, and CBA does not account for benefits flowing from transfers to the government.  So how will CBA be used in the tax regulatory process?

The way that OMB and Treasury construe these provisions could be the difference between almost all regulations proposed this year and next being subject to centralized review, or almost none, so these are significant questions.

The framework allows OIRA to defer the “economically significant” style of review for up to a year (until April 2019), in order for Treasury and OIRA to hire necessary personnel. And shortly after the framework was released, OIRA announced that Kristin Hickman is acting as an advisor, presumably sorting through these sorts of issues.  I address many of these challenges in my forthcoming piece Centralized Review of Tax Regulations(this linked version is newly updated – the previous version was written prior to the release of Trump administration framework).