Fifth Circuit Poised to Consider Validity of Temporary Regulations Aimed at Curbing Inversions

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March 7, 2018

We present here a guest post by our colleague Katherine Zhang.

In Chamber of Commerce v. Internal Revenue Service, the Fifth Circuit will consider whether “tax exceptionalism” exists in the context of temporary regulations. At issue in the case are Treasury regulations that provide special rules for calculating the “ownership fraction” for entities engaged in inversion transactions. The district court set aside the regulations as promulgated in violation of the Administrative Procedure Act (APA), and the government has appealed.

Since the Supreme Court consigned the broad notion of “tax exceptionalism” to the scrap heap in Mayo Foundation, 562 U.S. 44 (2011) (see our prior reports here and here), by applying Chevron deference principles to Treasury regulations, the courts have increasingly grappled with the extent to which the APA constrains the promulgation of Treasury regulations. The Altera case pending in the Ninth Circuit presents another important facet of the general interplay between the APA and Treasury regulations (see our reports on Altera here). In this case, the focus is on APA constraints on the issuance of temporary regulations.

Generally, an “inversion transaction” occurs where a foreign corporation replaces the U.S. parent of a multinational group. If the transaction meets certain criteria, then Code section 7874 applies to impose adverse U.S. tax consequences on the parties involved. One key criterion is that, after the transaction, former shareholders of the U.S. parent hold at least 60 percent of the stock of the new foreign parent. This percentage is commonly referred to as the “ownership fraction,” and it may be measured by either vote or value. If the ownership fraction is at least 60 percent and less than 80 percent, then in the ten-year period after the transaction, U.S. tax is imposed on income or gain recognized in this period from transfers or licenses that are part of the transaction or that are made to foreign related persons after the transaction. The resulting liability cannot be reduced by tax attributes such as net operating losses or foreign tax credits. If the ownership fraction is at least 80 percent, then the new foreign parent is treated as a domestic corporation.

In April 2016, the Treasury Department invoked its broad regulatory authority under section 7874 to adopt special rules for calculating the ownership fraction. Under one of these rules, the denominator of the ownership fraction (by value) disregards stock of the foreign corporation attributable to certain prior domestic entity acquisitions. As a result, the ownership fraction increases, and the 60 percent threshold brings more transactions within the ambit of section 7874. The rule is designed to prevent companies from using a series of transactions to safely achieve an inversion that would fall within section 7874 if done all at once or as part of a single plan. The rule was issued both as a temporary regulation that was effective immediately and as a proposed regulation.

This rule is the central focus of Chamber of Commerce. In August 2016, the U.S. Chamber of Commerce and the Texas Association of Business filed suit in the Western District of Texas, arguing that the rule was invalid for failure to meet the requirements of the APA. The government contested both the plaintiffs’ power to bring suit and the merits of the APA objections.

The district court first rejected the government’s jurisdictional challenges that were raised in a motion to dismiss. A plaintiff generally must establish standing by demonstrating that it suffered an “injury in fact” that was caused by the defendant’s conduct and that likely would be redressed by a favorable decision. But an association has standing to bring suit on behalf of its members if, among other elements, the members would have standing to sue in their own right. The court agreed that both plaintiffs had standing because Allergan plc was a member of each trade association.

Shortly after Treasury and the IRS issued the rule in April 2016, Allergan announced the cancellation of a previously announced merger with Pfizer Inc. According to the plaintiffs, the rule eliminated the tax benefits of the merger—because Allergan’s “corporate composition” included several prior acquisitions of domestic corporations, the rule would have applied to cause the entity resulting from the merger to be treated as a domestic corporation subject to U.S. federal income tax. On this basis, the court found that Allergan would have standing to sue in its own right. Although Allergan did not have a specific transaction pending, there was no need for it to “engage in futile negotiations” for a transaction that the rule has “altogether foreclosed or made economically impracticable.” Instead, it was sufficient that Allergan “identified a specific transaction that was thwarted by the Rule and asserted that it would actively pursue other inversions if this court were to set aside the challenged Rule.” The court went on to conclude that the plaintiffs demonstrated “injury in fact” by showing that Allergan was the “targeted object” of the rule. Therefore, the plaintiffs “have alleged an actual, concrete injury, that is fairly traceable to implementation of the Rule, and that would be redressed by a decision setting aside that Rule.”

The court also determined that the suit was not barred by the Anti-Injunction Act, which prohibits suits “restraining the assessment or collection of any tax.” According to the court, the plaintiffs’ suit did not seek to restrain the assessment or collection of tax. Citing Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2015), which analyzed the analogous Tax Injunction Act applicable to state taxes, the court reasoned that “[a]ssessment and collection of taxes does not include all the activities that may improve the government’s ability to assess and collect taxes.” Here, rather than trying to restrain the assessment or collection of tax, the plaintiffs merely challenged the validity of a rule “so that a reasoned decision can be made about whether to engage in a potential future transaction that would subject them to taxation under the Rule.” The rule itself did not constitute the assessment or collection of tax, but only determined who was subject to tax and facilitated the assessment or collection of tax.

The court then turned to the plaintiffs’ motion for summary judgment, which raised the substantive claims of an APA violation. Broadly speaking, the APA governs agency actions and judicial review of such actions. Provisions of the APA governing agency rulemaking require agencies to publish a notice of proposed rulemaking in the Federal Register and to provide “interested persons” with an opportunity to comment. The proposed rule must be published no less than 30 days before its effective date, to allow for adequate opportunity to comment. The APA also directs a reviewing court to “hold unlawful and set aside” certain types of agency action, including actions that exceed statutory jurisdiction, actions that are arbitrary and capricious, and actions taken without procedure required by law. The plaintiffs challenged the rule on all three of these grounds.

The district court rejected the government’s first two arguments, finding that the rule did not exceed Treasury and the IRS’s statutory jurisdiction and did not constitute arbitrary and capricious rulemaking. The court reached a different result, however, with respect to the plaintiffs’ third argument, ruling that issuance of the rule as an immediately effective temporary regulation violated the APA’s notice-and-comment requirements.

The government argued for a form of “tax exceptionalism” based on Code section 7805(e), which states that Treasury can issue temporary regulations (subject to automatic expiration after three years), as long as those temporary regulations are accompanied by proposed regulations that are subject to notice and comment. Although that provision contains no language restricting temporary regulations from becoming effective immediately, the court was not persuaded. The APA specifically contemplates that subsequent statutes might override its notice-and-comment requirements, but it requires that statutes make this change “expressly.” 5 U.S.C. § 559. According to the court, section 7805 did not make any such change “expressly”—it refers to effective dates of regulations in connection with limitations on retroactivity in section 7805(b), but “neither explicitly states nor suggests congressional intent to allow a regulation to become effective earlier in relation to publication than provided for in the APA.” The court also declined to look for any such intent in the legislative history, saying that it “will not disregard explicit directives of the APA in favor of legislative history.”

The court also held that the rule did not qualify for the APA’s exception for “interpretative” rules, which exempts such rules from notice-and-comment requirements. 5 U.S.C § 553(b)(A). As described by the court, an interpretative rule advises the public as to the “agency’s construction of the statutes and rules which it administers,” while a substantive rule “affects individual rights and obligations” and “is issued by an agency pursuant to statutory authority.” The court determined that the rule at issue was a substantive rule—it was promulgated pursuant to subsections of section 7874 that authorized Treasury to issue regulations to provide for “adjustments to the application of this section” and to “treat stock as not stock.” These types of rules are “modifications to the application of the statute,” not mere interpretations.

The impact of the Fifth Circuit’s decision in Chamber of Commerce could extend well beyond its effect on the particular inversion rule that is directly at issue. If the court of appeals agrees with the district court’s approach, its decision could well cast doubt on the validity of all temporary Treasury regulations. Conversely, the court of appeals may decide that, under section 7805, tax still is exceptional in at least one important respect.

The government’s opening brief is due March 16.

Chamber of Commerce – District Court opinion


Ninth Circuit Briefing Completed in Altera

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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.

Altera – Taxpayer brief

Altera- Gov’t Opening Brief

Altera – Gov’t Reply Brief