January 25, 2017
The parties have now completed briefing in the Ninth Circuit in the Altera case, in which the Tax Court struck down Treasury regulations that require taxpayers to include employee stock options in the pool of costs shared under a cost-sharing agreement. As described in our previous reports, the Tax Court’s decision implicated both the specific issue of whether the cost-sharing regulations are a lawful implementation of Code section 482 and the more general administrative law issue of the constraints placed on Treasury by the Administrative Procedure Act (APA) in issuing rules that involve empirical conclusions.
The government’s opening brief focuses only on the specific section 482 issue, maintaining that the Tax Court erred in believing that the challenged regulations involved empirical conclusions. Specifically, the government relies heavily on what it terms the “coordinating amendments” to the regulations promulgated in 2003. Those amendments, which purport to apply the “commensurate with income” language added to section 482 in 1986 for intangible property, state in part that a “qualified cost sharing arrangement produces results that are consistent with an arm’s length result . . . if, and only if, each controlled participant’s share of the costs . . . of intangible development . . . equals its share of reasonably anticipated benefits attributable to such development.” Treas. Reg. § 1.482-7(a)(3). By its terms, this regulation states that determining whether a cost-sharing agreement meets the longstanding section 482 “arm’s length” standard has nothing whatsoever to do with how parties actually deal at “arm’s length” in the real world. On that basis, the government argues that the APA rules are not implicated because the regulations did not rest on any empirical conclusions. And for the same reason, the government argues that the Ninth Circuit’s earlier decision under the prior cost-sharing regulations, Xilinx v. Commissioner, 598 F.3d 1191 (9th Cir. 2010), is irrelevant since that decision was premised on the understanding (now allegedly changed by the amended regulations) that how parties actually deal at “arm’s length” was relevant to whether the section 482 “arm’s length” standard was met under those prior regulations, which did not explicitly provide a rule for stock-based compensation. Finally, the government defends the validity of the regulation’s approach to “arm’s length” in the cost-sharing context as being in line with statements made in the House and Conference Reports on the 1986 amendments to section 482, which noted the general difficulty in finding comparable arm’s-length transfers of licenses of intangible property.
In its response brief, the taxpayer takes the government to task for relying on a “new argument” rather than directly addressing the reasoning of the Tax Court. The taxpayer first observes that Treasury never took the position in the rulemaking that the traditional “arm’s-length” standard in section 482 can be completely divorced from how parties actually operate at arm’s length—a position that assertedly “would have set off a political firestorm.” Accordingly, the taxpayer argues that the government’s position on appeal violates the bedrock administrative law principle of SEC v. Chenery Corp., 318 U.S. 80 (1943), that courts must evaluate regulations on the basis of the reasoning contemporaneously given by the agency, not justifications later advanced in litigation. And in any event, the taxpayer argues, this position cannot be sustained because it is an unexplained departure from Treasury’s longstanding position that the 1986 amendments to section 482 “did not change the arm’s-length standard, but rather supplied only a new tool to be used consistently with arm’s-length analysis rooted in evidence.”
The taxpayer describes the government’s reliance on the “coordinating amendments” in the regulations as “circular reasoning” that simply purports to define “arm’s length” to mean something other than “arm’s length.” Even if that is what the regulations say, the taxpayer continues, the regulations could not be sustained because they depart “from the recognized purpose of Section 482 to place controlled taxpayers at parity with uncontrolled taxpayers” and conflict with “the arm’s-length analysis implicit in the statute’s first sentence.”
The government’s reply brief criticizes the taxpayer for not even arguing that its cost-sharing agreement clearly reflects income, and it therefore characterizes the taxpayer as arguing that “the arm’s-length standard gives related taxpayers carte blanche to mismatch their income and expenses.” With respect to the correct interpretation of section 482, the government repeats its position from the opening brief, maintaining that the term “arm’s length” does not necessarily connote equivalence with real-world transactions. Instead, the government argues that it is the taxpayer that departs from the statute by failing to give proper effect to the “commensurate with the income attributable to the intangible” language added in 1986.
The government responds to the Chenery argument by denying that it is arguing a different ground for the regulation than that advanced by Treasury. Rather, the government states that its brief simply further develops the basis advanced by Treasury because it was clear in the regulations that emerged from the rulemaking that Treasury was rejecting the position that an “arms-length” standard can be applied only by looking at empirical evidence of transactions between uncontrolled taxpayers.
Although the briefs are quite long, the basic dispute can be stated fairly succinctly. The parties purport to agree that an “arm’s-length” standard must govern. The taxpayer says that application of this standard always depends on analyzing actual transactions between uncontrolled parties, where available. The government says no; in its view, “arm’s length” does not necessarily require reference to such transactions. Instead, according to the government, in the cost-sharing context “Treasury prescribed a different means of ascertaining the arm’s-length result,” one that “is determined by reference to an economic assumption rather than by reference to allegedly comparable uncontrolled transactions.”
The intense interest in this case is illustrated by the filing of many amicus briefs. The government, which rarely benefits from amicus support in tax cases, is supported by two different amicus briefs filed by groups of law professors—six tax law professors joining in one of the briefs and 19 other tax and administrative law professors joining the second brief. The taxpayer’s position is supported by seven amicus briefs—including one from the Chamber of Commerce and one from a large group of trade associations. Four briefs were filed by individual companies—Cisco, Technet, Amazon, and Xilinx. The seventh brief was filed by three economists—a business school professor (who testified as an expert witness for the taxpayer in Xilinx), a fellow at the American Enterprise Institute, and a managing director at the Berkeley Research Group. They profess no financial interest in the outcome but argue, based on their experience in dealing with issues relating to stock-based compensation, that, as a matter of economics, the government’s approach is not consistent with how parties acting at arm’s length would proceed.
Notwithstanding the interest in the case, no decision is expected in the near future. The Ninth Circuit has a backlog of cases awaiting the scheduling of oral argument. In recent years, oral arguments in tax cases typically have not been scheduled until at least a year after the briefing is concluded, and often closer to 18 months. Thus, oral argument in this case should not be expected before next winter. And then it will likely be several months after the argument before the court issues its decision. So at this point, it would be surprising if there were a decision in Altera before mid-2018.