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.
We have previously reported on the Tax Court’s important decision in Altera, which has significant implications both for IRS regulation of cost-sharing agreements under the transfer pricing rules and, more broadly, for how the Administrative Procedure Act might operate as a constraint on rulemaking by the Treasury Department in the tax area. Although there were some tactical considerations that could have made the government hesitant to seek appellate review from its defeat in Altera (see here), the government has now filed a notice of appeal to the Ninth Circuit.
The court of appeals will issue a briefing schedule in due course, and we will keep you posted on the progress of the appeal.
We reported earlier on the Tax Court’s important decision in Altera, which invalidated a transfer-pricing regulation for failure to satisfy the “reasoned decisionmaking” standard for rulemaking under the Administrative Procedure Act. At the time, there were outstanding issues that prevented the Tax Court from entering a final decision. The parties have now submitted agreed-upon computations, and on December 1 the Tax Court entered a final decision. The government has 90 days to file a notice of appeal from that decision.
As we noted previously, the government will be motivated to appeal this decision both because of its specific impact on the regulation of cost-sharing agreements and, more broadly, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules. On the other hand, the government could make a judgment that this particular case is not an ideal vehicle for litigating the broader APA issue, in part because an appeal would go to the Ninth Circuit where the Xilinx precedent on cost-sharing is on the books (see here for a report on Xilinx). It might then make the tactical choice to forego appeal in this case and await a stronger setting in which to litigate the APA issue for the first time in an appellate court. The Department of Justice will be weighing these competing considerations, and its conclusion should be evident when the 90-day period expires next March.
Tax Court Relies on APA to Invalidate the Cost-Sharing Regulation Governing Stock-Based Compensation
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.
The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”
The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.
The taxpayer filed its reply brief in the BMC Software case last week. As in its opening brief, BMC cites Fifth Circuit precedent for the tax law definition of “indebtedness” as an “existing unconditional and legally enforceable obligation to pay.” BMC argues that it is undisputed that the accounts receivable created under Rev. Proc. 99-32 do not meet that definition—they neither existed nor were legally enforceable during the testing period for related-party indebtedness under section 965. (BMC observes that instead of disputing this point, the Commissioner tried to distinguish that case law, much of which comes from the debt-equity context. And BMC points out that the Commissioner’s argument implies different definitions of “indebtedness” may apply depending on the posture of the case.) In our first post on this case, we speculated that the outcome in this case may depend on whether the Tax Court took the legal fictions in Rev. Proc. 99-32 too far. That issue lurks beneath this definitional dispute: That the accounts receivable are deemed to have arisen during the testing period does not settle whether those accounts were “indebtedness” during the testing period.
BMC then turns to the closing agreement, which makes no mention of section 965 or the term “indebtedness.” BMC therefore relies on the legal principle that closing agreements must be construed to bind the parties “only to the matters expressly agreed upon.” BMC also addresses the Commissioner’s other arguments based on the closing agreement.
Finally, BMC makes a strong policy argument against the result in the Tax Court. BMC observes that the Commissioner concedes that the clear purpose of the related-party-indebtedness rule in section 965 is that it is meant to ensure “that a dividend funded by a U.S. shareholder, directly or indirectly, and that does not create a net repatriation of funds, is ineligible for the benefits” of section 965. Of course, no taxpayer could fund a dividend by way of deemed accounts receivable created after the dividend was paid. Therefore, BMC concludes, the case does not implicate the underlying purpose of the related-party-indebtedness rule under section 965.
We will provide updates once oral arguments are scheduled.
The Commissioner filed his brief in the BMC Software case last week. The brief hews closely to the Tax Court’s decision below. The brief primarily relies on the parties’ closing agreement and trumpets the finality of that agreement.
The Commissioner argues that BMC’s problem is of BMC’s own making—BMC chose to avail itself of the relief available under Rev. Proc. 99-32 and signed a closing agreement under which the accounts receivable were deemed established during the relevant testing period for the related-party indebtedness rule under section 965. And as if to suggest that BMC deserves the reduction in its section 965 deduction, the Commissioner repeatedly asserts that the underlying adjustments that precipitated BMC’s use of Rev. Proc. 99-32 resulted from BMC’s “aggressive” transfer-pricing strategies.
The Commissioner briefly addresses BMC’s primary argument on appeal, which is that the relevant definition of “indebtedness” for purposes of section 965 is the definition established in case law and not—as the Tax Court had found below—the Black’s Law definition. The Commissioner’s brief argues that most of the cases on which BMC relies for a definition of “debt” are inapplicable because they arise in the context of debt-equity disputes or other settlements where the Commissioner was challenging the taxpayer’s characterization of an amount as debt. According to the Commissioner’s brief, those cases address whether the underlying substance of an instrument or payment was truly debt but that “[f]actual inquiries to ascertain whether, and when, debt was created by the parties’ dealings are irrelevant here.”
The brief also addresses BMC’s arguments that the Tax Court misinterpreted the closing agreement. The Commissioner argues that parol evidence is irrelevant because the agreement is unambiguous and that in any event, the extrinsic evidence does not support BMC’s position.
BMC’s reply brief is due April 28.
The taxpayer filed its opening brief in the Fifth Circuit appeal of BMC Software v. Commissioner. As we described in our earlier coverage, the Tax Court relied on the legal fiction that accounts receivable created pursuant to Rev. Proc. 99-32 in a 2007 closing agreement were indebtedness for earlier years (2004-06) in order to deny some of the taxpayer’s section 965 deductions. There are three main avenues of attack in the taxpayer’s brief.
First, the taxpayer argues that the Tax Court incorrectly treated those accounts receivable as “indebtedness” as that term is used in the exception to section 965 for related-party indebtedness created during the testing period. The taxpayer contends that the Tax Court looked to the Black’s Law definition of “indebtedness” when it should have looked to the tax law definition. And the taxpayer argues that the tax law definition—that “indebtedness” requires “an existing unconditional and legally enforceable obligation to pay”—does not include the fictional accounts receivable created under Rev. Proc. 99-32. The taxpayer argues that those accounts did not exist and were not legally enforceable until 2007 (after the section 965 testing period) and therefore did not constitute related-party indebtedness during the testing period for purposes of section 965.
Second, the taxpayer argues that the Tax Court was wrong to interpret the 2007 closing agreement to constitute an implicit agreement that the accounts receivable were retroactive debt for purposes of section 965. The taxpayer observes that closing agreements are strictly construed to bind the parties to only the expressly agreed terms. And the taxpayer argues that the parties did not expressly agree to treat the accounts receivable as retroactive debt for section 965 purposes. Moreover, the taxpayer argues that the Tax Court misinterpreted the express language in the agreement providing that the taxpayer’s payment of the accounts receivable “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustments.” The taxpayer then makes several other arguments based on the closing agreement.
Finally, the taxpayer makes some policy-based arguments. In one of these arguments, the taxpayer contends that the Tax Court’s decision is contrary to the purpose of section 965 and the related-party-indebtedness exception because the closing agreement postdated the testing period and therefore cannot be the sort of abuse that the related-party-indebtedness exception was meant to address.
In BMC Software v. Commissioner, 141 T.C. No. 5, the Tax Court was faced with considering the effect that some legal fictions (created under a Revenue Procedure regarding transfer pricing adjustments) have on the temporary dividends-received deduction under section 965. And while both the section 965 deduction and the legal fictions under the Revenue Procedure appear to have been designed to benefit taxpayers by facilitating tax-efficient repatriations, the Tax Court eliminated that benefit for some repatriated amounts. The taxpayer has already appealed the decision (filed on September 18) to the Fifth Circuit (Case No. 13-60684), and success of that appeal may hinge in part on whether the Tax Court took the legal fictions in the Revenue Procedure too far.
First, some background on the section 965 deduction: In 2004, Congress enacted the one-time deduction to encourage the repatriation of cash from controlled foreign corporations on the belief that the repatriation would benefit of the U.S. economy. To ensure that taxpayers could not fund the repatriations from the United States (by lending funds from the U.S. to the CFC, immediately repatriating the funds as dividends, and then later treating would-be dividends as repayments of principal), Congress provided that the amount of the section 965 deduction would be reduced by any increase in related-party indebtedness during the “testing period.” The testing period begins on the earliest date a taxpayer might have been aware of the availability of the one-time deduction—October 3, 2004—and ends at the close of the tax year for which the taxpayer elects to take the section 965 deduction. Congress thus established a bright-line test that treated all increases in related-party debt during the testing period as presumptively abusive, regardless of whether the taxpayer had any intent to fund the repatriation from the United States.
BMC repatriated $721 million from a controlled foreign corporation (BSEH) and claimed the section 965 deduction for $709 million of that amount on its 2006 return. On that return, BMC claimed that there was no increase in BSEH’s related party indebtedness between October 2004 and the close of BMC’s 2006 tax year in March 2006. In the government’s view, however, this claim became untrue after the IRS reached a closing agreement with the IRS in 2007 with respect to BMC’s 2003-06 tax years.
That agreement made transfer pricing adjustments that increased BMC’s taxable income for the 2003-06 tax years. The primary adjustments were premised on the IRS’s theory that the royalties BMC paid to its CFC were too high. By making those primary adjustments and including additional amounts in income, BMC was deemed to have paid less to its CFC for tax purposes than it had actually paid.
The typical way of conforming BMC’s accounts in this circumstance is to treat the putative royalty payments (to the extent they exceeded the royalty agreed in the closing agreement) as deemed capital contributions to BSEH. If BMC were to repatriate those amounts in future, they would be treated as taxable distributions (to the extent of earnings and profits). But Rev. Proc. 99-32 permits taxpayers in this circumstance to elect to repatriate the funds tax-free by establishing accounts receivable and making intercompany payments to satisfy those accounts. The accounts receivable created under Rev. Proc. 99-32 are, of course, legal fictions—the taxpayer did not actually loan the funds to its CFC. BMC elected to use Rev. Proc. 99-32 and BSEH made the associated payments.
To give full effect to the legal fiction, Rev. Proc. 99-32 provides that each account receivable is “deemed to have been created as of the last day of the taxpayer’s taxable year for which the primary adjustment is made.” So although BMC’s accounts receivable from BSEH were not actually established until the 2007 closing agreement, those accounts receivable were deemed to have been established at the close of each of the 2003-06 tax years. Two of those years (those ending March 2005 and March 2006) fell into the testing period for BMC’s section 965 deduction. The IRS treated the accounts receivable as related-party debt and reduced BMC’s section 965 deduction by the amounts of the accounts receivable for those two years, which was about $43 million.
BMC filed a petition in Tax Court, arguing (among other things) that the statutory rules apply only to abusive arrangements and that the accounts receivable were not related-party debt under section 965(b)(3). The government conceded that BMC did not establish the accounts receivable to exploit the section 965 deduction, but argued that there is no carve-out for non-abusive transactions and the accounts receivable were indebtedness under the statute.
The court held that the statutory exclusion of related-party indebtedness from the section 965 deduction is a straightforward arithmetic formula devoid of any intent requirement or express reference to abusive transactions. The court also held that the accounts receivable fall under the plain meaning of the term “indebtedness” and therefore reduce BMC’s section 965 deduction under section 965(b)(3). So even though both the section 965 deduction and Rev. Proc. 99-32 were meant to permit taxpayers to repatriate funds with little or no U.S. tax impact, the mechanical application of section 965(b)(3) and Rev. Proc. 99-32 eliminated that benefit for $43 million that BMC repatriated as a dividend.
This does not seem like the right result. And here it seems the culprit may be the legal fiction that the accounts receivable were established during the testing period. The statute may not expressly address abusive intent, but that is because Congress chose to use the testing period in the related-party-debt rule as a blunt instrument to stamp out all potential abuses of the section 965 deduction. This anti-abuse intent is baked into the formula for determining excluded related-party debt because the opening date of the testing period coincides with the earliest that a taxpayer might have tried to create an intercompany debt to exploit the section 965 deduction. BMC did not create an intercompany debt during the testing period; the accounts receivable were not actually established until after the close of the testing period. Perhaps the court took the legal fiction that the accounts receivable were established in 2005 and 2006 one step too far. And perhaps the Fifth Circuit will address this legal fiction on appeal.
Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial. The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development. Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property). The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.
The Tax Court held for the taxpayer in substantial part. Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever. This is Gunnery Sergeant Hartman’s valuation method:
Marines die, that’s what we’re here for. But the Marine Corps lives forever. And that means you live forever. Full Metal Jacket (1987).
Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.
The Tax Court is correct. The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either. The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts. Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former. Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates. Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.
In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous. However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim. The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas. The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.
This attempt by the IRS to use an AOD to continue to harass taxpayers should fail. The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments. And it did not exclude the possibility of future product value flowing from that original IP. Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value. The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity. (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.) IP does give competitive advantages that do not necessarily disappear in next generation product developments. However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business. Contra Litigating Treas. Reg. § 1.482-7T.
The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences. The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers. If it does not believe its position merits an appeal, the IRS should accept its loss. Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them. As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.” The Veritas AOD is nothing but smoke.