Out of Time: The Government (Mostly) Wins at the District Court in Govig

March 30, 2023 by 2 Comments

We welcome back previous guest blogger Susan C. Morse, who is the Angus G. Wynne Sr. Professor in Civil Jurisprudence and Associate Dean for Academic Affairs at the University of Texas at Austin School of Law.  Today’s post provides insight for those interested in challenging regulations and a cautionary tale if the regulations have been on the books for some time.  Keith

On March 23, Senior District Judge David G. Campbell of the District Court of Arizona decided Govig v. United States. He correctly dismissed as time-barred two administrative procedure claims because of 28 U.S.C. § 2401(a), the default six-year limitations period for suits against the federal government. As I’ve written in a forthcoming paper, Old Regs, this is the first time that a court has considered this six-year time bar for administrative procedure claims in a tax case. It shouldn’t be the last, given taxpayers’ interest in challenging the administrative procedure bona fides of Treasury and IRS actions taken decades ago and the government’s interest in raising the 6-year time bar as a defense. (Prior Procedurally Taxing coverage here.)

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Govig involves penalties that the government proposed to impose on taxpayers for failing to report their use of an employee welfare benefit tax plan that is a “listed transaction” under Notice 2007-83. The taxpayers engaged in the listed transaction in 2015, and the government applied the Notice to them in 2019. The key time-bar question is when the “right of action first accrues” for purposes of 28 U.S.C. § 2401(a). The taxpayer said 2019. The government said 2007. The taxpayer won as to one claim, and the government as to two claims. Govig not only breaks new ground as the first case to time-bar an administrative procedure claim in tax, but also contributes a clear explanation and illustration of how to distinguish between earlier-accrual and later-accrual cases. 

Before reaching the limitations period question, Judge Campbell considered the effect of both Mann Construction Inc. v. United States and the Anti-Injunction Act. He held that Mann Construction did not produce a win for the plaintiffs, and that the Anti-Injunction Act did not produce a win for the government. These analyses are described briefly below before the discussion returns to the limitations period issue.

Mann Construction, a Sixth Circuit 2022 case authored by Chief Judge Jeffrey Sutton, concluded that the IRS could not apply Notice 2007-83 to a plaintiff because the Notice was not issued under the notice-and-comment provisions of the APA. The question for Judge Campbell in Govig was whether Mann Construction established a nationwide set-aside ruling that invalidated the application of the same Notice in Govig, even though Govig arose outside the Sixth Circuit. Judge Campbell held that Mann Construction did not mean that Notice 2007-83 was set aside for purposes of the Govig case. Judge Campbell quoted Judge Sutton’s concerns about nationwide injunctions drawn from a concurring opinion in another case, where Sutton wrote that the “set aside” language of APA § 706(2) was ambiguous and that Sutton “would be inclined to stand by the long understood view of equity – that courts issue judgments that bind the parties in each case over whom they have personal jurisdiction.”

The Anti-Injunction Act bars many tax claims related to assessment and collection, and the government argued that it barred various claims in Govig. But Judge Campbell concluded that the Anti-Injunction Act does not block the plaintiffs from challenging reporting requirements far removed from the process of tax assessment and collection, particularly where criminal penalties are possible. This follows the logic of the 2021 Supreme Court case CIC Services v. IRS and reaches a result consistent with decisions in the First and Sixth Circuits. Judge Campbell concluded that the Anti-Injunction Act barred only one claim brought in Govig, which related to a claim for refund of tax penalties.

Judge Campbell then proceeded to analyze the limitations period issue. Perhaps he covered it last rather than first because the Ninth Circuit’s view is that 28 U.S.C. § 2401(a) is not jurisdictional. The D.C. and Sixth Circuits also hold the non-jurisdictional view, based on their interpretation of the Supreme Court’s Irwin v. Department of Veterans’ Affairs and United States v. Kwai Fun Wong precedents. The non-jurisdictional view is probably the better view, although the Fifth Circuit disagrees. If 28 U.S.C. § 2401(a) is not jurisdictional, as in the Ninth Circuit, then a court is not required to raise it sua sponte and the government may waive it. Govig, notably, is the first tax / administrative procedure case in which the government raised (rather than waiving) the six-year time bar as a defense.

The Govig court correctly explained the “two accrual rules for APA claims” in the Ninth Circuit. The first rule comes from Shiny Rock Mining Corp. v. United States, a 1990 case:  

[I]f a claim challenges the procedures the agency used in issuing the rule or the policy behind the rule, the claim accrues when the rule is issued.

The second rule comes from Wind River Mining Corp. v. United States, a 1991 case:

[A] plaintiff may challenge the substance of an agency rule as exceeding statutory or constitutional authority by bringing an APA claim within six years of the agency’s application of the rule to the plaintiff.

Together, these cases are known as the Wind River doctrine: 28 U.S.C. § 2401(a) accrues at the time of rulemaking for claims relating to procedure contemporaneous with rulemaking, but accrues later, at the time the rule is applied, for claims that the substance of agency rulemaking violates the Constitution or exceeds the bounds of the authorizing statute. In addition to the Ninth Circuit, the Second, Fourth, Fifth, Sixth, Eleventh, and Federal Circuits have also endorsed the Wind River doctrine. The D.C. Circuit and the Supreme Court, however, have not squarely addressed the time-of-accrual issue.

Judge Campbell’s cogent restatement of the Wind River doctrine supported his clean application of the time-bar defense to three claims in Govig:

First, the plaintiffs claimed that the IRS violated the notice-and-comment requirements of APA § 553 when it issued Notice 2007-83. This claim that the IRS did not use notice-and-comment procedure is a classic claim within the first category, i.e., that an agency did not follow proper procedure in issuing a rule. Thus, it accrued in 2007 and was time-barred.

Second, the plaintiffs claimed that the IRS Notice exceeded the authority of IRC § 6707A , which asked the IRS to identify “listed transactions,” ”because the notice failed to describe the listed transactions with the specificity required by the statute.” Judge Campbell held that this second claim amounted to a claim that the IRS exceeded the authority of the authorizing statute, like the ultra vires question presented by Wind River, where a plaintiff argued that a regulation was invalid because it applied to an area that was not “roadless” as required by the substantive statute. Thus, the second claim accrued in 2019 and was not time-barred.

Third, the plaintiffs claimed that the IRS acted arbitrarily and capriciously in violation of APA § 706(2)(A) because it did not give “adequate reasons” for the Notice and did not solicit public comments. This claim that the IRS acted in an arbitrary and capricious manner was also a rulemaking-contemporaneous procedural claim, because the alleged lack of reason-giving related to the procedures used at the time the agency issued the rule. Thus, the third claim accrued in 2007 and was time-barred.

The district court was not swayed by the fact that the Govig taxpayers did not have standing to sue in 2007. It acknowledged that the limitations period may run against a plaintiff for administrative procedure claims even before the plaintiff is injured. This at first may seem strange, but it is the only way that there can be an effective time limit on challenges to the procedures the agency used in issuing the rule. Otherwise, a plaintiff could always come into existence at a later date, acquire standing at that later date, and raise the stale administrative procedure question. If the rule violates the authorizing statute or the Constitution, that is different, because these are controlling forms of law that offer continued requirements or protections. Administrative procedure, in contrast, offers a general public right to participate in decisionmaking when that decisionmaking occurs. It relates to a particular moment in time – the moment when the agency issues a rule.

The Govig court also considered and rejected the plaintiffs’ equitable tolling claim. This exception provides the main avenue to relief from 28 U.S.C. § 2401(a). (Equitable estoppel is another exception sometimes raised, but it apparently was not in this case.) The Govig opinion explains that “because Plaintiffs did not diligently pursue their procedural challenges, they are not entitled to equitable tolling.” This is a good start, although it does not consider another important equity factor, which has to do with the defendant rather than the plaintiff. The court might have exercised its equity muscles more thoroughly.

For instance, the court could have used the Supreme Court’s two-part disjunctive test for equitable tolling in Irwin: 

We have allowed equitable tolling in situations where the claimant has actively pursued his judicial remedies by filing a defective pleading during the statutory period or where the complainant has been induced or tricked by his adversary’s misconduct into allowing the filing deadline to pass. [Emphasis added]

The Govig plaintiffs meet neither part of this disjunctive test. They did not file any pleading (or take any other relevant action) during the statutory period, which expired in 2013. And also, the government did not engage in any misconduct which would have delayed these plaintiffs’ ability to file within the statutory period. Equitable tolling has been allowed, for example, when the government fraudulently concealed facts or when a government office required to furnish a plaintiff with a form for filing a claim failed to provide the form. In contrast, in Govig, the government did not block or delay the plaintiffs’ ability to bring their administrative procedure challenge.

The district court’s careful application of Ninth Circuit precedent meant that it did not have to deconstruct the Wind River doctrine’s conclusion that 28 U.S.C. § 2401(a)’s reference to “first accrues” means the time when a rule is issued for administrative procedure claims. But if future courts – including the Supreme Court – consider this issue from a statutory interpretation perspective, they should conclude that a careful textual reading of the statute supports the Wind River reading, as explained further here. Judge Campbell’s holding correctly time bars the non-ultra vires APA claims in Govig.

Filed Under: Administrative Procedure Act (APA), Statutes of Limitation Tagged With:

Why a Win for CIC Services Would Be a Win for Tax Shelters

September 18, 2020 by 3 Comments

We welcome a group of guest bloggers who filed an amicus brief in CIC Services earlier this week.  Professors Susie Morse, Clint Wallace and Daniel Hemel and attorneys at Gupta Wessler filed a brief on behalf of former government officials Lily Batchelder, Mark Mazur, Eileen O’Connor, Leslie Samuels, Stephen Shay and George Yin.  Today, they provide us with an explanation of why the Supreme Court should uphold the decision of the 6th Circuit, which held that the Anti-Injunction Act bars CIC Services’ suit.  The Supreme Court has now scheduled this argument for December 1, 2020.  Keith

This week, a group of former government officials filed an amicus brief in support of the government in CIC Services v. IRS, the Anti-Injunction Act case before the Supreme Court this term. The case involves a tax shelter promoter that seeks to prevent the IRS from imposing penalties on the promoter and its clients if they fail to comply with tax-shelter reporting requirements. A ruling for CIC Services would, as the Solicitor General emphasizes in its brief, go a long way toward gutting the 153-year-old Anti-Injunction Act. It would also—as our brief demonstrates—deal a serious blow to the IRS in the agency’s decades-long battle to combat abusive tax shelters.

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Ever since the first wave of abusive tax shelters gathered momentum in the 1960s, Congress has taken a series of actions to give the IRS tools to fight back. Those include the at-risk rules in the Tax Reform Act of 1976, the passive activity loss limitations in the Tax Reform Act of 1986 and, at issue here, the reportable transaction disclosure regime in the American Jobs Creation Act of 2004. Specifically, in the 2004 law, Congress required tax shelter promoters and their clients to disclose certain large-dollar shelter transactions to the IRS, and it enacted new penalties so that those disclosure requirements had teeth. Of particular importance to this case, Congress placed those penalties in Subchapter 68B of the Code, which means that they qualify as “taxes” for purposes of the AIA.

The disclosure regime was, by most accounts, a resounding success. Prior to the disclosure rules, the IRS often found itself “looking for the tax shelter needle in the haystack of a complicated business tax return.” By requiring parties who arrange and participate in specific potentially abusive transactions to identify themselves to the IRS or face stiff penalties, Congress made it possible for the IRS to find the needle. To be sure, taxpayers still have the opportunity to argue that their transactions claim legal tax benefits. What they can’t do any more is keep their transactions outside the IRS’s view.

The reportable transaction scheme is designed to be agile. Congress wanted the IRS, upon learning of a new shelter, to require disclosure from promoters of the shelter and their clients. Congress specifically blessed the IRS’s practice of issuing reportable-transaction designations under already-existing authority (section 6011). That regime provides for issuance of designations by the IRS via notice in the Internal Revenue Bulletin—backed by penalties under the AJCA for failure to comply. Indeed, the IRS has designated dozens of transactions in this way, starting before Congress enacted the penalties for failure to report in the AJCA and continuing in recent years. CIC Services’ substantive argument is that the IRS should promulgate these notices through Administrative Procedure Act rulemaking rather than relying on the section 6011 framework. We think the AJCA endorsed the IRS’s approach. But in any event, the only issue here is whether CIC Services can obtain a pre-enforcement injunction that would block the IRS from imposing penalties for nondisclosure.

Allowing pre-enforcement challenges to these penalties—i.e., allowing taxpayers to challenge reportable transaction designations and to delay revealing to the IRS their participation in such transactions—would have severe consequences for the effort to fight abusive tax shelters. As we detail in our brief, injunctions of the sort that CIC Services seeks would yield three specific effects. First, they would prevent the IRS from detecting many abusive transactions. Second, when injunctions delayed detection, it would be likelier that the statute of limitations would lapse before the IRS could assess taxes that are rightfully owned. Third, in cases where the IRS is able to assess taxes before the statute of limitations runs out, delaying assessments would increase the risk of non-collection. The longer the delay, the likelier it is that taxpayers will have spent down their assets or moved their wealth beyond the IRS’s reach.

The petitioner wants to cast its effort in a different light. By its telling, the case has nothing to do with tax shelters at all. Petitioner tells the Court in its brief that its micro-captive products allow for “customized” risk management and a “more seamless claims process,” though it advertises itself to clients as a provider of a “legal tax shelter” that “can often double a business owner’s wealth.”

As readers of Procedurally Taxing know, petitioner’s argument received support from Professors Fogg and Book, who joined with the Center for Taxpayer Rights in an amicus brief opposing the Sixth Circuit’s interpretation of the AIA. Their brief argues that low-income taxpayers are especially disadvantaged when forced to rely on the AIA’s required remedy of post-enforcement judicial review. As Professor Fogg has written, under the Flora full-payment rule, in practice this can mean that post-payment judicial review for low-income taxpayers who face failure-to-report penalties is out of reach. And as Professor Book has written, the government’s approach to enforcing the tax law applicable to low-income taxpayers may excessively target taxpayers who make unintentional mistakes and lack access to constructive government guidance about how to comply.

Like Professors Fogg and Book, the authors of this blog post are concerned about the interaction between tax law enforcement and the situations faced by low-income taxpayers. But we think the remedy is to relax the full-payment rule in cases where it forces hardship for low-income individuals, and not to exempt CIC Services from the Anti-Injunction Act’s plain text.

The immediate result of a ruling for CIC Services would be to make it easier for tax-shelter promoters and their predominantly high-income clients to avoid paying the taxes they owe. That would result in less revenue overall, and more of the federal tax burden would be borne by lower-income taxpayers. The distributive result would be regressive.

Also, a ruling for petitioner is unlikely to provide relief for low-income taxpayers fighting the IRS. Petitioner’s theory is that it is challenging a “regulatory mandate” unrelated to its own tax liability. “Win or lose,” petitioner says in its brief, “the IRS will collect no additional revenue from CIC.” Petitioner accepts that taxpayers litigating about their own liabilities are covered by the Anti-Injunction Act but asks the Court to distinguish tax shelter promoters like CIC Services who are litigating about penalties for failure to disclose other taxpayers’ transactions. 

We agree with the government that the distinction that CIC Services draws is not a valid one. (Whether CIC Services wins or loses will affect the ability of the IRS to collect penalties from CIC Services itself under §§ 6707 and 6708—penalties that Congress has deemed to be taxes.) But let’s imagine that the Court disagrees and accepts CIC Services’ argument. That helps tax shelter promoters, but what does it accomplish for low-income taxpayers seeking to claim the earned income tax credit or the child tax credit? They are arguing about their own taxes and tax credits. 

In addition, a ruling for the government in CIC Services would leave undisturbed any equitable exceptions to the Anti-Injunction Act, which would allow low-income taxpayers to seek prepayment remedies in a case of clear government overreach. In the Bob Jones case, the Court said that such an equitable exception could be available where a plaintiff can show both a “certainty of success on the merits” and “irreparable injury.”  CIC Services has not sought that exception, and as our brief argues, it would not be eligible anyway. But Bob Jones may provide relief for low-income taxpayers in situations like the ones that Professors Fogg and Book highlight.  

The AIA lies at the foundation of federal tax administration and the modern tax shelter disclosure regime. That regime relies on a nimble IRS, backed by the threat of penalties for failure to disclose. Permitting tax shelter promoters to resist disclosure requirements with strategic lawsuits and pre-enforcement injunctions would mean trouble for tax collection.

Filed Under: AIA Tagged With: , , ,

In Altera Reply Brief, Taxpayer Doubles Down on Flawed Argument That the Government Changed Its Tune.

June 11, 2020 by 3 Comments

We welcome back guest bloggers Susan C. Morse and Stephen E. Shay.  They bring us a further update on the efforts of the taxpayer in the Altera case to have the Supreme Court accept the case for argument.  Keith

Previously we blogged here (crossposted at Yale JREG Notice & Comment) about the government’s May 14 brief in opposition to the taxpayer’s petition for certiorari in Altera v. Commissioner. On June 1,  Altera replied to the government’s brief, as explained here by Chris Walker. The case has been distributed for a Supreme Court conference later in June.

The Altera reply brief doubles down on an argument that the government brief has already persuasively dispatched: that Treasury gave the impression during the rulemaking process that comparability analysis – i.e., the analysis of comparable transactions between unrelated parties – was relevant to the determination of an arm’s length result under the transfer pricing regulation at issue, and that then the government changed its tune.

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First, some background to level-set for any new readers. In its cert petition, the taxpayer asked the Supreme Court to review a Ninth Circuit decision upholding a 2003 amendment to an existing tax regulation governing intra-group cost-sharing arrangements for the development of intangible property. (We submitted amicus briefs on behalf of the government to the Ninth Circuit in earlier stages of this litigation here (with coauthors Leandra Lederman and Clint Wallace), here and here.)

The regulation conditions the benefits of a qualified cost sharing arrangement, or QCSA, on including stock-based compensation deductions related to developing intangible property in the pool of costs to be shared. If this (and other) QCSA conditions are met, the cost-sharing party — typically an offshore subsidiary of a U.S. multinational firm — owns a share of the rights in intangible property, even though this intangible property is often developed within the United States. Allowing an offshore subsidiary to own a share of intangible property means that a U.S. multinational firm can attribute some profit from intangibles to the offshore subsidiary. This in turn means that the U.S. multinational firm can avoid paying U.S. corporate income tax on some of its profit.

Altera proposes that the Supreme Court should take this case because it is an opportunity to place limits on an inappropriate exercise of administrative agency power. The taxpayer’s cert petition argues that Treasury did not provide a reasoned explanation for the regulation as required under  State Farm, in light of evidence cited by commenters that unrelated parties to similar types of arrangements did not share stock-based compensation costs; that the government in litigation engaged in post hoc rationalization to defend the regulation, in violation of Chenery I; and that the Ninth Circuit accorded Chevron deference to a procedurally defective regulation.

The government in response observed that the taxpayer conflates the arm’s length standard with comparability analysis. It explained that the government has maintained a consistent argument throughout the rulemaking process and this litigation.  That is, the government has consistently maintained that the 2003 regulation’s rejection of comparability analysis as a means of determining an arm’s-length result in this limited context is consistent with both the “commensurate with income” language of the statute adopted in 1986 and the accompanying legislative history.

The core of Altera’s argument is that the government surprised taxpayers and tax advisers by making a “sea change in tax law without providing any notice of the change or opportunity to comment on it” (Reply Br. 1) and by taking a “new position” in litigation (Reply Br. 2) about the meaning of the arm’s length standard.  Altera’s reply brief states this claim in at least three ways. None hold up.

The first thing Altera claims is that “The arm’s length standard has a settled meaning: A transaction meets the arm’s length standard if it is consistent with evidence of how unrelated parties behave in comparable arm’s length transactions.” (Reply Br. 5) Altera may wish that this sentence stated doctrinal transfer pricing tax law, but it does not. As the government’s brief in opposition to the cert petition correctly explains, Altera’s statement conflates the arm’s length standard with comparability analysis. Comparability analysis is not a predicate for determining an arm’s length result. One clear indication of that reality is the residual profit split transfer pricing method contained in regulations promulgated in 1994.

The second claim Altera makes is that the government initially suggested that comparability analysis is relevant to the determination of an arm’s-length result under the regulation at issue in this case, but then changed its mind. This is also incorrect. As the government’s brief explains, Treasury promulgated the 2003 amendment to make explicit what it had consistently argued was implicit in the prior (1995) cost-sharing regulation: that QCSA stock-based compensation costs must be shared to produce an arm’s-length result, without regard to evidence of allegedly comparable transactions. And it consistently pointed to the commensurate-with-income language of the statute and the related legislative history to support its position. It referred to commensurate-with-income both in the 2002 Notice of Proposed Rulemaking and in the 2003 Preamble.

This government’s position in this regard has been at the heart of a longstanding and well-known disagreement between taxpayers and the government. In 2002, lawyers at Baker & McKenzie explained the already-long history, in a comment to the proposed regulations written on behalf of Software Finance and Tax Executives Council:

On audit, in Advance Pricing Agreement negotiations, in docketed Tax Court cases, in published field service advice, and in speeches by Service officials … the Service has taken the position that stock-based compensation … must be included in related parties’ cost sharing pools. … Taxpayers have steadfastly and vehemently disagreed[, … absent] any evidence that unrelated parties … share stock option “costs” in their own cost sharing pools. 

The third claim that Altera makes is that taxpayers did not realize that the government was promulgating a rule that did not rest on comparables and were caught by surprise. It writes that “none of the companies, industry groups, or tax professionals that participated in the rulemaking noticed” (Reply Br. 2) that the 2003 amendment made evidence of allegedly comparable uncontrolled transactions not determinative of an arm’s length result in this context. This claim also does not hold up.  Indeed, the amended regulation itself – in both its proposed and final form – unequivocally states that a QCSA will achieve an arm’s-length result “if, and only if,” the parties share all development-related costs (including stock-based compensation costs) in proportion to anticipated benefits.

In written submissions and at the 2002 hearing to consider the proposed regulation, commenters certainly realized that the regulation was not based on evidence of comparables. A representative for the American Electronics Association stated that the regulation identified an arm’s-length result “by fiat,” implicitly acknowledging that the government had rejected a comparables-based inquiry. A Fenwick & West partner explained that the regulation “deem[ed] a result to be arm’s length without providing any evidence.” A tax partner at PricewaterhouseCoopers noted the perception that the amendment “seem[s] contrary to the arm’s length standard as evidenced by actual transactions ….”  The rest of the regulatory record is consistent. Commenters understood. Taxpayers and tax advisers knew exactly what Treasury was doing.

Altera says it is making an administrative law argument, but it is really interested in a tax policy outcome. The asserted “immense prospective importance” (Reply Br. 4) is illusory. Even if the Court were to grant the petition and then hold that the 2003 amendment is procedurally defective, Treasury could simply re-promulgate the rule without substantive change but with a more detailed explanation. As for past tax years, Altera’s and similarly-situated companies’ financial statements have already incorporated the possibility that corporate income tax will be due based on compliance with the regulation. The real importance of the case for taxpayers lies in the hope that the Supreme Court goes beyond the administrative law issue and expresses a pro-taxpayer view as to the merits. But this tax issue is not presented.

Rather, the cert petition raises a procedural administrative law issue. It works for the taxpayer only if the government changed its tune. But to the contrary, the government has been singing the same tune for two decades or more.

The government did not surprise taxpayers and tax advisers with never-before-seen interpretations of the arm’s length standard. The government consistently explained that evidence of allegedly comparable transactions is not determinative of an arm’s-length result in this context. It consistently referred to the commensurate-with-income statutory language and legislative intent in support of its position. The government has been faithful to its argument and explanation since before the 2003 amendment and continuing through every stage of this litigation. There has been no surprise or change of course. Rather, this case involves the government making the same argument and explanation, over and over again. 

Filed Under: Administrative Procedure Act (APA), Chevron Deference Tagged With: ,

Pending Cert Petition in Altera: Tax Law in an Administrative Law Wrapper

May 22, 2020 by 2 Comments

Susan Morse & Stephen Shay return to discuss the Altera case. This piece is cross posted at JREG’s Notice & Comment blog. Keith

Each day of the COVID crisis we see unprecedented administrative action to respond to the pandemic. At the same time, litigants continue to ask courts to consider whether administrative agencies have exceeded their authority, sometimes relying on claims of deficient process. One such case is Altera v. Commissioner, in which the taxpayer filed a cert petition that asks the Supreme Court to review a Ninth Circuit decision upholding a tax regulation. The government submitted its brief in response on May 14, and the Court will presumably consider the case in conference before its summer recess. The taxpayer has not filed a reply as of this writing.

In its brief, the government stays squarely on the administrative law playing field laid out by the taxpayer’s petition. The government’s reply takes on – and, we think, successfully defeats – the core premise that underlies the taxpayer’s administrative law arguments.

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In 2015, Altera won a unanimous decision in the Tax Court, which invalidated a 2003 regulation as arbitrary and capricious under State Farm. Then the government won in the Ninth Circuit before the original three-judge panel in 2018 (withdrawn because of the death of Judge Reinhardt), before a revised three-judge panel in 2019, and when the Ninth Circuit denied the taxpayer’s request for a rehearing en banc in 2019. We contributed amicus briefs [here (with coauthors Leandra Lederman and Clint Wallace), here and here] on behalf of the government before the Ninth Circuit, and have blogged previously about the case here and here. In February, the taxpayer submitted a petition for certiorari to the Supreme Court.

The tax issue in Altera involves a final Treasury regulation promulgated in 2003. The reg applies to qualified cost-sharing agreements, or QCSAs, made between U.S. firms and their offshore subsidiaries. A QCSA requires an offshore subsidiary to pay its share of the costs of developing IP. If QCSA requirements are met, the offshore subsidiary owns non-U.S. rights to intangible property developed by its U.S. parent company for tax purposes. Then the firm can shelter resulting offshore profit from U.S. tax. As relevant here, the 2003 regulation at issue in Altera conditions the favorable tax treatment available for QCSAs on the inclusion of stock-based compensation costs in the pool of shared costs.  

Technology and other multinational firms that use stock option compensation (and use strategies to shift profit from intellectual property across borders) have had an understandable and longstanding interest in this issue. An appendix to Altera’s cert petition lists 82 companies that noted the Altera issue in their public financial statements. One entry alone – that of Alphabet, Inc. – reports $4.4 billion at stake.

We think the regulation gets it right as a matter of tax policy. It properly prevents stock-based compensation deductions from reducing U.S. taxable income when these expenses support foreign profit. The regulation falls securely under the Commissioner’s statutory discretion (under I.R.C. Section 482) and responsibility to ensure clear reflection of income. It squares with modern financial accounting rules. And it aligns with OECD and other international efforts to combat base erosion and profit shifting to low-tax jurisdictions.

But the hook in the cert petition is not the tax issue. It is an administrative law issue. The taxpayer hopes to persuade four justices that Altera is an attractive opportunity to rein in an administrative agency’s power and further limit the case law that supports administrative agency discretion. Perhaps it appears particularly juicy because the administrative agency at issue is the Treasury, given the complicated history and relationship between Treasury regulations and administrative law. Indeed, the regulation in this case was promulgated well before the Supreme Court held, in its 2011 Mayo case, that Chevron deference (rather than National Muffler review) applies to tax regulations just as it applies to other federal regulations.

The taxpayer’s administrative procedure argument includes two main claims. The first is that Treasury did not provide a reasoned explanation for the regulation and that the regulation was therefore arbitrary and capricious under State Farm. The second is that the government engaged in post hoc rationalization to defend the regulation, in violation of Chenery I. (A third claim, derivative of the first two, asks whether, assuming a regulation is held procedurally defective, a court may nevertheless uphold it under Chevron.)

Five out of six filings submitted to the Supreme Court on behalf of the taxpayer – including the primary cert petition and four out of five amicus briefs – hang their respective hats on a single premise. This premise is that Treasury first suggested that comparability analysis was relevant under the stock-based compensation QCSA regulation, and then Treasury broke its word. The government’s brief takes this premise head-on and, we think, persuasively disproves it.

Altera’s petition claims that in 2002 and 2003, “the government never said it was … adopting a new approach to cost-sharing” (8) and that the rationale that the “commensurate with the income” language supported the new approach “appeared nowhere in the rulemaking record.” (10-11) Amicus briefs argue that the government advances “a new statutory interpretation” in litigation (Chamber of Commerce 16), describe the government’s allegedly “newfound litigation position that comparables are irrelevant” (Cisco 11), assert a “transparent post hoc rationalization” (National Association of Manufacturers 15) and claim that there would have been comments on “the applicability and scope of the arm’s length standard” in notice-and-comment if taxpayers had only been aware that the government meant to make comparability analysis irrelevant to the determination of an arm’s-length result for stock-based compensation costs in the QCSA context. (PricewaterhouseCoopers 16).

Interestingly, the fifth of five amicus contributions supporting Altera – a brief filed by a group of former foreign tax officials – paints a picture of continuity, rather than change, in arguments made by Treasury and the IRS. It acknowledges that both in 2002 and 2003 and also in litigation before the Ninth Circuit, the government “ignor[ed] … potentially comparable transactions” and simultaneously “claim[ed] that its approach comported with the arm’s length standard.” (9-10) 

The government argues as follows in its brief in opposition to Altera’s cert petition: The taxpayer’s arguments “conflate (i) the arm’s length standard … and (ii) the use of comparability analysis” and “misunderstan[d] the relationship between the two concepts.” (19) In its rulemaking, the government did not suggest that empirical analysis and comparability were relevant to the determination of an arm’s length result in this context. Rather, the internal method adopted by the regulation is “an alternative to comparability analysis as a means of achieving an arm’s length result,”(20) consistent with the statute, as “Section 482 does not require any analysis of identified comparable transactions between unrelated parties.” (21) Moreover, the rulemaking and litigation record shows a constant commitment to a method that is not based on evidence of comparables. The government’s rulemaking record, as well as its arguments in litigation, consistently references the “commensurate with income” statutory language added in 1986. (24) So the “commensurate with income” argument made in litigation was not new either.

The government’s narrative gets this right. As the government’s brief explains, the regulatory history – not to mention the plain language of the regulation describing an arm’s-length result in this context – makes clear that interested taxpayers and tax advisers knew that “the proposed regulation would make any evidence of comparable transactions irrelevant” in the context of QCSAs. (22) Taxpayers certainly understood the proposed regs’ departure from comparability analysis. They just didn’t agree with it. Indeed, the battle lines over comparability analysis in the context of stock-based compensation costs were already clearly drawn, well before Treasury issued its Notice of Proposed Rulemaking in 2002. As the Software Finance and Tax Executives Council explained during the 2002 notice and comment period: 

On audit, in Advance Pricing Agreement negotiations, in docketed Tax Court cases, in published field service advice, and in speeches by Service officials … the Service has taken the position that stock-based compensation … must be included in related parties’ cost sharing pools. … Taxpayers have steadfastly and vehemently disagreed[, … absent] any evidence that unrelated parties … share stock option “costs” in their own cost sharing pools. 

This disagreement between taxpayers and the government was a tax policy dispute over the role of comparables in transfer pricing between related parties. Taxpayers argued that the arm’s length principle required comparables, even in the specific case covered by the QCSA regulation. The government consistently took the opposite position, beginning well before 2002 and continuing through the present cert petition in Altera.

Taxpayers may still disagree with the government on the tax policy issue. But that ship has sailed. Indeed, there are other examples of transfer pricing methods that do not rely on comparable transactions. One is the 1994 promulgation of the residual profit split method, also contained in a final regulation issued under I.R.C. Section 482.  

The issue before the Supreme Court is an administrative law issue. A necessary premise of Altera’s argument is that Treasury started with, but then abandoned, a commitment to empirical comparables analysis for its rule covering stock-based compensation in QCSAs. And as the government explains, this premise does not hold up.

Filed Under: Administrative Procedure Act (APA), Chevron Deference Tagged With: ,

The Ninth Circuit Reverses the Tax Court Decision in Altera

July 31, 2018 by 1 Comment

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.

 

 

 

Filed Under: Administrative Procedure Act (APA) Tagged With: ,

The Altera Oral Argument

October 17, 2017 by 1 Comment

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.

 

 

 

 

 

 

Filed Under: Competent Authority, Tax Court, Tax Treaty Tagged With: ,

Ninth Circuit Hears Altera Tomorrow

October 10, 2017 by 1 Comment

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.

 

Filed Under: Administrative Procedure Act (APA), Advanced Pricing, Auer deference Tagged With: ,

Treasury on the Right Side of the APA in Altera

July 14, 2016 by Leave a Comment

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.

 

Filed Under: Administrative Procedure Act (APA), Auer deference, Chevron Deference Tagged With: ,
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