Supreme Court Denies Cert in Altera

Despite the glut of high-powered amicus briefs in support of the taxpayer’s petition for certiorari and last week’s landmark APA decision on DACA (the relevance of which to the issues in Altera we covered here), the Supreme Court declined to review the Ninth Circuit’s decision in Altera this morning.

Supreme Court’s DACA Decision May Affect Altera

Altera’s petition for certiorari is pending at the Supreme Court. With the support of several amici, Altera has asked the Court to review the Ninth Circuit’s decision (see our prior coverage here) to uphold the validity of Treasury’s transfer-pricing regulation (Treas. Reg. § 1.482-7A(d)(2)) requiring taxpayers to include employee-stock-option costs in the pool of costs that parties to cost-sharing arrangements must share. Two APA arguments loom large in Altera’s petition. Today’s Supreme Court decision on Deferred Action for Childhood Arrivals (DACA) and the APA in Department of Homeland Security v. Regents of the University of California, No. 18-587, may change the complexion of both arguments and provide the Court with an alternative route for the Court in handling Altera’s petition.

In today’s decision, the Court struck down efforts by the Department of Homeland Security (DHS) to terminate DACA because the initial action by the Acting Secretary of DHS failed to comply with the APA. DHS promulgated DACA in 2012. And in 2014, DHS sought to expand DACA by removing an age cap and creating a new program for parents (DAPA). That expansion was mired in litigation for several years and enjoined by the Fifth Circuit on the grounds that the expansion was more than a mere agency decision to not enforce particular immigration laws.

In 2017, the new administration sought not only to undo that expansion but altogether to rescind DACA, with DHS issuing a memorandum relying on little more than a citation to the Fifth Circuit’s decision (which addressed only the 2014 expansion) and reference to a letter from the Attorney General. The Fifth Circuit decision, however, had been limited to the aspects of the DACA expansion that related to eligibility for some public benefits (and not to the animating policy of forbearing deportations); the Attorney General’s letter reiterated only that the Fifth Circuit decision was correct. The NAACP (among others) challenged the administration’s attempt to rescind DACA based on this DHS memorandum. And in that suit, the D.C. District Court found that DHS’s “conclusory statements [in the memorandum] were insufficient to explain the change in [DHS’s] view of DACA’s lawfulness,” giving DHS a chance to explain itself more fully.

The new DHS Secretary offered up a second memorandum in which she stated that she “decline[d] to disturb” the first memorandum’s DACA rescission. That second memorandum had other conclusory statements and several prudential and policy reasons that were not in the first DHS memorandum. The D.C. District Court found the new explanations insufficient. That case and other related cases were appealed, and the Supreme Court ultimately granted certiorari in the California case in which it issued a decision today. The Supreme Court addressed, among other things, “whether the [DHS] rescission [of DACA] was arbitrary and capricious in violation of the APA.”

The Court held that it was. There are two elements to that decision, both of which may bear on Altera’s arguments in its petition for certiorari. First, the Court held that “[d]eciding whether agency action was adequately explained requires, first, knowing where to look for the agency’s explanation.” And the Court held that it would look only to the first, conclusory DHS memorandum because “[i]t is a ‘foundational principle of administrative law’ that judicial review of agency action is limited to ‘the grounds that the agency invoked when it took the action.’” This means that DHS could have either (1) issued a new memorandum that better explained the reasoning behind the first memorandum (thus propping up the agency action embodied in the first memorandum) or (2) taken altogether new agency action with a distinct explanation (which new explanation would be subject to a distinct APA review). DHS did not take new action but sought instead to explain its earlier action. In doing so, however, DHS did not offer a better explanation of previously identified reasons, but rather offered reasons that were not in the first memorandum at all. (In the Court’s words, the “reasoning [of the second DHS secretary in the second memorandum] bears little relationship to that of her predecessor.”) The Court elaborated on the reasons why administrative law principles bar agencies from introducing new justifications for agency action after the fact, not the least of which is that “[c]onsidering only contemporaneous explanations for agency action … instills confidence that the reasons given are not simply ‘convenient litigating position[s].’” Therefore, the Court held, “[a]n agency must defend its actions based on the reasons it gave when it acted.”

This element of the Court’s decision goes to the heart of one of Altera’s leading arguments for certiorari. Altera observed that the government pivoted from arguing (in the regulatory preamble and before the Tax Court) that its cost-sharing regulation was consistent with the arm’s-length standard to arguing (in its briefs before the Ninth Circuit) that the addition of the “commensurate-with-income” language to section 482 permitted Treasury to adopt a rule under which a “comparability analysis plays no role in determining” the costs that taxpayers must share. Altera argued that by invoking one rationale in its rulemaking and then invoking a different rationale in litigation, Treasury violated the Chenery rule, which “ensures that an agency cannot say one thing in a rule-making proceeding, and then change its mind as soon as the rule is challenged in court.”

Today’s decision provides some reason to think the Ninth Circuit was incorrect in looking to the rationale that the government offered in litigation to decide whether to uphold the cost-sharing regulation. As Altera has argued extensively, the rationale that the government has offered in litigation bears little resemblance to the reasons offered in the regulatory preamble. And because they offer such different characterizations of how the arm’s-length standard operates, it is difficult to reconcile the former with the latter. If the Ninth Circuit was incorrect in entertaining the government’s rationale offered in litigation, then there are significant problems with the Ninth Circuit’s conclusion.

The second element of today’s decision that may be germane to Altera is the Court’s decision that DHS’s action to rescind DACA was “arbitrary and capricious” under the APA. The Court observed that the first DHS memorandum relied almost entirely on the Fifth Circuit’s decision (since the Attorney General letter cited in that memorandum also relied on the Fifth Circuit’s decision). But that Fifth Circuit decision pertained only to the benefit-eligibility features of the DACA expansion and did not address what the Court called the “defining feature” of DACA—“the decision to defer removal (and to notify the affected alien of that decision).” And on that front, the first DHS memorandum “offers no reason for terminating forbearance.” In fact, the Court held, the DHS memorandum “contains no discussion of forbearance or the option of retaining forbearance without benefits” and therefore “‘entirely failed to consider [that] important aspect of the problem’” in violation of the reasoned decision-making standard in the Court’s State Farm decision. In particular, the Court here observed that in taking any action with respect to the forbearance aspects of the DACA rescission, DHS had to consider the consequences of rescission on aliens’ obvious reliance interests.

This second element may affect the outcome with respect to another one of Altera’s APA arguments. Altera argued that the regulation was the result of arbitrary and capricious agency decision-making. Treasury “purported to apply the arm’s-length standard” and “stated that whether that standard is satisfied depends on an empirical and factual analysis of real-world behavior of unrelated parties.” But then, Altera argued, when confronted with “extensive evidence demonstrating that unrelated parties would not share stock-based compensation,” Treasury “ignored or dismissed that evidence because it was inconvenient” and enacted the regulation. There is no dispute that Treasury was aware of that evidence when it finalized the disputed cost-sharing regulation, but Altera has argued that neither Treasury’s regulatory preamble nor the government’s subsequent litigating position adequately address that evidence. Just as DHS’s failure to consider obvious reliance interests in its attempt to rescind DACA created a fatal APA problem, so too, the taxpayer might argue, does Treasury’s failure to consider obvious evidence that runs counter to its cost-sharing regulation when enacting that regulation.

Although the Court’s decision on DACA is directly relevant to issues in Altera, it may not ultimately result in the Supreme Court hearing the case. But the DACA decision gives the Court an opportunity to deal with the Altera decision in a much less labor-intensive way. The Court can issue a “GVR” (grant, vacate, and remand) order, which is a one-paragraph order in which the Court grants certiorari, immediately vacates the judgment below, and remands the case to the court of appeals for “further consideration in light of” a new development not previously considered—usually an intervening Supreme Court decision.

In many cases in which the Court issues such orders, the remanded case is on all fours with the new Supreme Court decision, and the circuit court’s decision on remand is a formality. That would not be true in Altera. Even so, if the Court were to issue such a GVR, it would send a clear message about what the Ninth Circuit would need to do on such a remand. Invoking the GVR procedure would allow the Court to vacate the Ninth Circuit’s Altera decision without having to entertain full briefing and argument. The Court often issues numerous GVR orders on the last day of its Term before breaking for the summer recess. That is usually at the end of June, though the timing could get extended somewhat this year because of the delays in the Court’s spring argument schedule caused by the coronavirus. But some resolution of the pending Altera petition should be expected within the next few weeks.

Supreme Court Opinion – DHS v. Regents of Univ. of Cal

Ninth Circuit Denies Petition for Rehearing

On Tuesday, the Ninth Circuit denied Altera’s petition for rehearing en banc (which petition we discussed in our recent post here). The order issuing that denial includes a strong, 22-page dissent written by Judge Smith and joined by Judges Callahan and Bade. (Ten judges recused themselves, meaning that the vote was 10-3 against rehearing.) The dissent made several arguments for why the petition should have been granted, taking aim at the panel’s reasoning in upholding the regulation and warning about the decision’s broader effects.

Quoting State Farm, the dissent stated that it would have invalidated the regulations because Treasury’s “‘explanation for its decision [ran] counter to the evidence before’ it.” When it promulgated the regulations, Treasury asserted that it was applying the traditional arm’s-length standard, stating that “‘unrelated parties entering into [cost-sharing arrangements] would generally share stock-based compensation costs.’” But the evidence showed that “unrelated entities do not share stock-based compensation costs.”

Although the dissent stated that “[t]his should be the end of our analysis,” it went on to explain why the panel’s decision violates the Chenery rule that courts cannot provide “‘a [purportedly] reasoned basis for the agency’s action that the agency itself has not given.’” The dissent observed that despite Treasury’s clear statement in the preamble that its cost-sharing rule was “based on a traditional arm’s length analysis employing (unsubstantiated) comparable transactions,” the panel upheld “Treasury’s convenient litigating position on appeal that it permissibly jettisoned the traditional arm’s length standard altogether.” That mismatch undermines the regulation’s validity under APA notice-and-comment principles because Treasury cannot offer one rationale in its preamble, dismiss public comments on that rationale, “and then defend its rule in litigation using reasoning the public never had notice of.” Compounding this notice problem, the panel accepted Treasury’s argument that it could jettison a traditional arm’s length analysis because of the addition of the “commensurate-with-income” sentence to section 482 in 1986. But Treasury had stated in the 1988 White Paper that the addition of that sentence did not amount to a “departure from the arm’s length standard.” So not only did the panel uphold the regulation based on a rationale that Treasury did not offer in its preamble, it also upheld the regulation based on a rationale that Treasury itself had previously disclaimed.

The dissent also took up a cause that we’ve explored here before. By its own terms, the commensurate-with-income provision in section 482 applies only to “transfers of intangible property.” The panel concluded that provision was implicated here because there were “future distribution rights” transferred in Altera’s cost-sharing arrangement. The dissent disagreed because (1) cost-sharing agreements contemplate the “development” of intangibles, which implies that not every intangible subject to the arrangement must have been transferred to the arrangement, and (2) the intangibles enumerated in the pertinent regulation do not include future intangibles because they are all “property types that currently exist.” The dissent therefore concluded that the commensurate-with-income language “simply does not apply to” cost-sharing arrangements.

Finally, the dissent detailed three “particularly deleterious” consequences of the panel’s decision. First, the decision will “likely upset the uniform application of the challenged regulation” because the Tax Court’s decision invalidating the regulation still applies to taxpayers outside of the Ninth Circuit. Second, the decision “tramples on the longstanding reliance interests of American businesses,” many of whom relied not just on the Tax Court unanimously invalidating the regulation but also on Treasury reaffirming the primacy of the arm’s-length standard in the 1988 White Paper and the 2003 regulatory preamble. The dissent observed that these reliance interests are far-reaching because at least 56 major companies have noted the Altera issue in annual reports. Third, the decision threatens international tax law uniformity insofar as the arm’s-length standard (setting aside GILTI and the latest from the OECD) has been the method for allocating taxable income among major developed nations.

At a minimum, the dissent should strengthen the Tax Court’s resolve to invalidate the regulation again for taxpayers from other circuits—the dissent remarked on the “uncommon unanimity and severity of censure” in the Tax Court’s decision. And the dissent can be read as encouragement for Altera to seek certiorari—the dissent stated that the panel’s reversal of a Tax Court decision that would have applied nationwide produces “a situation akin to a circuit split.” Unless extended, the time for Altera to file a petition for certiorari will expire on February 10.

Thanks to Colin Handzo for his help with this post.

Altera – Ninth Circuit Rehearing Denial

Reflections on the Ninth Circuit’s Decision in Amazon.com

Although some time has passed (and we’ve fallen short of our hope here to get something up “soon”), we nevertheless wanted to post some thoughts on the Ninth Circuit’s unanimous affirmance of the taxpayer’s victory in the Tax Court in Amazon.com while also revisiting some of the topics that we covered here after oral argument. The panel’s opinion is brief, but it touched on several important aspects of the law under section 482.

Finding Ambiguity in the Regulatory Definition of “Intangible”

As you’ll recall, the primary dispute on appeal was whether the regulatory definition of “intangible” under Treas. Reg. § 1.482-4(b) included residual business assets like goodwill, going concern, and the amorphous notions of “growth options” and “culture of continuous innovation” that the government theorized the taxpayer made available in its cost-sharing agreement.

The taxpayer argued that the definition excluded such residual business assets because it did not expressly list them in any of the six subparagraphs of the definition. And the taxpayer argued that the 28 specified items in the regulation all “can be sold independently” from the business while the residual business assets cannot, invoking the statutory-interpretation canon of ejusdem generis to reason that the regulation therefore excludes residual business assets (which cannot be sold without a sale of the entire business).

The government argued that those residual business assets fell under the sixth subparagraph of Treas. Reg. § 1.482-4(b), which provides that “intangible” includes “other similar items” and that “an item is considered similar … if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” Since residual business assets do not derive their value from physical attributes but from other intangible properties, the government reasoned, they must be included here. And the government went on to argue that residual business assets must be compensable because otherwise, taxpayers could have transferred assets of value to a cost-sharing arrangement without compensation, which the government asserts would have violated the arm’s-length principle that undergirds section 482 and its regulations.

The panel held that although the taxpayer’s “focus on the commonality of the 28 specified items has some force,” that argument did not carry the day. The panel drew this conclusion from the plain language in the sixth subparagraph: that paragraph does not state that the commonality is that each item “can be sold independently” but rather states that each item “derives its value … from its intellectual content or other intangible properties.” The panel reasoned that the regulation therefore “leaves open the possibility of a non-listed item being included in the definition even if it doesn’t share the attribute of being separately transferable.” The panel thus echoed the concern that Judge Fletcher raised at oral argument—that while the 28 specified items share the commonality of being independently transferable, that commonality is “not the one the text [describing what constitutes a ‘similar item’ under the regulation] gives me.”

Resolving the Ambiguity by Looking to the Drafting History of the Regulation

After concluding that the regulatory definition “is susceptible to, but does not compel, an interpretation that embraces residual-business assets,” the panel looked to the overall regulatory scheme but held that to be inconclusive. The panel then turned to the drafting history of Treas. Reg. § 1.482-4(b) and found it to show that Treasury’s 1994 final regulations (which amended the sixth subparagraph of Treas. Reg. § 1.482-4(b)) both (1) exclude residual business assets from the definition of intangible and (2) provide reason to think that the definition of “intangible” includes only independently transferable assets.

The panel described how when Treasury issued temporary and proposed regulations in 1993, it asked “whether the definition of intangible property … should be expanded to include … goodwill or going concern value.” The panel concluded that since Treasury asked whether the definition should be “expanded” to include residual business assets, those assets were not included in the then-existing definition. And when Treasury issued final regulations in 1994 without expressly enumerating goodwill or going concern value in that definition, Treasury stated that its final rule “merely ‘clarified’ when an item would be deemed similar to the 28 items listed in the definition.” The panel concluded that by its own admission, Treasury would have needed to “expand” the definition to include residual business assets but instead opted to merely “clarif[y]” its definition, and therefore Treasury did not intend for the 1994 final regulations to include residual business assets.

Moreover, Treasury’s 1993 regulations limited the universe of compensable intangibles to “any commercially transferable interest.” But when it issued final regulations in 1994, Treasury dropped the “commercially transferable interest” language because “it was superfluous: if the property was not commercially transferable, then it could not have been transferred in a controlled transaction.” The panel concluded that the transfer-pricing regulations thus “contemplate a situation in which particular assets are transferred from one entity to another.” Since Treasury stated that it would have been “superfluous” to expressly state that the definition of “intangible” includes only commercially transferable assets, the panel held that the regulatory history “strongly supports Amazon’s position that Treasury limited the definition of ‘intangible’ to independently transferable assets.”

That the panel found this history dispositive comes as no surprise. We observed in our prior post that both Judge Callahan and Judge Christen recounted the regulatory history, with Judge Callahan questioning government counsel about whether Treasury ever expressed an intent to expand the definition to include residual business assets.

What Is the Rationale for Including Only Independently Transferable Assets in the Definition of Intangible?

Although the panel’s explanation for how it concluded that the definition of intangibles includes only independently transferable assets is explicit, the rationale for why Treasury would include only independently transferable assets is markedly subtler. It’s possible, however, to cobble together an explanation from other statements in the decision.

The first clue is when the panel looked to the genesis of the cost-sharing regulations, where Treasury identified “intangibles as being the product of R&D efforts.” In that sense, the panel reasoned, the “regulations seem to exclude” residual business assets, “which ‘are generated by earning income, not by incurring deductions.’” This distinction is clear enough—businesses incur expenses in undertaking R&D efforts, while goodwill and going concern value are byproducts of a well-run and successful business.

Why does this distinction matter? One answer lies in the legislative history and policy underpinnings for the statutory definition of “intangibles.” As the panel observed in a footnote, the “Senate Report states that the Committee viewed the bill as combatting the practice of transferring intangibles ‘created, developed or acquired in the United States’ to foreign entities to generate income tax free.” Which is to say that one animating concern in defining intangibles was to prevent U.S. entities from developing intangibles domestically but then transferring those intangibles to foreign affiliates whose income is not subject to U.S. tax.

And the reason why this is a concern for intangibles that result from R&D and other independently transferrable assets but not goodwill or going-concern value should be apparent: while the former involve expenditures that are deductible against U.S. income (but where the asset transfer will prevent the income from being taxed in the U.S.), the latter involve assets that exist only if the taxpayer has generated business income in the U.S. in the first place. In other words, the definition of “intangible” was initially meant to prevent taxpayers from incurring expenses to create intangibles in the U.S. and deducting those expenses against U.S. income, but then turning around and transferring those intangibles to foreign affiliates that may not owe U.S. tax on the income resulting from those intangibles.

Distinguishing the Definition of “Intangibles” from the Value of Those Intangibles

On brief and at oral argument, the government repeatedly cited deposition testimony by one of the taxpayer’s experts in which that expert admitted that parties at arm’s length would pay for residual business assets. The government tried to leverage that admission to argue that the arm’s-length standard itself means that residual business assets are compensable because “it is undisputed that a company entering into the same transaction under the same circumstances with an unrelated party would have required compensation.”

The panel addressed that argument in a footnote, holding that the government’s argument “misses the mark.” The panel explained that while the arm’s-length standard “governs the valuation of intangibles; it doesn’t answer whether an item is an intangible.” This is a decisive response to the government’s arguments; it cannot be the case that any value associated with a business falls under the definition of “intangible.”

Putting Footnote 1 in Context

One aspect of the panel’s decision that is certain to receive attention in future transfer-pricing disputes is the discussion in the first footnote. In that footnote, the panel described the 2009 changes to the cost-sharing regulations as “broadening the scope of contributions for which compensation must be made” and explained that the TCJA “amended the definition of ‘intangible property’” in section 936(h)(3)(b). The footnote then stated that “[i]f this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the Commissioner’s position would be correct.”

There are a few things worth noting about this footnote, the first of which is arguably the most important: It’s dicta. The question of whether residual assets are compensable under the 2009 cost-sharing regulations or the 2017 statutory amendment was not before the court. And since the panel says nearly nothing in the footnote about the language in those 2009 regulations or the TCJA amendment, there is no reason to think that the panel gave material consideration to whether the outcome in the case would have been different under either.

Second, given some of the panel’s other statements, it is not so clear that “there is no doubt the Commissioner’s position would be correct” for years after the 2009 changes to the regulations. Recall that the government’s case was predicated on charging a higher buy-in for the purported transfer of “growth options” and a “culture of continuous innovation” to the cost-sharing arrangement. Although the 2009 regulatory amendments changed the cost-sharing regulations and TCJA amended the statutory definition for “intangibles,” there was no change to the definition under Treas. Reg. § 1.482-4(b). That regulation provides that an item not otherwise specified is an intangible only if it “has substantial value independent of the services of any individual.” The panel itself expressed serious doubt about whether the purported intangibles in this case met that requirement, stating that “residual business assets, such as ‘growth options’ and a ‘culture of innovation,’ are amorphous, and it’s not self-evident whether such assets have ‘substantial value independent of the services of any individual.’”

Finally, the TCJA amendments would affect the result in the case only if the purported “growth options” and “culture of continuous innovation” are items of property that fall under the new statutory category of “goodwill, going concern value, or workforce in place” or constitute an item “the value or potential value of which is not attributable to … the services of any individual.” But there is reason to think that the government is itself unconvinced that “growth options” and “culture of continuous innovation” fall under that new statutory category. At oral argument, the panel asked government counsel why, if Treasury meant to expand the definition of “intangible” with its 1994 changes, Treasury didn’t just add “goodwill and going concern” to the list. In response, government counsel argued that merely adding “goodwill and going concern” to the list would not have solved anything because then taxpayers would just fight about whether particular assets fell under those additions to the list. The government cannot coherently maintain both that (1) Treasury could not have achieved the Commissioner’s desired result in this case by expanding the regulatory list to include goodwill and going concern in 1994 and (2) Congress’s addition of goodwill and going concern to the list in TCJA would change the result in this case. Even though Congress meant to change the result in cases like this, government counsel’s argument suggests an absence of faith that expanding the list succeeds in changing the result.

Whether the Commissioner’s Litigating Position Warrants Auer Deference

The government also argued that under Auer, the Tax Court should have deferred to the Commissioner’s interpretation of Treas. Reg. § 1.482-4(b) as including residual business assets. The panel rejected this argument for two reasons.

First, the panel found that pursuant to the Supreme Court’s decision in Kisor, the Commissioner’s interpretation warrants Auer deference only if the regulation is “genuinely ambiguous.” The panel states that Auer thus implicates a higher standard for ambiguity. Under that standard, a regulation is “genuinely ambiguous” for Auer purposes only if ambiguity remains once the court has exhausted the traditional tools of construction, which requires it to consider “the text, structure, history, and purpose of a regulation.” The panel concluded that the text of Treas. Reg. § 1.482-4(b), its place in the transfer-pricing regulations, and its rulemaking history “leave little room for the Commissioner’s proffered meaning.” The panel’s holding is therefore that the definition of “intangible” under Treas. Reg. § 1.482-4(b) is ambiguous but not genuinely ambiguous.

Second, the panel also rejected the government’s deference argument because the government first advanced an interpretation of Treas. Reg. § 1.482-4(b) in the litigation that had never appeared in the drafting history of the regulations or anywhere else. As we remarked earlier, reliance concerns loomed large at oral argument, and especially in Judge Callahan’s questions. The panel’s conclusion that “Amazon and other taxpayers were not given fair warning of the Commissioner’s current interpretation of the regulatory definition of an ‘intangible’” was thus foreseeable from oral argument.

Whether the Cost-Sharing Regulations Provide a Safe Harbor

As we observed in our prior post, at oral argument the government disavowed the notion that the Treasury Regulations create a safe-harbor for cost-sharing arrangements. We surmised that whether the Ninth Circuit agreed with the government on this point might be pivotal in the outcome.

While the extent to which that issue factored into the panel’s decision is not evident, the panel’s decision is entirely consistent with the notion that cost sharing operates as a safe harbor. First, the panel described cost sharing as “an alternative to licensing … under which [the parties to the cost-sharing arrangement] become co-owners of intangibles as a result of the entities’ joint R&D efforts.” If the cost-sharing arrangement qualifies, then it “provides the taxpayer the benefit of certainty because … new intangibles need not be valued as they are developed.” But the panel explained that the certainty comes at a price—the R&D payments by the foreign cost-sharing participants “serve to reduce the deductions the [domestic] taxpayer can take for the R&D costs (thereby increasing tax liability).” What the panel thus described operates like a safe harbor—taxpayers that ensure that their cost-sharing arrangements qualify and sacrifice some deductions for intangible development costs can gain certainty that their intangibles need not be re-valued. The panel’s decision will hamper any future IRS arguments that cost-sharing does not operate like a safe harbor.

Procedural Status

The government did not file a petition for rehearing in the case; the mandate issued on October 8. There is still time for the government to file a petition for certiorari; it is due November 14.

Ninth Circuit Affirms Tax Court in Amazon.com

In a unanimous opinion issued today, the Ninth Circuit affirmed the taxpayer’s victory in the Tax Court in Amazon.com. We previously covered the case and oral argument here. We will take some time to digest the opinion and post on its finer points soon. In the meantime, one key sentence in the opinion is worth noting because it appears to capture the thrust of the Ninth Circuit’s decision about the disputed scope of the relevant regulatory definition for the term “intangible”: “Although the language of the definition is ambiguous, the drafting history of the regulations shows that ‘intangible’ was understood to be limited to independently transferable assets.”

Amazon.com Ninth Circuit Opinion

Petition for Rehearing En Banc Filed in Altera

As most expected, Altera filed a petition for rehearing en banc after the reconstituted three-judge panel decided to reverse the Tax Court’s invalidation of Treasury’s cost-sharing regulations. (A link to the petition is below.) As we explained previously, those regulations have been the subject of much controversy over the last two decades, and the success that Xilinx had with its petition for rehearing several years ago made it likely that Altera would ask for rehearing.

The petition picks up on one of the themes we discussed in our most recent post here. The taxpayer takes aim at the majority’s conclusion that the “commensurate with income” language added to section 482 in 1986 is relevant in the cost-sharing context. The taxpayer argues that language was aimed at addressing a different issue from the one before the court here—“how to value transfers of existing intangible property from one related entity to another” and not “intangible property yet to be created.”

The taxpayer makes four or five (the petition combines arguments (3) and (4) below) arguments for why its petition should be granted:

(1) The decision upsets settled principles about the application of the arm’s-length standard because the majority permitted Treasury to “cast aside the settled arm’s-length standard” for “a new standard” that is “purely internal.”

(2) The decision “validates bad rulemaking” because, contrary to the majority’s account of the regulation’s history, “[n]o one involved in the rulemaking thought the IRS was interpreting ‘commensurate with income’ to justify a new standard that did not depend on empirical evidence.” And under the law in Chenery, the court must assess the “‘propriety of [the agency’s] action solely by the grounds invoked by the [agency]’ in the administrative record.”

(3) The decision is irreconcilable with the Ninth Circuit’s decision in Xilinx, which held that parties would not share in employee stock option costs at arm’s length.

(4) The decision “threatens the uniform application of the tax law” because, under the Golsen rule, the Tax Court will continue to apply its unanimous decision declaring the regulation invalid to cases arising anywhere outside the Ninth Circuit.

(5) As evidenced by the glut of amicus briefs, the treatment of employee stock options in cost-sharing arrangements is “exceptionally important.”

It is likely that additional amicus briefs will be filed in support of the rehearing petition. And given the prominence of the issue, we anticipate that the court will order the government to file a response to the petition. We will report on further developments as warranted.

Altera Petition for Rehearing En Banc July 2019

Observations on Changes in the Ninth Circuit’s Second Altera Decision

As we posted earlier here (with a link to the new decision), the Ninth Circuit issued a new decision in Altera after replacing the late Judge Reinhardt with Judge Graber on the panel. But the result was the same as the withdrawn July 2018 decision—the Ninth Circuit upheld the validity of Treasury’s cost-sharing regulation that requires taxpayers to include the cost of employee stock options under qualifying cost sharing arrangements (QCSAs). Today, we present some observations after comparing the majority and dissent in the new decision with those in the Ninth Circuit’s withdrawn decision.

In the new decision, Judge Thomas recycled much of the language and logic from his withdrawn opinion, and Judge O’Malley reused much of her original dissent. Although they are few, some changes in the two opinions are interesting and notable. Overall, the changes serve to sharpen the disagreements between the parties (and the disagreements between the majority and dissent) in ways that will focus the discussion in the likely event of a rehearing en banc petition (or possible petition for certiorari). We focus here on two aspects of the changes.

Was There a Transfer of Intangibles that Implicated the Commensurate-With-Income Language in the Second Sentence of Section 482?

The majority did not address this issue in its withdrawn opinion, so some background is in order. When Treasury proposed cost-sharing regulations that explicitly required related parties to include employee-stock-option costs in the pool of shared costs, commenters put forward evidence that unrelated parties do not share employee-stock-option costs. But Treasury did not heed those comments and ultimately determined that the arm’s-length standard would be met if the regulations required taxpayers in QCSAs to include the cost of employee stock options in the pool of shared costs, regardless of what a comparability analysis might show about whether unrelated parties share those costs. So in order to uphold the Treasury Regulations, the majority had to conclude that the arm’s-length standard under section 482 does not mandate the use of comparable transactions.

In reaching that conclusion, the majority relied on the history of section 482 and especially on the addition of the second sentence of section 482. That second sentence provides that “[i]n 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.” The majority held that the Congressional intent behind the addition of that language in 1986 is what made it reasonable for Treasury to conclude that it was permitted “to dispense with a comparable transaction analysis in the absence of actual comparable transactions.”

Was there a “transfer (or license) of intangible property” such that Treasury could invoke the commensurate-with-income language to justify dispensing with a comparable-transaction analysis? There was indeed a transfer of intangibles at the outset of the QCSA in this case; Altera transferred intangible property to its QCSA with its foreign subsidiary. But that initial transfer is unrelated to the disputed employee-stock-option costs. Those stock-option costs relate to subsequently developed intangibles, not to the value of the pre-existing intangibles that Altera initially contributed. Then-applicable Treasury Regulation § 1.482-7A(g)(2) required a buy-in payment only for “pre-existing intangibles.”

It is, then, wholly unclear how those employee-stock-option costs for as-yet undeveloped intangibles constitute a “transfer (or license) of intangible property” such that the commensurate-with-income language is implicated at all. The taxpayer argued—both in its initial and supplemental briefing—that by its own terms, the commensurate-with-income language is not implicated once a QCSA is in place and therefore that language is irrelevant to the dispute. The taxpayer reasoned that “no ‘transfer (or license)’ occurs when entities develop intangibles jointly” because jointly developed intangibles “are not transferred or licensed between the parties, but rather are owned upon their creation by each participant.”

The majority said little about this issue in its withdrawn opinion and did not address the taxpayer’s argument. In its new opinion, the majority addressed the argument and declared itself “unpersuaded.” It held that “[w]hen parties enter into a QCSA, they are transferring future distribution rights to intangibles, albeit intangibles that are yet to be developed.” The majority does not, however, explain how “intangibles that are yet to be developed” are “pre-existing intangible property” under Treas. Reg. § 1.482-7A(g)(2) or, perhaps more importantly, how such undeveloped future intangibles can constitute intangible assets at all under the words of the statute. Instead, the majority leaned on the language in the second sentence of section 482 providing that the commensurate-with-income standard applies to “any” transfer of intangible property, holding that “that phrasing is as broad as possible, and it cannot reasonably be read to exclude the transfers of expected intangible property.”

The dissent seized on whether there was any transfer of intangibles that implicated the commensurate-with-income language. The dissent stated that “[t]he plain text of the statute limits the application of the commensurate with income standard to only transfers or licenses of intangible property.” And it observed that there is a contradiction between the majority’s conclusion that QCSAs “constitute transfers of already existing property” and Treasury’s own characterization (in the very preamble of the disputed regulations) of QCSAs “as arrangements ‘for the development of high-profit intangibles,’” inferring that parties cannot transfer something that is not yet developed. The dissent concluded that Treasury’s failure to make “a finding that QCSAs constitute transfers of intangible property” should be, as a matter of review under the APA, fatal to Treasury’s cost-sharing regulations.

Has the Arm’s-Length Standard Historically Required a Comparable-Transaction Analysis?

The majority made several changes from its withdrawn opinion in its account of the history of the arm’s-length standard under section 482. The changes appear to be aimed at bolstering the majority’s conclusion that Treasury was justified in concluding that the arm’s-length standard does not necessitate a comparable-transaction analysis. These changes take a couple of forms.

First, the changes add justifications for the proposition that the arm’s-length standard has not always mandated a comparable-transaction analysis in all cases. The withdrawn opinion included some evidence for this historical account, recounting the Tax Court’s Seminole Flavor decision from 1945 (where the Tax Court “rejected a strict application of the arm’s length standard in favor of an inquiry into whether the allocation…was ‘fair and reasonable’”). In its new opinion, the majority added the observation that Treasury provided for an unspecified fourth method for pricing intangibles in its 1968 regulations. And the majority refined its discussion of the Ninth Circuit’s 1962 decision in Frank, still quoting the language from that opinion denying that “‘arm’s length bargaining’ is the sole criterion for applying” section 482 (as it did in the withdrawn opinion) but then adding the new assertion that the “central point” of Frank is that “the arm’s length standard based on comparable transactions was not the sole basis” for reallocating costs and income under section 482. (As the dissent pointed out, a later Ninth Circuit decision limited the holding in Frank to the complex circumstances in that case and noted that the parties in Frank had stipulated to apply a standard other than the arm’s-length standard.)

Second, the majority made changes to add a series of new and more sweeping assertions that under section 482, Treasury has always had the leeway to dispense with comparable-transaction analyses in deriving the correct arm’s-length price. For instance, as a rejoinder to the taxpayer’s argument that the arm’s-length standard requires a comparable-transaction analysis, the majority wrote that “historically the definition of the arm’s length standard has been a more fluid one” and that “courts for more than half a century have held that a comparable transaction analysis was not the exclusive methodology to be employed under the statute.” It added similarly broad historical statements elsewhere in the new opinion, all in service of concluding that Treasury acted reasonably in dispensing with a comparable-transaction analysis in its cost-sharing regulations: “[a]s demonstrated by nearly a century of interpreting § 482 and its precursor, the arm’s length standard is not necessarily confined to one methodology” (p. 33); “the arm’s length standard has historically been understood as more fluid than Altera suggests” (p. 41); and “[g]iven the long history of the application of other methods…Treasury’s understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable” (p. 49).

In one of the subtler but more interesting changes from the withdrawn opinion, the majority’s new opinion removed a single word. In its withdrawn opinion, the majority said that Treasury’s 1988 White Paper “signaled a dramatic shift in the interpretation of the arm’s length standard” by advancing the “basic arm’s length return method…that would apply only in the absence of comparable transactions….” (emphasis added). But consistent with its conclusion in the new opinion that “for most of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology,” the majority appears to have concluded that shift in the White Paper was not so “dramatic,” dropping that word altogether in its new opinion. (In this vein, the majority also removed its assertion in the withdrawn opinion that “[t]he novelty of the 1968 regulations was their focus on comparability.”)

The new dissenting opinion disputed the majority’s historical account, stating that the first sentence of section 482 “has always been viewed as requiring an arm’s length standard” and that before the 1986 amendment, the Ninth Circuit “believed that an arm’s length standard based on comparable transactions was the sole basis for allocating costs and income under the statute in all but the narrow circumstances outlined in Frank.” And the dissent observed that even with the 1986 addition of the commensurate-with-income language, “Congress left the first sentence of § 482—the sentence that undisputedly incorporates the arm’s length standard—intact,” thus requiring a comparable-transaction analysis everywhere that comparable transactions can be found. The dissent pointed out that the White Paper clarified that this was true “even in the context of transfers or licenses of intangible property,” quoting Treasury’s own statement in the White Paper that in that context the “‘intangible income must be allocated on the basis of comparable transactions if comparables exist.’”

Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera

The Ninth Circuit issued a new opinion in Altera today after having withdrawn its July 2018 opinion. But today’s opinion does not change the result—by a 2-1 vote, the Ninth Circuit upheld the validity of the Treasury Regulation under section 482 that requires taxpayers to include the cost of employee stock options in the pool of costs that must be shared in qualifying cost sharing arrangements. Judge Thomas again wrote the panel’s opinion, Judge O’Malley again dissented, and Judge Graber—who was added to the panel to replace the late Judge Reinhardt—voted with Judge Thomas.

Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison.

The taxpayer may seek a rehearing of the decision by the full Ninth Circuit (which is likely after the success that another taxpayer had in the Ninth Circuit’s rehearing of a similar issue in Xilinx). A petition for rehearing would be due July 22.

Altera Ninth Circuit Opinion June 2019

Both Parties Face Tough Questions in Amazon.com Ninth Circuit Argument

As we previewed here, the Ninth Circuit heard oral argument in Amazon.com v. Commissioner on Friday, April 12. Before giving a detailed recap of that oral argument, some background on the dispute is in order.

The Primary Issue in Dispute

Amazon.com, the U.S. parent company (Amazon US), entered into a qualified cost-sharing agreement with its Luxembourg subsidiary (AEHT) in 2005. Amazon US contributed the intangible assets required to operate its European website business to that cost-sharing agreement. Then effective Treas. Reg. § 1.482-7(g)(2) provided that AEHT owed Amazon US a buy-in payment for the “pre-existing intangibles” that Amazon US contributed. Although AEHT made a buy-in payment for that contribution of over $100 million, the IRS determined that the buy-in should have been $2.7 billion higher.

At trial, the parties submitted competing valuations of the contributed pre-existing intangibles—the taxpayer used comparable uncontrolled transactions (CUTs) to separately price the website technology, marketing intangibles, and European customer information that Amazon US contributed; the Commissioner used a discounted-cash-flow (DCF) method to determine the present value of the projected future income that AEHT would earn using the contributed intangibles. Underlying the methodological differences between the parties, however, is a fundamental dispute about the scope of the pre-existing intangibles for which AEHT owed a buy-in payment.

The taxpayer’s position was that AEHT owed a buy-in payment for only those intangibles enumerated in the definition of “intangible” in Treas. Reg. § 1.482-4(b), which definition does not expressly include so-called “residual” business assets like goodwill and going-concern value, and that the taxpayer’s CUT method accurately priced the enumerated intangibles that Amazon US contributed. The Commissioner argued that despite not explicitly naming residual business assets, any such assets are included in the definition of “intangible” in Treas. Reg. § 1.482-4(b)(6) and that only his DCF method captured the value of those residual business assets. He also argued that the bundle of compensable pre-existing intangibles that Amazon US made available in the cost-sharing arrangement included its “culture of continuous innovation” and other unspecified “growth options.”

Treas. Reg. § 1.482-4(b) provides that “[f]or purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual—” and then lists 28 specified intangibles in the first five subparagraphs (like patents and trademarks) and concludes with a sixth subparagraph that states that the definition encompasses “[o]ther similar items.” That subparagraph goes on to say that “[f]or purposes of section 482, an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.”

The Tax Court sided with the taxpayer’s reading of Treas. Reg. § 1.482-4(b), concluding that the Commissioner’s DCF included the value of residual business assets that were not “pre-existing intangibles” under the cost-sharing regulations. The Tax Court made some material adjustments to the taxpayer’s CUTs, ultimately finding that AEHT owed a higher buy-in, albeit nowhere near the size of the Commissioner’s proposed adjustment. The government appealed the Tax Court’s decision on legal grounds, arguing that the pertinent Treasury Regulations do not foreclose the DCF method that was the basis for the Commissioner’s adjustments. The government argued in its brief that “[t]he Treasury Regulations broadly define intangibles and do not exclude residual-business assets from the scope of the buy-in requirement.” Oral argument at the Ninth Circuit was held before the three-judge panel of Judges Fletcher, Callahan, and Christen. (The video is available here.)

Plain Language of the Regulation

Government counsel started oral argument by asserting that the plain language of Treas. Reg. § 1.482-4(b) favored the government’s position because the regulatory definition of “intangible” was so broad that it must include residual business assets like “growth options” and “corporate culture.” In support, she argued that the sixth regulatory category of “other similar items” is “written so broadly to include any item that derives its value from anything other than physical attributes.”

Amazon’s counsel responded that the government’s argument proves too much. If the definition of “intangible” truly encompassed any asset that is not tangible, then it would belie the regulation’s enumeration of 28 items that count as “intangibles” under the regulatory definition. As Amazon argued in its brief, “[i]f Treasury intended to capture all intangibles, there would have been no reason to specify any particular types of intangibles, let alone list 28 of them.” Amazon’s brief went on to argue that the court should be guided by the interpretive canon of ejusdem generis. That canon requires the court to “focus ‘on the common attribute’ of the list of items that precedes the catch-all.”

This meant, however, that Amazon’s counsel had to explain what that “common attribute” is. He argued that the 28 listed items share characteristics that the residual business assets do not have—the 28 listed items are independently transferable and created by expenditures, but residual intangibles are not independent of the business and are the product of the operation’s income-producing success. As for why the list includes only items that are independently transferable, taxpayer’s counsel argued that only those assets that can be transferred independent of the entire business are susceptible to valuation while residual business assets like goodwill or so-called “growth options” were inextricable from the entire business and impossible to value with any precision.

But the panel questioned Amazon’s invocation of ejusdem generis. Judge Callahan asked why the court should apply that canon here where the regulation defines what it means to be similar (providing that “an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties”). And in his only remarks of the day, Judge Fletcher called the taxpayer’s ejusdem generis argument “somewhat peculiar.” He went on to remark that he understood Amazon counsel’s explanation of what the 28 enumerated items had in common “but it’s not the one the text gives me,” going on to state that if he were “a pure textualist, you lose.” (Judge Fletcher’s remarks may not indicate how he will vote; he prefaced his remarks with the assertion that “I’m not sure that in the end that I would disagree with your position.”)

The description of “other similar items” was not the only regulatory language that drew the panel’s attention. Judge Christen questioned government counsel about how to reconcile the government’s reading of “other similar items” to include residual business assets like “corporate culture” with the regulation’s limitation that the universe of intangibles was limited to only those assets that have “substantial value independent of the services of any individual.” (That language played a role in the Tax Court’s decision; it found that residual business assets like goodwill and growth options “often do not have ‘substantial value independent of the services of any individual.’”) Amazon made the same point in its brief, arguing that its purported “culture of innovation” is “inseparable from the individuals in the company’s workforce.” And Judge Christen appeared unmoved by government counsel’s attempt to explain away that language by arguing that while the “value” of the intangible needs to be independent of services, the “intangible itself” does not need to be independent and that other expressly listed items—like “know-how”—were not entirely independent of services.

Regulatory History

Taxpayer’s counsel attacked the government’s case as based on reading the regulatory language in the abstract, divorced entirely from its context and history. The applicable definition of “intangibles” in Treas. Reg. § 1.482-4(b) was the result of regulatory changes in 1994. Before making those regulatory changes, Treasury asked for comments on whether it should “expand” the definition of “intangibles” to include observed assets like goodwill and going concern. It received comments that the definition should not be expanded, and when Treasury issued revised regulations, it noted that it added language to the “other similar items” subparagraph but described the change as a “clarifi[cation].” Amazon’s counsel recounted this history and argued that since Treasury acknowledged that the definition would have to be expanded to include residual business assets, “Treasury could not thereafter ‘clarify’ that these intangibles had been included all along.” This was, in the words of taxpayer’s counsel, a classic case of “regulator’s remorse.”

In questioning government counsel, both Judge Callahan and Judge Christen recounted the same regulatory history and observed that Treasury asked if it should expand the definition and ultimately called its change a clarification. Judge Callahan asked whether the government could point the panel to specific language where Treasury said it intended to expand its definition to include residual business assets.

Government counsel acknowledged that Treasury used the word “clarified” in the preamble but offered a different history of the regulatory language. She argued that some initial Treasury guidance included “goodwill, consumer acceptance, and market share” as intangibles (all of which could not be transferred independent of the business) and pointed to other statutory changes and another court decision as narrowing the definition beyond what Treasury initially intended.

Government counsel also had to explain why, if Treasury had in fact expanded the definition of “intangibles” to include residual business assets, it did so by amending the definition of “other similar items” rather than just adding residual business assets to the list. She argued that Treasury opted for the latter because merely listing residual business assets like “goodwill” would just precipitate fights about whether intangibles (like the so-called “growth options” that the government says Amazon US contributed to its cost-sharing agreement) fell within the scope of the listed residual business assets. Judge Callahan acknowledged that potential issue but replied that if Treasury had expressly included “goodwill” or “going concern” the taxpayers “wouldn’t have had as good of an argument” that the disputed residual business assets here are excluded, and government counsel conceded that it was less likely that the taxpayer would have won below in that circumstance.

Subsequent Statutory Changes

In the tax reform legislation enacted in 2017 (the TCJA), Congress took steps to address the concern that government counsel raised at oral argument—the transfer of residual business assets without compensation. Congress amended section 936(h) (which is the operative definition of “intangible” for purposes of section 482 by cross-reference) to expressly include goodwill and going concern. Government counsel acknowledged that with the TCJA, “Congress has codified our interpretation of” the “other similar items” provision.

Judge Callahan observed that Congress did not say that they were clarifying what has always been true, and government counsel agreed. And Judge Callahan rehearsed Amazon’s argument that if Congress needed to amend that definition, then it’s reasonable to infer that—contrary to the government’s interpretation—the definition did not always include those residual business assets. She then gave Amazon’s counsel the opportunity to identify what he thought was the best indication in the legislative history that the statutory addition of goodwill and going concern value is a revision and not a clarification of the definition of “intangible.” He answered that the best indicator is the conference report’s description of the change as a “revision” of the definition. He then went on to argue that given the statutory language, no one could “realistically think that isn’t a vast shift” in the definition’s scope. And he added that because the TCJA effected an enormous rewrite to the Code, it is only reasonable to think that the change to add goodwill and going concern was a substantial revision.

But the legislative change did not categorically favor Amazon’s case. Although Judge Christen remarked that the legislative history for the TCJA change is “compelling,” she pressed Amazon’s counsel on the tension between, on the one hand, the new statutory requirement to include the value of goodwill and going concern as pre-existing intangibles and, on the other hand, Amazon’s argument that Treasury opted to exclude those assets from the definition of “intangibles” because they are “impossible” to value independent of the entire business. And government counsel tried to capitalize on this tension in her rebuttal, arguing that although it is difficult to value residual business assets, the DCF—which values all intangibles together—is the panacea to this problem and that is why the government seeks the Ninth Circuit’s endorsement of that method.

Cost Sharing and the Arm’s-Length Standard

One cornerstone of government counsel’s argument was that the government’s interpretation of the definition of intangible must be correct because “nothing of value can be transferred for free.” And the government—both on brief and in oral argument—made much of the taxpayer’s expert’s admission on cross-examination that parties at arm’s length would have paid for all the value associated with residual business assets because “‘no company is going to give away something of value without compensation.’” The government tried to tie this admission in with the arm’s length principle that is the lodestar of section 482. The government argued on brief that the Tax Court was “not free to disregard” the arm’s-length principle, which meant, according to the government, that the Tax Court was required to adopt a valuation that included residual business assets.

Amazon observed in its brief, however, that the arm’s-length principle also arguably supports its position. The Commissioner conceded that residual business assets “generally cannot be transferred independently from the business enterprise” and thus are not independently transferred in an arm’s-length transaction (absent the extraordinary alternative of selling the entire business), thus making it all the more plausible to think that Treasury did not contemplate taxpayers valuing them and paying a buy-in for those residual business assets in a cost-sharing agreement.

At oral argument, taxpayer’s counsel observed that the government’s argument is hard to reconcile with the very existence of the safe harbor created by the cost-sharing regulations. He argued that those regulations contemplated precisely what happened here—AEHT paid a buy-in for static intangibles, the parties shared R&D and other costs for developing new and better intangibles going forward “in a way that’s formulaic,” and then the parties benefitted from those co-developed intangibles according to that formula. Government counsel flatly disputed the notion that the 1986 and 1994 changes created a safe-harbor for cost-sharing arrangements. Although it didn’t receive significant attention at oral argument, whether the Ninth Circuit agrees with the taxpayer or the government on this point might be pivotal in the outcome.

The Nature and Life of the Residual Business Assets

One interesting feature of the government’s argument—both on brief and at oral argument—was its attempt to articulate the precise nature of the residual business assets that Amazon US transferred to its cost-sharing agreement “for free.” Counsel closely hewed to the brief’s description of those assets in oral argument, saying that the “other similar items” category was broad enough to include residual business assets like “growth options” and “corporate culture” (although the latter of these raises the obvious question of whether that culture can be independent of the services of any individual).

Amazon raised other problems with these purported assets in its brief, including the observation that the residual business assets (at least as the government conceives them) have apparently perpetual useful lives. If the government were to conceive of the assets as having unlimited useful lives, then its theory runs headlong into caselaw and the common-sense notion that no asset, however valuable, lasts forever. The government nevertheless bit the bullet on this issue, arguing in its brief that “[q]uite simply, existing technology begets new technology.” Judge Christen asked government counsel to answer for this position, and government counsel conceded that the government’s argument assumes perpetual lives for “certain assets in the bundle,” stating that under the government’s theory, “the corporate culture will last as long as the corporation is there.” But government counsel tried to downplay this concession, arguing that the terminal value of the perpetual assets was very small and that the Tax Court could have done with those residual assets what it had done with some marketing intangibles in the case—limit their useful lives to something like 20 years.

Taxpayer’s counsel reminded the panel of this useful-life problem in the context of responding to the government allegations that taxpayer transferred assets to the cost-sharing agreement for free. He argued that the Tax Court assigned substantial value to the intangibles that Amazon US contributed to the cost-sharing agreement, and in so doing, characterized those assets “static intangibles” with values that will ultimately dissipate.

Other Issues

A couple of other items from oral argument are worth noting. First, the government had argued on brief that the IRS’s interpretation of the regulation was owed deference. Perhaps wary that this deference principle may disappear in a few months when the Supreme Court decides the Kisor case (see our reports here), government counsel was quick to downplay that argument when Judge Callahan probed the topic: “That is a back-up argument; I don’t think the court needs to get there.” And the panel took issue with the fact that the government had no argument for the reasonableness of the IRS’s interpretation other than pointing to Congress’s 2017 change to the pertinent law as after-the-fact evidence. It was clear that deference argument did not sit well with Judge Callahan or Judge Christen, both of whom questioned how taxpayers were conceivably on notice of the interpretation of “other similar items” that the government was advocating in this case.

Second, Judge Callahan expressed a keen interest in how the court’s decision would affect other taxpayers, including those without Amazon’s “firepower.” Government counsel conceded that if the government were to prevail, the IRS could pursue other taxpayers using the Ninth Circuit’s interpretation of the 1994 regulations. Amazon’s counsel argued that the “entire business community” relied on the understanding that residual business assets were not compensable and structured their cost-sharing arrangements accordingly. But when the panel asked whether a reversal would affect taxpayers in all years before the TCJA, he acknowledged that the 2009 changes to the cost-sharing regulations that require a buy-in for “platform contributions,” which arguably already include some residual business assets.

Finally, at oral argument, government counsel repeatedly raised the “realistic alternatives” principle (which is now part of section 482 and was in the 482 regulations already), arguing that principle is “central to the arm’s-length standard” because no entity is going to accept a price that is less than one of its realistic alternatives and that the Tax Court’s opinion amounted to a “rewriting” of that principle. But on brief, the government posed no alternative transaction that achieved the ends of the cost-sharing agreement. Instead, it argued that the “realistic alternative” to the cost-sharing arrangement was “not entering into the cost-sharing arrangement and continuing to operate the European Business as it had before.” The taxpayer’s brief took this point head on, arguing that the regulations implementing the realistic-alternatives principle “did not allow the Commissioner to consider alternatives to cost-sharing itself.” The Tax Court had rejected the Commissioner’s argument at trial, finding that empowering the Commissioner to use the realistic-alternatives principle to price the transaction as if it never happened at all would “make the cost sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless.”

On balance, the panel’s questions and remarks appear to favor affirmance of the Tax Court. But both parties faced hard questions at oral argument. There is no deadline for the court’s ruling, and it will likely be several months before a decision is issued.

Amazon.com Tax Court Opinion

Ninth Circuit to Hear Oral Argument in Amazon Transfer-Pricing Dispute Friday

We wanted to alert our readers that oral argument in the Ninth Circuit in Amazon.com Inc. v. Commissioner will be held this Friday. Similar to Veritas Software Corp. v. Commissioner, this transfer-pricing dispute is about the value of intangibles that the U.S. parent contributed to a cost-sharing arrangement with a foreign subsidiary. In particular, the parties dispute whether particular intangibles, like goodwill and going concern values, are compensable and thus require a buy-in payment upon their contribution to a cost-sharing arrangement. The government lost in the Tax Court.

The briefs are below. The Ninth Circuit will stream the oral arguments (held in Seattle) live on its website here; Amazon is the last of five oral arguments to be heard beginning at 9:00 a.m. Pacific/12:00 p.m. Eastern Friday. There are 90 minutes of oral argument scheduled before Amazon (see the schedule here). You can also watch or listen to oral arguments after the fact in the Ninth Circuit’s archive here.

Amazon.com Government Opening Brief

Amazon.com Taxpayer Response Brief

Amazon.com Government Reply Brief

Altera Case Submitted for Decision

The reargument of the Altera case was held on October 16. Chief Judge Thomas, who penned the original majority decision, was quiet during the argument, asking only one question. But both Judge O’Malley, who wrote the original dissent, and Judge Graber, who is the new judge on the panel and who might reasonably be expected to cast the deciding vote, were very active questioners. A video tape of the argument can be viewed at this link.

The oral argument was not quite the last gasp in the parties’ presentations to the panel. At the end of the week, counsel for Altera filed a post-argument letter further addressing some of the points that were raised at the argument. The letter stated that some of the statements made by government counsel at the argument were contrary to the provisions of Treas. Reg. § 1.482-4(f)(2)(ii), and that these departures from the existing regulations underscored why adminstrative law principles “do not permit an abandonment of arm’s-length evidence and the parity principle, even if the statute permitted it, without complying with the rules governing administrative procedure.” The government filed its own letter in response, asserting that its counsel’s statements did “not contradict any Treasury regulations” and did not implicate the administrative law principles referenced by Altera.

These letters are attached below.

The case is now submitted for decision. Ordinarily, one would expect several months to elapse after argument before a decision from the Ninth Circuit would issue in a complex case. (The original opinion in this case was issued more than nine months after the oral argument.) Given that Judges Thomas and O’Malley have already written opinions in the case, however, it is very possible that a decision could come much sooner.

Altera – Altera post-argument letter

Altera – Government post-argument letter

 

Supplemental Briefing Completed in Altera

Attached are the four supplemental briefs filed by the parties in the Altera case.  First, in anticipation of the reargument of the case, with Judge Graber now sitting on the panel in place of the deceased Judge Reinhardt, the court invited the parties to file supplemental briefs limited to half of the length of a normal court of appeals brief.  This briefing opportunity was designed to give the parties the chance to restate or add to their arguments on the issues previously addressed in the case, having now had the opportunity to read the competing opinions of Judges Reinhardt and O’Malley that had been vacated.  Although the court’s order took pains to tell the parties that they were “permitted, but not obligated,” to file “optional” supplemental briefs, it will surprise no one that both parties took advantage of the option and filed supplemental briefs on September 28 that pressed right up against the 6500 word limit.  In addition to the parties’ briefs, four supplemental amicus briefs were filed by:  1) the Chamber of Commerce; 2) a group of trade associations; 3) Cisco; and 4) a group of law school professors, with that last one being in support of the government.

This deluge of paper, however, was not enough for the panel.  On the same day that the supplemental briefs were due, the court issued the following order inviting another set of supplemental briefs on the question whether Altera’s suit was barred by the statute of limitations:

“The parties should be prepared to discuss at oral argument the question as to whether the six-year statute of limitations applicable to procedural challenges under the Administrative Procedure Act, 28 U.S.C. 2401(a), applies to this case and, if it does, what the implications are for this appeal. Perez-Guzman v. Lynch, 835 F.3d 1066, 1077-79 (9th Cir. 2016), cert. denied, 138 S. Ct. 737 (2018). Additionally, the parties are permitted, but not obligated, to file optional simultaneous supplemental briefs on this question on or before October 9, 2018. The briefs should be no longer than 6,500 words [that is, half the length of an ordinary appellate brief].”

The court’s injection of this new issue into the case was potentially a very significant development.  If the court were to conclude that Altera’s APA challenge was barred by the statute of limitations, the Ninth Circuit decision in Altera would not shed any light on any of the important issues thought to be presented involving the APA or the substance of the cost-sharing regulations.

In the end, however, it appears that the court’s latest order will not amount to anything.  Altera filed a full-fledged supplemental brief in response to the court’s order in which it raised several objections to the court’s suggestion, including an argument that the government had waived any possible statute of limitations claim.

More significantly, the government did not embrace the court’s suggestion either.  The government simply filed a short letter brief in which it stated that any prepayment suit filed by Altera within the six-year limitations period would have been barred by the Tax Anti-Injunction Act.  (In this connection, the government cited to its brief in the Chamber of Commerce case; see our coverage of that appeal here.)  Hence, the government acknowledged that it would be “unfair” to Altera if that six-year period were held to bar its later suit because that would have the effect of depriving Altera of any ability to sue in the Tax Court.   Moreover, the government noted that the limitations period is not “jurisdictional” and therefore, even if it would otherwise be applicable, the government had waived its right to invoke a limitations defense just as Altera argued in its brief.  The government concluded by stating its position that the six-year statute of limitations that is generally applicable to  APA challenges “does not apply to this case.”  Thus, there is no realistic possibility that the Ninth Circuit will toss the case on statute of limitations grounds, and it can be expected to address the important issues presented by the Tax Court’s opinion.

The oral argument is scheduled for October 16.

Altera – Altera Supplemental Brief

Altera – Government Supplemental Brief

Altera – Altera Statute of Limitations Supplemental Brief

Altera – Government Statute of Limitations Letter Brief

Altera Opinion Withdrawn

In a surprising move, the Ninth Circuit announced today that it has withdrawn its opinion in Altera “to allow time for the reconstituted panel to confer on this appeal,” even though no petition for rehearing has been filed yet.  See our prior report on the Altera decision here.  The mention of  the “reconstituted panel” refers to an order issued by the court last week that appointed Judge Graber as a replacement judge for Judge Reinhardt, who passed away in March.

At the time, the order appointing Judge Graber seemed to be an exercise in closing the barn door after the horse is gone.  But it now appears that Judge Graber is being asked to review the case and give her independent judgment regarding the issues, notwithstanding the decision issued in July.  If so, that would place the outcome in doubt again, since the two other living judges, Chief Judge Thomas and Judge O’Malley, differed on their views of the case.

In some courts, the death of a judge while a case is under consideration automatically means that the judge’s vote will not count.  Unless the remaining two judges agree, that death would necessitate appointing a third judge to render a decision.  But the Ninth Circuit does not follow that approach.  The now-withdrawn opinion recited that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion prior to his death.”  For whatever reason, the court now seems to have decided on its own that it made a mistake in allowing Judge Reinhardt to cast the decisive vote from the grave in such an important case.

Altera – Ninth Circuit order substituting Judge Graber

Altera – Ninth Circuit order withdrawing opinions

 

Ninth Circuit Reverses Altera and Revives Cost-Sharing Regulations

The Ninth Circuit today by a 2-1 vote reversed the Tax Court’s Altera decision that had invalidated Treasury regulations requiring taxpayers to include employee stock options in the pool of costs shared under a cost-sharing agreement. See our previous reports here. The court’s decision (authored by Chief Judge Thomas) held that the regulations were a permissible interpretation of Code section 482 in imposing that requirement even in the absence of any evidence that taxpayers operating at arm’s length actually share such costs in similar arrangements. The court also held that Treasury’s rulemaking did not violate the Administrative Procedure Act (APA).

The court’s opinion follows the structure of the government’s brief in first analyzing section 482, even though the Tax Court decision rested on the APA. The court began with a detailed history of the development of section 482 and the related regulations. Quoting a law review article, the court stated that Congress and the IRS gradually realized in the years after 1968 that the arm’s-length standard “did not work in a large number of cases” and therefore they made “a deliberate decision to retreat from the standard while still paying lip service to it.” Relying heavily on legislative history, the court stated that the addition of the “commensurate with income” language in the 1986 Act was intended “to displace a comparability analysis where comparable transactions cannot be found.”

Armed with that conclusion, the court found that there was no violation of the APA. The court explained that the commenters had attacked the regulation as inconsistent with the arm’s-length standard, but Treasury in its notice had “made clear that it was relying on the commensurate with income provision”; therefore, the comments in question were just “disagree[ing] with Treasury’s interpretation of the law,” and there was no reason for Treasury to address those comments in any detail. The taxpayer argued that the notice of rulemaking indicated that Treasury would be applying the arm’s-length standard and therefore the Chenery principle of administrative law did not permit the regulations to be defended on the ground that the arm’s-length standard did not apply. See our prior summary of the parties’ arguments here. The court rejected this argument in cursory fashion, stating that it “twists Chenery . . . into excessive proceduralism.” It maintained that the citation of legislative history in the notice was a sufficient indication that Treasury believed that it could dispense with comparability analysis, and therefore the regulations were not being upheld on a different ground from the one set forth by the agency.

Having concluded that there was no APA violation in issuing the regulations, the court then applied the Chevron standard of deferential review to analyze the regulations, and it concluded that they were a reasonable interpretation of the statute. Pointing to the legislative history, the court ruled that the “commensurate with income” language was intended to create a “purely internal standard . . . to ensure that income follows economic activity.” The court added that “the goal of parity is not served by a constant search for comparable transactions.” Rather, by amending section 482 in 1986, Congress had “intended to hone the definition of the arm’s length standard so that it could work to achieve arm’s length results instead of forcing application of arm’s length methods.”

Finally, the court rejected the argument that the new regulations were inconsistent with treaty obligations. It remarked that “there is no evidence that the unworkable empiricism for which Altera argues is also incorporated into our treaty obligations,” describing the arm’s-length standard as “aspirational, not descriptive.”

Judge O’Malley (of the Federal Circuit, sitting by designation) dissented. She approached the case along the lines of the taxpayer’s argument and concluded that the Tax Court had correctly found an APA violation because “[i]n promulgating the rule we consider here, Treasury repeatedly insisted that it was applying the traditional arm’s length standard and that the resulting rule was consistent with that standard.” And “Treasury never said . . . that the nature of stock compensation in the [cost-sharing] context rendered arm’s length analysis irrelevant.” Accordingly, “Treasury did not provide adequate notice of its intent to change its longstanding practice of employing the arm’s length standard.” Finally, Judge O’Malley also noted her disagreement with the majority’s conclusion on the merits that the regulations are consistent with section 482. She explained that the plain language of the commensurate with income provision restricts its application to a “transfer (or license) of intangible property,” which would not encompass a cost-sharing agreement, even if the agreement relates to joint development of intangibles.

It is likely that the taxpayer will seek rehearing of the decision by the full Ninth Circuit, especially since such a rehearing petition was successful a decade ago in Xilinx. A rehearing petition would be due on September 7. If the taxpayer elects not to seek rehearing, a petition for certiorari would be due October 22.

Altera – Ninth Circuit opinion

 

Ninth Circuit Briefing Completed in Altera

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

Tax Court Overrules Its BMC Software Decision in Analog Devices

In its recent reviewed decision in Analog Devices, the Tax Court revisited and overruled its decision in BMC Software. We previously covered the BMC Software decision and the Fifth Circuit’s reversal of the Tax Court here. Analog Devices involves facts nearly identical to those in BMC Software: The taxpayer claimed a one-time dividends received deduction under section 965 for its 2005 tax year. Pursuant to a 2009 closing agreement with respect to some section 482 adjustments, the taxpayer elected to establish accounts receivable via a closing agreement under Rev. Proc. 99-32 in order to repatriate amounts included in U.S. income for the 2005 tax year (among others). And just as it did in BMC Software, the IRS determined that the retroactive creation of those accounts receivable for 2005 constituted related party indebtedness under section 965(b)(3) for the 2005 tax year, thus reducing the taxpayer’s dividends received deduction for 2005.

Analog Devices is appealable to the First Circuit, and therefore the Fifth Circuit’s decision in BMC Software is not binding precedent under the Golsen rule. Nevertheless, the Tax Court’s decision begins with an explanation of why the court was willing to reconsider its prior decision in BMC Software. Acknowledging the importance of stare decisis, the Tax Court stated that it was “not capriciously disregarding” its prior analysis and held that the principles that it articulated in BMC Software are “not entrenched precedent.” The Tax Court also observed that while its BMC Software decision implicates contract rights (specifically, closing agreements under Rev. Proc. 99-32), it was “unlikely” that the IRS would have relied on BMC Software in structuring later closing agreements.

The Tax Court then proceeded to follow the Fifth Circuit on both issues presented in the case. One issue was whether, as a statutory matter, section 965 required the parties to treat the accounts receivable as related party indebtedness. Following the Fifth Circuit, the Tax Court held that there was no such statutory requirement because section 965(b)(3) looks only to indebtedness “as of the close of the taxable year for which the [section 965] election . . . is in effect.” Because the taxpayer’s closing agreement did not create the accounts receivable until 2009—long after the testing period for the taxpayer’s 2005 year—the Tax Court held that the accounts receivable did not constitute related party indebtedness under section 965.

The other issue was whether the parties had agreed to treat the accounts receivable as related party indebtedness under the closing agreement. In what the Tax Court termed an “introductory phrase,” the closing agreement provided that the accounts receivable were established “for all Federal income tax purposes.” The Commissioner argued that with this language, the parties had agreed to treat the accounts receivable as related party indebtedness for purposes of section 965. But looking to the facts and circumstances of the closing agreement, the Tax Court concluded that the taxpayer made no such agreement. The Tax Court cited law for the principle that each closing agreement is limited to the “matters specifically agreed upon and mentioned in the closing agreement” as well as some self-limiting language in the agreement itself. Since there is no specific mention of section 965 in the agreement, the Tax Court held that to treat the accounts receivable as related party indebtedness would be to ignore the intent of the parties.

But the introductory phrase in the closing agreement in BMC Software—which had the phrase “for Federal income tax purposes”— was different from that in Analog Devices—“for all Federal income tax purposes.” Four judges on the Tax Court concluded that this difference was material and dissented. The dissent invoked interpretive canons for giving effect to the word “all” and addressed the equities of the situation, stating that even if the parties did not bargain over the wording of the introductory phrase, the “wording was not foisted on an unrepresented or unsuspecting taxpayer, or rendered in fine print, or hidden in a footnote, or even inserted in the midst of other terms of the agreement.” Several judges joined in a concurring opinion stating that the dissent “points to a distinction without a difference” and observing that the phrase “for Federal income tax purposes” means the same thing as the phrase “for all Federal income tax purposes.”

If the government appeals Analog Devices (which it may well do given the dissent), we will cover that appeal.

Analog Devices Tax Court Opinion

Government Files Notice of Appeal in Altera

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.

Altera Decision Now Ripe for 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.

Altera – Tax Court opinion

Fifth Circuit Reverses Tax Court in BMC Software

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.

BMC Software Fifth Circuit Opinion

Taxpayer’s Reply Brief Filed in BMC Software

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.

BMC Software – Taxpayer’s reply brief

Commissioner’s Brief filed in BMC Software

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.

BMC Software – Commissioner’s brief

Taxpayer’s Opening Brief Filed in BMC Software

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.

BMC Software – Taxpayer’s Opening Brief

Fifth Circuit to Address Section 965 Deduction in BMC Software Appeal

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.

BMC Software – Tax Court Opinion

The Curious Non-Appeal of Veritas

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.

Conversation with Bob Kirschenbaum Regarding Great Debate

We previously mentioned the IFA “Great Debate,” held on the campus of Stanford University on October 27, 2010, where the debaters squared off on the debatable utility of the Temporary Cost Sharing Regulations Income Method in valuing intangible transfers for transfer pricing purposes.  As forecast, the debate was extremely well-attended (notwithstanding the conflicting start of the first game of the World Series just up the road in San Francisco).   Bob Kirschenbaum and Clark Chandler drew the “pro” (i.e., you should never use the Income Method) while Jim O’Brien and Keith Reams drew the “con.”  After the debate, Bob and I kicked around his presentation, how things went, and how he feels about the issue generally.  The discussion seemed interesting enough to formalize and post. 

Did you enjoy arguing the “pro” position? Would you have preferred to have the “con” position?

We were prepared for either and I think Clark and I did a good job advocating.  However, I actually would have preferred the “con” position.  It is more interesting analytically because you get to drill down on how the Code and Regulations might be read to permit an income method analysis that would fairly measure the value of the IP actually transferred.   

With most taxpayers fighting the income method at Exam, wasn’t the “pro” position easier?

It is easier in the sense that the argument can be made very simply. That is true.  The argument goes like this: The existing cost sharing regulatory construct already enabled the evaluation of rights to the anticipated income stream without essentially disregarding the transaction as actually structured by the parties.   The “con” position, on the other hand, requires a more nuanced understanding of transfer pricing principles, what they are trying to achieve, and how one might go about constructing a set of variable inputs that could be used to indirectly derive the value of the IP transferred. 

Personally, do you think the income method has a place in transfer pricing practice?

I think it does.  However, Clark made a very persuasive argument that the Income Method as constituted in the Temporary Regs, while not to be discarded out of hand, becomes much more tenuous: (i) if the Regulations are read as mandating a counterfactual perpetual useful life of transferred IP (see Veritas v. Commissioner), and (ii) when coupled with the Periodic Trigger look-back provisions of the Temporary Regulations.  If fairly applied, and in the right circumstances, the Income Method can be a powerful convergence tool for valuing IP.  We have proven that in our dealings with Exam on cases where the IRS seeks to require CIP-compliant outcomes.  Obviously, it will never be as good as a valid CUT, but it can be useful and does have a place in the practice. 

What does the Tax Court’s recent decision in Veritas tell us about the viability of the Income Method?

At the end of the day, probably not much.  Veritas was a gross overreach by the IRS; ultimately, the decision is just Bausch & Lomb revisited.  Taxing a neutral transfer of business opportunity is not going to fly, nor is the imposition of a perpetual life for IP that produces premium profits for some limited number of years. That dog just will not hunt against a sophisticated and well-advised taxpayer.  But it certainly doesn’t mean that the Income Method, properly applied, is never useful. 

What do you see as the biggest errors the IRS makes in applying the Income Method?

 (1) The perpetual useful life edict, and (2) the implicit presumption of unlimited sustention of competitive advantage.  Technology progresses and, the fact is, legacy technology often doesn’t persist for multiple generations.  You could not find too many people in Silicon Valley—where I do a fair amount of my work—who would take the other side of that proposition.  Even where technology does persist for an extended period, the IRS at times contends that fundamentally new products, developed at great risk under Cost Sharing, owe their genesis entirely to foundational IP.  You cannot assume large growth rates decades out and try to allocate all of that value to the original IP.  At some point the competitive advantage associated with the pre-existing IP will dissipate. This is very basic finance theory.  There are certainly other concerns but these are the most glaring weaknesses in the application of the Income Method.

The Best Minds in Transfer Pricing Spar Over the Income Method

Practitioners interested in the more interesting conceptual aspects of transfer pricing should mark October 27th on their calendars.  On that day, the International Fiscal Association is sponsoring a debate on the usefulness of the income method to value intangibles in the transfer pricing context.  Dubbed “The Great Debate” by IFA, this year’s event will pit the best transfer pricing practitioners in the world (including Miller & Chevalier’s Bob Kirschenbaum and Baker & McKenzie’s Jim O’Brien) against each other.  Neither will know which position they are arguing prior to a coin toss.  The gloves will surely come off and our current understanding is that the only thing missing will be a steel cage.  Attendance is limited to IFA members and special guests (which you can become by being sponsored by an IFA member).

Xilinx AOD Straightforward but Finds the IRS Still Intent on Redefining the Arm’s Length Standard

On July 28, 2010, the IRS released AOD 2010-33; 2010-33 IRB 1.  The AOD acquiesces in the result but not the reasoning of Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1196 (9th Cir. 2010) which held that stock option costs are not required to be shared as “costs” for purposes of cost sharing agreements under old Treas. Reg. §1.482-7.  For prior analysis of Xilinx see this.  The AOD in and of itself is relatively unsurprising.  New regulations (some might say “litigating regulations”) have been issued that explicitly address the issue, and those regulations will test the question of whether Treasury has the authority to require the inclusion of such costs.  The IRS surely realized that from an administrative perspective it was smart to let this one go.  The best move for most taxpayers is likely to grab a bucket of popcorn and watch the fireworks as a few brave souls test Treasury’s mettle by challenging the validity of the new regulations.  Including a provision in your cost sharing agreements that allow adjustments in the event of a future invalidation of the regulations might go well with the popcorn.

The only really interesting item in the AOD is the gratuitous bootstrap of the Cost Sharing Buy-In Regs “realistic alternatives principle.”  The still warm “realistic alternatives principle” – the IRS assertion that an uncontrolled taxpayer will not choose an alternative that is less economically rewarding than another available alternative – “applies not to restructure the actual transaction in which controlled taxpayers engage, but to adjust pricing to an arm’s length result.”  AOD, 2010 TNT 145-18, pp.4-5.  That assertion appears to ignore that “arm’s length” is not some obscure term of art cooked up by the IRS, but rather an established concept that lies at the heart of most countries’ approach to international taxation.

Still clinging to the withdrawn Ninth Circuit opinion, the AOD offers in support of this premise that “the Secretary of the Treasury is authorized to define terms adopted in regulations, especially when they are neither present nor compelled in statutory language (such as the arm’s length standard), that might differ from the definition others would place on those terms.”  Xilinx, Inc. v. Comm’r, 567 F.3d 482, 491 (9th Cir. 2009).

In short, the IRS appears to have dusted off the rule book of the King in Alice and Wonderland:

The King: “Rule Forty-two. All persons more than a mile high to leave the court.”

“I’m not a mile high,” said Alice.

“You are,” said the King.

“Nearly two miles high,” added the Queen.

“Well, I shan’t go, at any rate,” said Alice: “besides, that’s not a regular rule: you invented it just now.”

“It’s the oldest rule in the book,” said the King.

“Then it ought to be Number One,” said Alice.

Alice’s Adventures in Wonderland at 125 (Giunti Classics ed. 2002).  The IRS has often been disappointed with the real rule Number One (the arm’s length principle) when the results of real-world transactions do not coincide with the results the IRS desires.   Now the IRS looks to magically transform that rule into one that replaces those real-world transactions with the IRS’s revenue-maximizing vision.  Tax Wonderland is getting curiouser and curiouser.