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.