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.

 

 

 

The Altera Oral Argument

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, build on their post last week to fill us in on what happened before the 9th Circuit in Altera. Keith

At the Ninth Circuit on Wednesday October 11, government counsel carefully threaded the needle of statutory and regulatory interpretation in Altera, a case about transfer pricing and administrative law. Taxpayer counsel appeared to overreach. It refused to concede that Treasury has any authority to regulate the pricing of intercompany intellectual property sharing under qualified cost sharing arrangements (QCSAs) unless the guidance proceeds from the starting data point of unrelated party dealings, otherwise known as comparability analysis.

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The panel included Ninth Circuit Chief Judge Sidney Thomas, Ninth Circuit Judge Stephen Reinhardt, and D.C. Circuit Judge Kathleen O’Malley, sitting by designation. Reinhardt joined the first Ninth Circuit Xilinx decision overturning the Tax Court decision, which interpreted the prior cost sharing regulation to allow the IRS to include stock option costs in the pool of shared costs. After a rehearing, Reinhardt dissented in the superceding Ninth Circuit Xilinx opinion that upheld the Tax Court. In Xilinx, he would have allowed the government to require inclusion of stock option costs in a cost-sharing pool even under earlier regulations that did not explicitly address stock options. The final regulations at issue in Altera, the current case, plainly say that stock option costs must be included in a QCSA cost pool, to the disadvantage of U.S. multinational groups which as a result may take fewer tax deductions resulting from the exercise of stock options. Billions of dollars of tax revenue are at stake in Altera.

The oral argument featured three important threads: The imposition of an administrative law framework with a Chevron starting point; the argument that “arm’s length” is not synonymous with “comparability analysis”; and the idea that the second sentence of section 482, which refers to “commensurate with income” payment for intellectual property “transfers”, specifically envisioned transfer pricing not tethered to unrelated party data points.

Judge O’Malley, who brought seven years’ worth of D.C. Circuit administrative law experience    to the hearing, repeatedly insisted on a textbook administrative law analysis. She asked both parties whether there is statutory authority for these regulations under Chevron. Yes, replied the government. Chief Judge Thomas asked whether the government has the statutory authority to “eliminate” comparability analysis altogether, for all transactions. No, replied the government, here trying to thread the needle. The statute does not say “arm’s length,” let alone comparability. Both are described in regulations. But there is “too much history.”

Well, then if the government cannot erase the arm’s length standard, how can it write regulations that set aside unrelated party data, like the agreements taxpayers point to under which unrelated parties develop technology together without mentioning stock options? Judge Reinhardt suggested that the validity of the regulation had to do with its subject: the sharing of intangible assets. Perhaps comparability analysis is not relevant for transactions involving intangibles in particular, he suggested. Agree, with respect to cost-sharing arrangements, replied the government.

But why doesn’t the departure from comparability analysis for intangibles violate the arm’s length standard? In response to prompts from the panel, the government agreed that arm’s length and comparability do not “go hand in hand” and are “not synonymous.” There are several “means to [the] end” of an arm’s length result. In the case of QCSAs, unrelated party data is “inherently not comparable” and cannot support clear reflection of income.

Taxpayer counsel, in contrast, contended that “it has to be an empirical analysis” and that “you have to take comparables as far as they will go,” and appeared to argue that this approach was required by the statute itself. “What if [the comparables] don’t go anywhere?” asked Chief Judge Thomas. Well, replied taxpayer counsel, then the government should “erase” regulations’ reference to an arm’s length standard. In rebuttal, the government further argued that the term “arm’s length standard” is a “term of art” and that Treasury’s interpretation is entitled to deference.

The second sentence of Section 482, added in 1986, allows the government to adjust related parties’ inclusions from “transfer” of intangibles so that they are “commensurate with income.” As the government pointed out, the legislative history clearly explains that unrelated party data points – i.e., comparability analysis – are not sufficient to allow clear reflection of income in these situations involving intangibles. This is strong evidence of statutory authority for the government to write regulations that depart from comparability analysis. Taxpayer counsel suggested that a QCSA might not qualify as a “transfer” under this sentence of the statute, so that perhaps it was not statutory authority at all. But government counsel disagreed, arguing that the word “transfer” was broad enough to encompass QCSAs and noting that this issue was apparently briefed, and ignored, in Xilinx.

The Tax Court cited State Farm, which requires reasonable explanation of policy changes, in its decision to set aside the Treasury’s regulations. Other reasonable explanation cases include Fox Television and Encino Motorcars, both of which came up during oral argument. O’Malley asked government counsel why the regulations requiring cost sharing were not a change; the government replied that the policy of requiring stock options costs to be included in pools had existed since 1997, years before the regulations were promulgated. Later, taxpayer counsel pushed the State Farm argument, insisting that some of the government’s arguments in litigation were “not what they said” in the preamble. But the panel did not pursue the specifics of the preamble’s language. And taxpayer counsel’s assertion that Chevron should be the “last step” of the analysis of regulatory validity was met with silence by the court.

Stay tuned for our analysis of the Ninth Circuit’s Altera decision – we’ll blog it here in due course.

 

 

 

 

 

 

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.

 

Treasury on the Right Side of the APA in Altera

We welcome back guest blogger Professor Susan C. Morse from University of Texas School of Law and first-time PT blogger Professor Stephen E. Shay from Harvard.  Professors Morse and Shay joined forces with other law professors with expertise in tax administration and international tax identified in the body of the blog to produce an amicus brief designed to persuade the 9th Circuit that the Tax Court went too far in striking down Treasury regulations requiring the sharing of stock-based compensation costs in Altera.  This post explains the arguments presented in their brief.  We have previously blogged about Altera here.  It is certainly no exaggeration to describe Altera as the most important decision of the Tax Court in 2015.  The outcome of the case at the Circuit Court level has significant importance and the amicus brief offers the Court valuable insight.  Keith

In 2013, one of us did a presentation at a Tax Executives’ Institute lunch panel in the heart of Silicon Valley.   In the presentation, she dismissed the idea that Treasury’s 2003 regulations requiring the sharing of stock-based compensation costs in cost-sharing agreements could be anything but valid.  There was an audience question, “What about Altera?”  She simply replied, “What about Mayo?”  It seemed the obvious response.  But, apparently, Mayo was not sufficient for the Tax Court.

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Mayo confirmed that Treasury regulations promulgated under Administrative Procedure Act (APA) notice and comment procedures, like administrative regulations under non-tax law, receive full Chevron deference.  For several years around the time that Mayo was decided, the tax administrative law literature was largely absorbed with issues like the deference due to more informal guidance, such as notices and revenue rulings.  But the final, notice-and-comment regulations that required the inclusion of stock-based compensation in the cost base for cost-sharing agreements were outside that discussion.   Surely, deference would be due.

Yet the Tax Court in Altera invalidated Treas. Reg.  § 1.482-7(d)(2)(2003) under the APA.  The Tax Court’s decision was not based on APA § 553(c), which contemplates the notice-and-comment rulemaking process and supports deference under Mayo (as well as Chevron).  Rather, the decision was based on APA § 706(2)(A), which empowers a court to invalidate a rule that is “arbitrary” and “capricious.”  The Tax Court relied on case law including State Farm, a 1983 Supreme Court case that found an administrative action reversing prior action to be arbitrary because it was unexplained and contrary to evidence in the regulatory record.   In Encino Motorcars, a June 2016 case, the Supreme Court said the arbitrary and capricious standard required of an agency “adequate reasons for its decisions.”

The Altera Tax Court focused its arbitrary and capricious analysis on Treasury’s decision to require the sharing of stock-based compensation expense for controlled party cost-sharing agreements in the presence of evidence (submitted in the notice-and-comment process) that uncontrolled parties did not share costs in joint development agreements.  There are now three briefs that support the government’s appeal and request to the Ninth Circuit that it reverse the Tax Court decision, including the Department of Justice’s brief and two amicus briefs.

The government’s brief, filed on June 27, argues that the uncontrolled joint development agreements were not relevant because clear reflection of income for high-profit intangibles is not supposed to rely on uncontrolled party data.  The government points to “coordinating amendments” promulgated with 1.482-7(d)(2) to show coordination between the “commensurate with the income” language of § 482, and its 1986 legislative history, and the general arm’s length standard thereby supporting exclusive reference to facts internal to the transaction.  As we say in our brief, we agree with the government.  A brief principally drafted by NYU’s Clint Wallace and joined by 18 law professors argues that the “commensurate with the income” portion of the statute provides an independent basis for the validity of the regulation (whether or not the general rule is satisfied).  Our brief agrees with that position as well.

The brief that we wrote with the help and advice of our fellow amici (Dick Harvey, Leandra Lederman, Ruth Mason and Bret Wells) makes a complementary, alternative argument under the “traditional” view of the arm’s length standard.  We argue that uncontrolled joint development agreements that do not take account of stock option expense do not provide good evidence of the prices that will “clearly reflect income” in controlled transactions.  This is because they are not sufficiently comparable to be reliable evidence under the standards of I.R.C. §482.

A key example in the brief is “Example 2”, which assumes unrelated parties in a joint development agreement have stock-based compensation costs disproportionate to expected benefits:

Company C and Company D are not commonly controlled and want to share the R&D costs for a new innovation on a 50/50 sharing ratio (based on expected future benefits from the innovation).   Company C and Company D will jointly own the resulting intellectual property on a 50/50 basis. Company C pays cash compensation of 80 and grants stock options with a cost of 20 for its R&D employees. Company D pays cash compensation of 20 and grants stock options with a cost of 80 for its R&D employees.

If stock option expenses are included, the pool of expenses is 200, and each company pays 100, so no cost-sharing payment is necessary. This is the correct answer. If stock option expenses are disregarded, however, the pool of expenses appears to be 100, and Company D appears to contribute only 20 to the pool of expenses. Under this (incorrect) analysis, Company D would be required to make a net payment of 30 to Company C as its share of costs. In other words, Company D and its shareholders will suffer an additional compensation burden of 30 if the stock-based compensation costs are not shared. This burden would be in addition to the 20 of cash compensation expense and the 80 of stock-based compensation expense that Company D already incurs.

In this litigation and in litigation over the sharing of stock-based compensation before such sharing was explicitly required by the cost-sharing arrangement regulations, taxpayers argued that stock-based compensation was disregarded because they were not real economic costs.  Yet the economics and accounting disciplines, in addition to the tax law, have recognized stock compensation, including stock options, as economic costs for some time.  A 1995 FASB release, for example, stated that financials would be more “representationally faithful if the estimated fair value of employee stock options was included in determining an entity’s net income, just as all other forms of compensation are included.”

Within the bounds of “traditional” arm’s length analysis, we think the most reasonable conclusion is that the uncontrolled party agreements cannot further the objective of clearly reflecting income, because they are not reliable comparables. The brief highlights that controlled parties generally have a common issuer of stock underlying stock-based compensation whereas uncontrolled parties do not, which presents incentives and risks in the uncontrolled transaction not found in the controlled transaction.

Altera is a case about administrative procedure. The issue presented is not whether the Treasury’s decision to disregard uncontrolled party joint development agreements was the only permitted interpretation, but rather whether Treasury’s decision was arbitrary and capricious under the APA § 706(2)(A) (not the IRC § 482) standard. Under the APA § 706(2)(A) arbitrary and capricious standard, the government need only show that it provided a sufficient explanation for its conclusion that these agreements could not form a basis for clearly reflecting income. This the government did, we argue, in the regulatory Preamble. For instance, it explained that “[t]he uncontrolled transactions cited by commentators do not share enough characteristics of QCSAs involving the development of high-profit intangibles to establish that parties at arm’s length would not take stock options into account in the context of an arrangement similar to a QCSA.” It also stated that “at arm’s length the parties to an arrangement … would ensure through bargaining that the arrangement reflected all relevant costs, including all costs of compensating employees.”

As tax law encounters administrative law more regularly in litigation, it turns out that things can be made more complicated than a straightforward application of Mayo.   The Ninth Circuit faces the challenge of translating the APA arbitrary and capricious legal standard to the tax setting in this case. Depending on how the case plays out, it may also have an opportunity to consider whether the Treasury’s interpretation of its own regulations deserves Auer deference.

If the Ninth Circuit were to disagree with us and also with the other arguments in favor of the government’s position, the question of remedy would arise.   Perhaps the regulations should be remanded to Treasury, as the NYU brief argues; as we say in our brief, we concur with that argument. Or, if the reg is invalid and the remand remedy is not pursued, the Ninth Circuit may have a chance to say what should happen to an elaborate statutory safe harbor – here, the -7 regulations that authorize cost sharing agreements – when one piece of the regime is invalidated. There appears to be the assumption that the rest of the taxpayer-favorable safe harbor stands even if one of the building blocks falls. Yet the safe harbor falls far short of achieving clear reflection of income in many cases without the stock-based compensation regulation. If the stock-based compensation reg is invalid, our brief observes that Treasury might reasonably conclude that the whole safe harbor ought to be withdrawn.

 

Can the IRS Tell a Good Story?

Today’s post is by guest blogger Susan Morse, who is an Assistant Professor of Law at the University of Texas School of Law.  Professor Morse is a prolific scholar.  Her articles reflect a deep understanding of taxpayer and advisor practice and research from many differing disciplines. Prior work includes one of my favorite tax compliance articles, a co-authored qualitative review of evasion in the small cash business economy. An incomplete list of her work includes a paper on the use of tax havens by corporate taxpayers,  an analysis of the FBAR penalty regime, a review and critique of FATCA and an analysis of the transition taxation of offshore corporate profits. A link to her SSRN author page is here, where you can review the abstracts and download her articles for free.

The post below is based on her recent article  Narrative and Tax Compliance that appeared in the journal FinanzArchiv/Public Finance Analysis. Professor Morse recognizes that for issues where there is limited reporting and withholding, IRS  faces significant and persistent error rates.  In the article and post below, she argues that despite obstacles, IRS should systematically add the use of storytelling and narrative to its tool kit. Les

Some taxpayers are beyond the reach of tax administrators’ reliable compliance tools.  Third-party withholding and reporting cannot cover all transactions.  When a tax administrator encounters an elusive taxpayer, such as a proprietorship that conducts a large portion of its business in cash, it cannot realistically say that it will be able to discover an act of tax evasion.  Instead, the tax administrator faces the question of how to persuade the elusive taxpayer to pay tax.   I argue in Narrative and Tax Compliance that the IRS and other tax administrators should prepare themselves for some storytelling.

Public persuasion is stock in trade for politicians and advertisers.  It is no core strength of the IRS, or any other tax administration for that matter.  Episodes like the release of an “embarrassing” Star Trek-themed training video justifiably make the IRS reluctant to depart from its same-old, same-old approach to enforcement and compliance.

But sometimes the government cannot escape a problem of persuasion.  This is so when other tools such as third-party reporting fail.  In this case, a tax administration should at least recognize the problem for what it is and consider persuading its human audience using punishment or prosocial narratives.

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A tax administrator might use a punishment narrative to persuade taxpayers that evasion will be discovered (even though the chance of audit is very low).  Stories about other taxpayers, similar to target taxpayers, who have gotten caught can help persuade the audience about the likelihood of audit.  The U.S. government did a nice job with this with respect to its criminal prosecution of holders of secret offshore accounts.  Its strategy was straightforward – it simply wrote press releases that gave some detail about the lives of the individuals who struck plea bargains, for example describing one taxpayer as a retired sales manager for Boeing.

Scholars of narrative, such as Walter Fisher, describe the quality of stories using concepts of “probability” and “fidelity.”  Probability means the story’s logic and believability in the context of other stories known to the audience.  Fidelity means congruence between the story’s values and audience values.

Stories can be very short.  One famous six-word effort is sometimes attributed to Ernest Hemingway:  “For sale: baby shoes, never worn.”  The IRS offshore account press releases, barebones as they were, gave enough information to permit other taxpayers to fill in the blanks, and make a persuasive story out of the skeleton information.   It helps that the offshore account stories targeted a fairly specific kind of tax avoidance.  Leigh Osofsky, for example, has written about the promise of a strategy that tailors enforcement efforts for micro-groups of taxpayers.

A tax administrator might use a prosocial narrative to persuade taxpayers, for example, that fellow citizens depend on tax payments from all taxpayers in order to support necessary and valued public goods.   Prosocial narratives have drawn some support from lab experiments, but less support from empirical results based on actual tax return filings.  For example, the sending of a note stating that “your income tax dollars are spent on services that we … depend on” did not increase tax compliance.  Despite these results, continued support exists for prosocial compliance initiatives.  For example, David Schizer and Yair Listokin have recently written about the potential of such strategies for tax compliance, and the United Kingdom government’s so-called “Nudge Unit” has embraced the idea of prosocial approaches more generally.

Prosocial and other narrative strategies carry risks for the tax administrator.  Challenges include execution risk, cost, the navigation of taxpayer confidentiality rights, and questions about the capacity of a narrative strategy to impact nonautomatic behavior.  But sometimes the tax administrator may need narrative, either because it cannot persuade taxpayers without it or because it requires a tool that will effectively counteract the way another party – perhaps the media – shapes a story about the tax administrator’s compliance or enforcement program.  Either way, the IRS should be prepared to tell a good story.