Divided Ninth Circuit Reverses Tax Court in Sophy on Question of Mortgage Interest Deduction Limits for Unmarried Taxpayers
October 13, 2015
We previously reported (see here and here) on the Ninth Circuit’s consideration of an appeal involving the mortgage interest deduction – specifically, whether the statutory limits on that deduction apply on a per-taxpayer or per-residence basis. The unmarried taxpayers here (Charles Sophy and Bruce Voss) argued that they were each entitled to take a deduction up to the $1.1 million limit for the residence that they co-owned, and thereby receive double the tax benefit that a similarly situated married couple would receive, but the Tax Court disagreed. The briefing in this case was completed in April 2013, but the Ninth Circuit did not schedule oral argument until almost two years later. The court has finally issued its decision, reversing the Tax Court by a 2-1 vote. (Although we have referred to the case as Sophy based on the Tax Court’s caption, the Ninth Circuit opinion reverses the order of the two taxpayers in its caption, and therefore the case may come to be referred to as Voss in the future.)
The majority opinion (authored by Judge Bybee and joined by 8th Circuit Senior Judge Melloy, sitting by designation) recognized that neither the statute nor the regulations directly address this question and then engaged in a detailed textual analysis of various provisions of Code section 163. The majority found the strongest evidence of the correct answer in the statute’s treatment of married taxpayers who file separately. In order to put them in the same position as married taxpayers who file jointly, the statute provides in a parenthetical that married taxpayers filing separately are each entitled to a $550,000 deduction. Because that approach reflects a per-taxpayer rather than per-residence treatment, the majority concluded that the same per-taxpayer approach should be applied to unmarried taxpayers, even though it arguably gives them a windfall double deduction.
The majority rejected the Tax Court’s argument that other provisions of Code section 163 reveal a “focus” on the residence, and it also rejected the Tax Court’s explanation that the approach to married-filing-separately taxpayers was meant to address only the proper allocation of a deduction that is already limited to $1.1 million per residence. Finally, the majority acknowledged that its holding results in a “marriage penalty,” but surmised that “Congress may very well have good reasons for allowing that result” and added that, even if Congress didn’t, the court was bound by the text of a statute that singles out married taxpayers (who file separately) for specific treatment that is not explicitly provided for unmarried co-owners.
Judge Ikuta dissented, arguing primarily that the court should defer to the IRS’s administrative interpretation of the statute set forth in a 2009 Chief Counsel Advice memorandum. She maintained that this informal guidance is entitled to “Skidmore deference,” which the Supreme Court has described as a measure of deference equivalent to the interpretation’s “power to persuade.” The majority found that this level of deference was negligible because the CCA contained only a fairly cursory analysis of the statute, which carried little power to persuade. Judge Ikuta reasoned, however, that the CCA is “more persuasive” than the taxpayer’s interpretation, “which would result in a windfall to unmarried taxpayers.” As to the majority opinion, Judge Ikuta characterized as “the thinnest of reeds” its reliance on the treatment of married taxpayers filing separately.
The government has until November 3 to seek certiorari, but there is no reason to expect that the government would seriously consider seeking Supreme Court review in this case.
Federal Circuit Set to Address Post-Merger Application of “Same Taxpayer” Requirement for Interest Netting
October 9, 2015
The Federal Circuit is now considering an appeal by the government that seeks to restrict the availability of interest netting following mergers. Section 6621(d) provides for a “net interest rate of zero” on “equivalent underpayments and overpayments by the same taxpayer.” As we previously reported here and here, the government declined to pursue an appeal in Magma Power Co. v. United States, 101 Fed. Cl. 562 (2011), in which the Court of Federal Claims held that the “same taxpayer” requirement did not prevent interest netting where the taxpayer was a member of a consolidated group with respect to the period of overpayment interest but was outside the group in the tax year that triggered the underpayment interest. The court concluded there that since the taxpayer had the same taxpayer identification number (TIN) both before and after it became of member of the consolidated group it was the “same taxpayer.”
In Wells Fargo v. United States, however, the government again invoked this statutory language to oppose interest netting—this time in the context of a large taxpayer that had emerged from a series of mergers. The government contended that the “same taxpayer” requirement barred interest netting because the mergers altered the corporate identity of the taxpayers who incurred the overpayments and underpayments. The facts are complex, but the trial court distilled them into three possible scenarios – whether it is permitted to net interest from underpayments and overpayments between: 1) a pre-merger acquiring corporation and a pre-merger acquired corporation; or 2) a pre-merger acquiring corporation and the post-merger surviving corporation; or 3) a pre-merger acquired corporation and the post-merger surviving corporation.
Seizing on the rationale of Magma Power, the government argued that interest netting was unavailable in situations 1 and 3 because the two taxpayers involved do not have the same TIN. The government also relied upon Energy East Corp. v. United States, 645 F.3d 1358 (Fed. Cir. 2011), where the court of appeals held that a parent corporation and subsidiary that were not affiliated at the time each made tax payments could not later net interest in their consolidated return. By contrast, the taxpayer argued that, under established principles, the legal identities of the pre-merger companies are absorbed into the new, post-merger corporation. The new entity, of course, has a different TIN because the acquired corporation no longer exists, but that should not change the availability of interest netting.
The Court of Federal Claims first found that Energy East and Magma Power were distinguishable because “they involved separate but affiliated corporations,” not merged corporations. The court then examined merger law, noting that the surviving corporation is “liable retroactively for the tax payments of its predecessors.” The court concluded that “following a merger, the law treats the acquired corporation as though it had always been part of the surviving entity,” and therefore “the corporations in the present case became the ‘same taxpayer’ by virtue of the statutory merger.” As a result, the court ruled that Wells Fargo was entitled to interest netting in all three of the described scenarios.
The trial court agreed to certify the issue for interlocutory appeal, and the Federal Circuit accepted the appeal. In its briefs, the government relies primarily on the same arguments it made below. It argues that both Energy East and the TIN rule require that interest netting be denied in scenarios 1 and 3. The brief distinguishes between the two scenarios, however, arguing that even if the court were to adopt “a broader inquiry into corporate identity” that would allow netting for scenario 1, it should still deny netting for scenario 3 because the “relevant essentials” of the two entities involved are too different.
The taxpayer’s brief largely defends the rationale of the Court of Federal Claims, relying on “longstanding principles of state merger law.” The taxpayer also emphasizes, as did the trial court, that prior to Energy East the IRS had generally applied the “corporate continuity principle” in its administrative rulings in areas of federal tax law other than interest netting.
Oral argument is scheduled for November 5.
Tax Court Relies on APA to Invalidate the Cost-Sharing Regulation Governing Stock-Based Compensation
October 2, 2015
We present here a guest post from our colleagues Patricia Sweeney and Andrew Howlett. A longer version of this post is published here.
In Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), the Tax Court put the IRS and Treasury on notice that, when promulgating regulations premised on “an empirical determination,” the factual premises underlying those regulations must be based on evidence or known transactions, not on assumptions or theories. Otherwise, the regulations do not comply with the requirements of the Administrative Procedure Act (“APA”), 5 U.S.C. § 551 et seq. Applying the arm’s-length standard of Code section 482, the Altera decision provides another example of transfer-pricing litigation being decided on the basis of evidence of actual arm’s-length dealings rather than economic theories. Looking more broadly beyond the section 482 context, the decision is an important reminder to the IRS and Treasury that, in the wake of the Supreme Court’s decision in Mayo Foundation (562 U.S. 44 (2011), see our prior reports on the decision and oral argument in that case here and here), tax regulations are subject to the same APA procedures as regulations issued by other federal agencies. As a result, Treasury cannot ignore the evidence and comments submitted during the rulemaking process. If it is to reject that evidence, Treasury must engage in its own factfinding, and it must explain the rationale for its decision based upon the factual evidence.
Because of its specific impact on the regulation of cost-sharing agreements and, more generally, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules, the government will strongly consider an appeal of this decision to the Ninth Circuit. A notice of appeal will be due 90 days after the Tax Court enters its final decision, but there is not yet a final, appealable order in Altera.
The Context for the Dispute. Code section 482 authorizes the Commissioner to allocate income and expenses among related parties to ensure that transactions between them clearly reflect income. Treas. Reg. § 1.482-1(b)(1) provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” In 1986, Congress amended section 482 to provide that, “in the case of any transfer (or license) of intangible property . . ., the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” As noted by the Tax Court, Congress enacted this amendment to section 482 in response to concerns regarding the lack of comparable arm’s-length transactions, particularly in the context of high-profit-potential intangibles. Congress did not intend, however, to preclude the use of bona fide cost-sharing arrangements under which related parties that share the cost of developing intangibles in proportion to expected benefits have the right to separately exploit such intangibles free of any royalty obligation. See H.R. Conf. Rep. No. 99-841 (Vol. II), at II-637 to II-638 (1986).
In 1995, Treasury issued detailed new cost-sharing regulations that generally authorized the IRS “to make each controlled participant’s share of the costs . . . of intangible development under the qualified cost sharing arrangement equal to its share of reasonably anticipated benefits attributable to such development.” In Xilinx, Inc. v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010), the Ninth Circuit affirmed the Tax Court’s holding that the regulations did not require the taxpayer to include employee stock options (“ESOs”) granted to employees engaged in development activities in the pool of costs shared under the cost-sharing arrangement. The court reasoned that the term “costs” in the regulation did not include ESOs because that would not comport with the “dominant purpose” of the transfer pricing regulations as a whole, which is to put commonly controlled taxpayers at “tax parity” with uncontrolled taxpayers. Because of the overwhelming evidence that unrelated parties dealing at arm’s length in fact do not share ESOs in similar co-development arrangements, the court concluded that such tax parity is best furthered by a holding that the ESOs need not be shared. (For a more detailed examination of Xilinx, see our contemporaneous analysis here.)
In 2003 (prior to the Xilinx decision), Treasury had amended the transfer pricing regulations that were applicable to the years at issue in Xilinx. The amended regulations explicitly address the interaction between the arm’s-length standard and the cost-sharing rules, as well as the treatment of ESOs. Treas. Reg. § 1.482-1(b)(2)(i) now states that “Treas. Reg. § 1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement . . . produces results consistent with an arm’s length result.” Contrary to Xilinx, Treas. Reg. § 1.482-7(d)(2), as amended, specifically identifies stock-based compensation as a cost that must be shared.
Altera did not include ESOs or other stock-based compensation in the cost pool under the cost-sharing agreement it entered into with a Cayman Islands subsidiary. In accordance with the 2003 regulations, the IRS asserted that those costs should be included in the pool, and that, as a result, Altera’s income should be increased by approximately $80 million in the aggregate.
The Tax Court’s Analysis. Ruling on cross motions for summary judgment, the Tax Court, in a 14-0 decision reviewed by the full court, agreed with the taxpayer that the 2003 amendments to the cost-sharing regulations were invalid under the APA because Treasury did not adequately consider the evidence presented by commentators during the rulemaking process that stock-based compensation costs are not shared in actual third-party transactions.
The Tax Court first addressed the threshold issue of whether the 2003 regulations were governed by the rulemaking requirements of section 553 of the APA. To that end, it analyzed whether the regulations were “legislative” (regulations that have the force of law promulgated by an administrative agency as the result of statutory delegation) or “interpretive” (mere explanations of preexisting law). (This legislative/interpretive distinction under the APA is different from the distinction between legislative and interpretive Treasury regulations that was applied for many years in tax cases, but rendered largely obsolete by the Supreme Court’s Mayo decision.) Relying on Hemp Indus. Ass’n v. DEA, 333 F.3d 1082 (9th Cir. 2003), the Tax Court found that the 2003 cost-sharing regulations were legislative because there would be no basis for the IRS’s position that the cost of stock-based compensation must be shared under section 482 absent the regulation and because Treasury invoked its general legislative rulemaking authority under Code section 7805(a) with respect to the regulation.
APA section 553 generally requires the administrative agency to publish a notice of proposed rulemaking in the Federal Register, to provide interested persons an opportunity to participate in the rulemaking through written comments, and to incorporate in the adopted rules a concise general statement of their basis and purpose. APA section 706(2)(A) empowers courts to invalidate regulations if they are “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” The Tax Court cited Motor Vehicles Mfrs. Ass’n v. State Farm, 463 U.S. 29 (1983), as holding that this standard requires “reasoned decisionmaking” and that a regulation may be invalidated as arbitrary or capricious if it is not based on consideration of the relevant factors and involves a clear error of judgment.
The Tax Court found that the stock-based compensation rule did not comply with the reasoned decisionmaking standard because the rule lacked a factual basis and was contrary to evidence presented to Treasury during the rulemaking process. The Tax Court stated that, although the preamble to the 2003 rule stated that unrelated parties entering into cost-sharing agreements typically would share ESO costs (thereby relating the regulation to the arm’s-length requirement of section 482), Treasury had no factual basis for this assertion. Commentators had provided substantial evidence that stock-based compensation costs were not shared in actual third-party agreements, which the Tax Court itself had found (and which the government conceded) in Xilinx. Treasury could draw no support from any of the submitted comments nor did it engage in any of its own factfinding to support its position. Absent such factfinding or other evidence, the Tax Court concluded that “Treasury’s conclusion that the final rule is consistent with the arm’s-length standard is contrary to all of the evidence before it.”
The Tax Court also stated that Treasury’s failure to respond to any of the comments submitted was evidence that the regulation did not satisfy the State Farm standard, stating “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is [because m]eaningful judicial review and fair treatment of affected persons require an exchange of views, information and criticism between interested persons and the agencies.” As a result, the final rule failed to satisfy State Farm’s reasoned decisionmaking standard.
Challenges for Treasury. The Altera decision highlights the limitations of the Treasury Department’s rulemaking authority when the regulation is based on a factual determination. In that situation, the deference normally given to Treasury because of its expertise as an administrative agency carries little weight unless it is supported by specific factfinding Treasury has done with respect to the rule at issue. In other words, Treasury cannot expect tax regulations that seek to implement a fact-based standard to be upheld simply because Treasury believes that they reach the right theoretical result. Instead, Treasury must explicitly cite the evidence and explain how that evidence provides a rational basis for the regulation.
The Altera decision should motivate Treasury to incorporate responses to submitted comments in its descriptions of final regulations. By specifically citing Treasury’s failure (1) to respond to comments or (2) to engage in independent factfinding as being important components of judicial review under the APA, the Tax Court’s decision effectively directs Treasury to spend more resources during the rulemaking process.
More broadly, the Altera decision underscores the constraints placed on Treasury and other administrative agencies under the APA. Although Mayo announced that Chevron deference principles would apply to Treasury regulations in the future, that was not a radical shift in the law because Treasury regulations had always been subjected to a deference analysis that bore considerable similarity to Chevron. By contrast, as the Tax Court noted, Treasury regulations have not traditionally been measured by APA standards, and Treasury’s notice-and-comment procedures have not been analyzed under State Farm. The Tax Court’s unanimous decision in Altera shows that judicial review under the State Farm standard is more than a mere paper tiger; where Treasury does not demonstrate that it adequately considered the relevant factors, including submitted comments, its regulation is at risk of being overturned. Although Altera as of now is binding authority only in Tax Court cases, challenges to Treasury regulations in other forums likely will cite its reasoning with respect to what constitutes reasoned decisionmaking for purposes of judicial review under the APA.
Considerations for Taxpayers. Absent reversal on appeal, Altera will have an impact on all related-party cost-sharing agreements. Although cost-sharing agreements governed by the 2003 regulations typically have provided for a sharing of stock-based compensation, they often have provided for a retroactive adjustment back to the start of the agreement if there is any relevant change in law. Taxpayers with cost-sharing agreements should carefully review their agreements and tax positions to determine whether their agreement provides for an adjustment mechanism or whether if claims for refund for open years are appropriate based on the Altera holding.
In addition, taxpayers should consider whether Altera has opened the door for additional regulatory challenges, both in the transfer pricing arena and elsewhere, in contexts where the regulations were premised on factual or theoretical assumptions by Treasury that lack sufficient evidentiary support. The Altera case already has been brought to the attention of the district court handling the Microsoft summons litigation in the Western District of Washington as relevant to determining whether the Treasury regulations at issue there are valid, and the case will likely also be cited in cases involving the validity of other transfer pricing regulations, such as the regulations currently under review by the Tax Court in 3M Co. et al. v. Commissioner; No. 005816-13. In addition, the transfer pricing regulations governing services transactions, which were developed following the regulations at issue in Altera, also define the term “cost” to include stock-based compensation and therefore may be vulnerable to reasoning similar to that in Altera.
Finally, taxpayers and other commentators should consider the Tax Court’s reasoning in Altera in developing comments to proposed regulations. Altera demonstrates that such comments can be important in laying a foundation for future judicial challenge even if the commentators are not successful in persuading Treasury to adopt their position.