A Massive Loss and a Huge Rebuke for the IRS from the Tax Court in Altera Decision

The specific issue in the case was the validity of a provision in the current cost-sharing regulations requiring that the cost of stock-based compensation must be included among the costs that are shared under such arrangements. See Treas. Reg. §1.482-7(d)(2). This is clearly a very important issue in and of itself.  However, the significance of the Altera decision clearly goes far beyond that specific issue and encompasses the entire approach that the IRS and Treasury have traditionally taken in issuing regulations.

The taxpayer in Altera argued that, for a number of reasons, this provision in the cost-sharing regulations was invalid under the “arbitrary and capricious” standard in the Administrative Procedure Act.  Under the Supreme Court’s landmark 1983 State Farmdecision, in order for agency action to satisfy the arbitrary and capricious standard, the agency action must be the product of “reasoned decision-making,” and the agency must, at the time it takes the action being reviewed, provide a reasoned explanation for why it made the particular decision it did.

Although challenges to agency regulations and other agency action outside the tax context almost always include a challenge based on an asserted violation of the arbitrary and capricious standard, usually based on the failure of the agency to provide a satisfactory explanation of the reasons for its action, the invocation of this standard in challenges to tax regulations has traditionally been very rare.  The first case in which a court applied the arbitrary and capricious standard to invalidate a tax regulation was the 2012 decision of the Federal Circuit in Dominion Resources, a case in which two of my partners and I represented the taxpayer.

I have discussed the potential application of the arbitrary and capricious standard to challenge tax regulations and other IRS action in a number of articles (links can be found here, here, here, here, and here.)  As I have pointed out in those articles, many tax regulations are vulnerable to challenge under the arbitrary and capricious standard because the IRS and Treasury often do not provide the type of reasoned explanation for the decisions made in issuing regulations that State Farm requires.  As I have pointed out in those articles, and as the Tax Court opinion in Altera noted in a parenthetical quotation, until very recently, the provisions of the Internal Revenue Manual regarding the drafting of preambles to regulations explicitly stated that “[i]t is not necessary to justify the rules that are being proposed or adopted or alternatives that were considered,” assertions that are clearly inconsistent with the requirements of the arbitrary and capricious standard as interpreted in State Farm.

Before addressing the merits of the taxpayer’s challenge in Altera, the Tax Court addressed some extremely significant preliminary issues.  The first of these issues was whether the regulation that was being challenged was subject to the notice-and-comment requirements for rulemaking in section 553 of the APA.  These requirements apply to “substantive” regulations (the term the APA itself uses), which are often referred to as “legislative” regulations, the term the Tax Court used in Altera.  However, the notice-and-comment requirements do not apply to “interpretative” regulations.

The distinction between these two categories of regulations is not always clear, but one point that is clear is that legislative regulations have the force of law, while interpretative regulations do not.  The IRS has traditionally claimed that regulations issued under the general authority of section 7805(a) are interpretative regulations and as such are exempt from the APA’s notice-and-comment requirements.  However, the IRS also claims that these regulations have the force of law and are therefore entitled to Chevron deference, and this latter position was upheld by the Supreme Court in Mayo.  The Tax Court concluded that because the IRS and Treasury intended the regulation being challenged in Altera to have the force of law, the regulation was subject to the APA notice-and-comment requirements.  While this seems like an easy conclusion, it is very welcome to have it stated so forcefully by the Tax Court, repudiating one of the IRS’s many attempted departures from normal administrative law principles.

The second significant preliminary issue addressed by the Tax Court in Altera was whether State Farm was applicable to the challenge.  The IRS contended that the challenge was governed by Chevron and not by State Farm.  This was another completely untenable position, since numerous decisions by the D.C. Circuit make clear that both standards are applicable to challenges to the validity of agency regulations that involve the interpretation of statutory provisions, and the Tax Court resoundingly repudiated this position as well.  I have noted in my articles that the Supreme Court’s decision in Judulang v. Holder makes clear that State Farm and Chevron step two are essentially equivalent, and the Tax Court in Altera reached the same conclusion.  The Tax Court concluded that because of this equivalence, it was not necessary to decide between applying State Farm and Chevron.  However, the court phrased its reasoning in deciding the merits in terms of the State Farm requirements.

After deciding these preliminary issues, the Tax Court reached the merits of the taxpayer’s challenge.  Section 482 permits the IRS to allocate income, deductions, and other items between related commonly controlled parties where such an allocation is necessary to clearly reflect the income of the parties.  Section 482 does not itself refer to the arm’s length standard, but the long-standing regulations, much case law, and many treaties take the position that allocations under section 482 are appropriate only when those allocation are consistent with the results that would be reached between unrelated parties bargaining at arm’s length.  As the Tax Court phrased the ultimate issue, the validity of the provision in the cost-sharing regulations requiring that the cost of stock-based compensation must be included in the costs that are shared turns on whether the IRS and Treasury reasonably concluded that this position was consistent with the arm’s length standard.

The taxpayer contended that the regulation violated the reasoned decision-making standard because the IRS and Treasury had no evidence that unrelated parties would include the cost of stock-based compensation in the costs that are shared under a cost-sharing agreement and were provided with considerable evidence by the parties who submitted comments that unrelated parties would not in fact agree to share this type of cost.  The Tax Court agreed.  The Tax Court concluded that the issue of whether unrelated parties would share this type of cost was inherently an empirical issue and that it was unreasonable for the IRS and Treasury to rely on their unsupported belief that this type of cost would be shared by unrelated parties.  The Tax Court also agreed with the taxpayer’s argument that the IRS and Treasury acted unreasonably and improperly in failing to adequately respond to the comments that presented evidence that unrelated parties would not share the costs of stock-based compensation.

While Altera is not the first case in which a court has invalidated a tax regulation under the arbitrary and capricious standard, nevertheless, Altera represents a far more significant loss for the IRS than the first such case, Dominion Resources, not only because the particular provision of the regulations that was at issue in Altera had a much broader application than the provision at issue in Dominion Resources, but also because of the breadth of the IRS’s failings in Altera as compared to Dominion Resources.  The holding in Dominion Resources was based on the failure of the IRS and Treasury to provide an explanation of the reasons behind the rule at issue in the preamble to the regulations.  In contrast, the holding in Altera was based on the fact that the reasoning that was disclosed in the preamble was, in the Tax Court’s view, fundamentally flawed.

In the context of most challenges to actions by agencies other than the IRS that are based on the arbitrary and capricious standard, the challenge is, like the one in Dominion Resources, based on a claimed failure by the agency to provide an adequate explanation of the reasons for its action.  In contrast, when the preamble to a regulation discloses the nature of the reasoning process used by the agency in reaching its decision, and the reviewing court concludes that this reasoning process was defective, this represents a much more serious and fundamental flaw in the agency’s actions than a mere failure to explain its reasoning.  There is absolutely no doubt that the Tax Court’s holding in Altera will prompt other challenges to other tax regulations in contexts having nothing to do with section 482.  Hopefully, it will also prompt some rethinking by the IRS of its processes for issuing regulations.