Supreme Court Denies Cert in Altera

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June 22, 2020

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

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June 18, 2020

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

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November 21, 2019

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

Petition for Rehearing En Banc Filed in Altera

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July 24, 2019

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

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June 27, 2019

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

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June 7, 2019

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

Altera Case Submitted for Decision

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October 22, 2018

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

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October 10, 2018

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 Set for October 16 Reargument

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August 17, 2018

The Ninth Circuit has announced that the panel (with Judge Graber substituted for the deceased Judge Reinhardt) will hear a new oral argument in the Altera case on the afternoon of October 16.  This announcement eliminates the possibility that Judge Graber would simply review the materials in the case and decide to join the prior majority opinion.  The outcome of the case now appears to be up for grabs, and most likely in the hands of Judge Graber unless either Judge Thomas or Judge O’Malley changes his or her mind in the case.

Altera Opinion Withdrawn

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August 7, 2018

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

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July 24, 2018

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 Panel Ready to Hear Oral Argument in Altera on October 11

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October 9, 2017

As discussed in our prior post, the briefing on the government’s appeal of the Altera decision was completed last January.  The Ninth Circuit is scheduled to hear oral argument in the case in San Francisco this Wednesday afternoon, October 11.

The three-judge panel for the arguments consists of Chief Judge Sidney Thomas, Judge Stephen Reinhardt, and Judge Kathleen O’Malley (of the Federal Circuit, sitting by designation). Judge Thomas was appointed in 1996 by President Clinton, Judge Reinhardt was appointed in 1980 by President Carter, and Judge O’Malley was appointed by President Obama in 2010.  The government is probably particularly happy to see Judge Reinhardt on the panel, as he was the dissenting judge who sided with the government in 2010 in the 2-1 Xilinx decision that set the stage for the new cost-sharing regulations at issue in Altera.  (The Xilinx decision was discussed in this contemporaneous Tax Alert.)  The Ninth Circuit has allocated 20 minutes for each side to present argument, which indicates the court’s recognition of the importance and/or complexity of the case; most cases are set for 10 or 15 minutes per side.

The Ninth Circuit now videotapes its oral arguments, so the argument can be watched on a live stream through a link on the Ninth Circuit’s website. The videotape will also be made available after the fact elsewhere on the court’s website.  The afternoon session begins at 1:30 Pacific time.  Because Altera is the third case scheduled for that session, it is likely that the argument in Altera will not begin before 2:15 Pacific time.

Ninth Circuit Briefing Completed in Altera

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January 25, 2017

The parties have now completed briefing in the Ninth Circuit in the Altera case, in which the Tax Court struck down Treasury regulations that require taxpayers to include employee stock options in the pool of costs shared under a cost-sharing agreement.  As described in our previous reports, the Tax Court’s decision implicated both the specific issue of whether the cost-sharing regulations are a lawful implementation of Code section 482 and the more general administrative law issue of the constraints placed on Treasury by the Administrative Procedure Act (APA) in issuing rules that involve empirical conclusions.

The government’s opening brief focuses only on the specific section 482 issue, maintaining that the Tax Court erred in believing that the challenged regulations involved empirical conclusions. Specifically, the government relies heavily on what it terms the “coordinating amendments” to the regulations promulgated in 2003.  Those amendments, which purport to apply the “commensurate with income” language added to section 482 in 1986 for intangible property, state in part that a “qualified cost sharing arrangement produces results that are consistent with an arm’s length result . . . if, and only if, each controlled participant’s share of the costs . . . of intangible development . . . equals its share of reasonably anticipated benefits attributable to such development.”  Treas. Reg. § 1.482-7(a)(3).  By its terms, this regulation states that determining whether a cost-sharing agreement meets the longstanding section 482 “arm’s length” standard has nothing whatsoever to do with how parties actually deal at “arm’s length” in the real world.  On that basis, the government argues that the APA rules are not implicated because the regulations did not rest on any empirical conclusions.  And for the same reason, the government argues that the Ninth Circuit’s earlier decision under the prior cost-sharing regulations, Xilinx v. Commissioner, 598 F.3d 1191 (9th Cir. 2010), is irrelevant since that decision was premised on the understanding (now allegedly changed by the amended regulations) that how parties actually deal at “arm’s length” was relevant to whether the section 482 “arm’s length” standard was met under those prior regulations, which did not explicitly provide a rule for stock-based compensation.  Finally, the government defends the validity of the regulation’s approach to “arm’s length” in the cost-sharing context as being in line with statements made in the House and Conference Reports on the 1986 amendments to section 482, which noted the general difficulty in finding comparable arm’s-length transfers of licenses of intangible property.

In its response brief, the taxpayer takes the government to task for relying on a “new argument” rather than directly addressing the reasoning of the Tax Court. The taxpayer first observes that Treasury never took the position in the rulemaking that the traditional “arm’s-length” standard in section 482 can be completely divorced from how parties actually operate at arm’s length—a position that assertedly “would have set off a political firestorm.”  Accordingly, the taxpayer argues that the government’s position on appeal violates the bedrock administrative law principle of SEC v. Chenery Corp., 318 U.S. 80 (1943), that courts must evaluate regulations on the basis of the reasoning contemporaneously given by the agency, not justifications later advanced in litigation.  And in any event, the taxpayer argues, this position cannot be sustained because it is an unexplained departure from Treasury’s longstanding position that the 1986 amendments to section 482 “did not change the arm’s-length standard, but rather supplied only a new tool to be used consistently with arm’s-length analysis rooted in evidence.”

The taxpayer describes the government’s reliance on the “coordinating amendments” in the regulations as “circular reasoning” that simply purports to define “arm’s length” to mean something other than “arm’s length.”  Even if that is what the regulations say, the taxpayer continues, the regulations could not be sustained because they depart “from the recognized purpose of Section 482 to place controlled taxpayers at parity with uncontrolled taxpayers” and conflict with “the arm’s-length analysis implicit in the statute’s first sentence.”

The government’s reply brief criticizes the taxpayer for not even arguing that its cost-sharing agreement clearly reflects income, and it therefore characterizes the taxpayer as arguing that “the arm’s-length standard gives related taxpayers carte blanche to mismatch their income and expenses.”  With respect to the correct interpretation of section 482, the government repeats its position from the opening brief, maintaining that the term “arm’s length” does not necessarily connote equivalence with real-world transactions.  Instead, the government argues that it is the taxpayer that departs from the statute by failing to give proper effect to the “commensurate with the income attributable to the intangible” language added in 1986.

The government responds to the Chenery argument by denying that it is arguing a different ground for the regulation than that advanced by Treasury.  Rather, the government states that its brief simply further develops the basis advanced by Treasury because it was clear in the regulations that emerged from the rulemaking that Treasury was rejecting the position that an “arms-length” standard can be applied only by looking at empirical evidence of transactions between uncontrolled taxpayers.

Although the briefs are quite long, the basic dispute can be stated fairly succinctly. The parties purport to agree that an “arm’s-length” standard must govern.  The taxpayer says that application of this standard always depends on analyzing actual transactions between uncontrolled parties, where available.  The government says no; in its view, “arm’s length” does not necessarily require reference to such transactions.  Instead, according to the government, in the cost-sharing context “Treasury prescribed a different means of ascertaining the arm’s-length result,” one that “is determined by reference to an economic assumption rather than by reference to allegedly comparable uncontrolled transactions.”

The intense interest in this case is illustrated by the filing of many amicus briefs. The government, which rarely benefits from amicus support in tax cases, is supported by two different amicus briefs filed by groups of law professors—six tax law professors joining in one of the briefs and 19 other tax and administrative law professors joining the second brief.  The taxpayer’s position is supported by seven amicus briefs—including one from the Chamber of Commerce and one from a large group of trade associations.  Four briefs were filed by individual companies—Cisco, Technet, Amazon, and Xilinx.  The seventh brief was filed by three economists—a business school professor (who testified as an expert witness for the taxpayer in Xilinx), a fellow at the American Enterprise Institute, and a managing director at the Berkeley Research Group.  They profess no financial interest in the outcome but argue, based on their experience in dealing with issues relating to stock-based compensation, that, as a matter of economics, the government’s approach is not consistent with how parties acting at arm’s length would proceed.

Notwithstanding the interest in the case, no decision is expected in the near future. The Ninth Circuit has a backlog of cases awaiting the scheduling of oral argument.  In recent years, oral arguments in tax cases typically have not been scheduled until at least a year after the briefing is concluded, and often closer to 18 months.  Thus, oral argument in this case should not be expected before next winter.  And then it will likely be several months after the argument before the court issues its decision.  So at this point, it would be surprising if there were a decision in Altera before mid-2018.

Altera – Taxpayer brief

Altera- Gov’t Opening Brief

Altera – Gov’t Reply Brief

Government Files Notice of Appeal in Altera

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February 23, 2016

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

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December 2, 2015

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

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October 2, 2015

We present here a guest post from our colleagues Patricia Sweeney and Andrew Howlett. A longer version of this post is published here.

In Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), the Tax Court put the IRS and Treasury on notice that, when promulgating regulations premised on “an empirical determination,” the factual premises underlying those regulations must be based on evidence or known transactions, not on assumptions or theories. Otherwise, the regulations do not comply with the requirements of the Administrative Procedure Act (“APA”), 5 U.S.C. § 551 et seq. Applying the arm’s-length standard of Code section 482, the Altera decision provides another example of transfer-pricing litigation being decided on the basis of evidence of actual arm’s-length dealings rather than economic theories. Looking more broadly beyond the section 482 context, the decision is an important reminder to the IRS and Treasury that, in the wake of the Supreme Court’s decision in Mayo Foundation (562 U.S. 44 (2011), see our prior reports on the decision and oral argument in that case here and here), tax regulations are subject to the same APA procedures as regulations issued by other federal agencies. As a result, Treasury cannot ignore the evidence and comments submitted during the rulemaking process. If it is to reject that evidence, Treasury must engage in its own factfinding, and it must explain the rationale for its decision based upon the factual evidence.

Because of its specific impact on the regulation of cost-sharing agreements and, more generally, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules, the government will strongly consider an appeal of this decision to the Ninth Circuit. A notice of appeal will be due 90 days after the Tax Court enters its final decision, but there is not yet a final, appealable order in Altera.

The Context for the Dispute. Code section 482 authorizes the Commissioner to allocate income and expenses among related parties to ensure that transactions between them clearly reflect income. Treas. Reg. § 1.482-1(b)(1) provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” In 1986, Congress amended section 482 to provide that, “in the case of any transfer (or license) of intangible property . . ., the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” As noted by the Tax Court, Congress enacted this amendment to section 482 in response to concerns regarding the lack of comparable arm’s-length transactions, particularly in the context of high-profit-potential intangibles. Congress did not intend, however, to preclude the use of bona fide cost-sharing arrangements under which related parties that share the cost of developing intangibles in proportion to expected benefits have the right to separately exploit such intangibles free of any royalty obligation. See H.R. Conf. Rep. No. 99-841 (Vol. II), at II-637 to II-638 (1986).

In 1995, Treasury issued detailed new cost-sharing regulations that generally authorized the IRS “to make each controlled participant’s share of the costs . . . of intangible development under the qualified cost sharing arrangement equal to its share of reasonably anticipated benefits attributable to such development.” In Xilinx, Inc. v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010), the Ninth Circuit affirmed the Tax Court’s holding that the regulations did not require the taxpayer to include employee stock options (“ESOs”) granted to employees engaged in development activities in the pool of costs shared under the cost-sharing arrangement. The court reasoned that the term “costs” in the regulation did not include ESOs because that would not comport with the “dominant purpose” of the transfer pricing regulations as a whole, which is to put commonly controlled taxpayers at “tax parity” with uncontrolled taxpayers. Because of the overwhelming evidence that unrelated parties dealing at arm’s length in fact do not share ESOs in similar co-development arrangements, the court concluded that such tax parity is best furthered by a holding that the ESOs need not be shared. (For a more detailed examination of Xilinx, see our contemporaneous analysis here.)

In 2003 (prior to the Xilinx decision), Treasury had amended the transfer pricing regulations that were applicable to the years at issue in Xilinx. The amended regulations explicitly address the interaction between the arm’s-length standard and the cost-sharing rules, as well as the treatment of ESOs. Treas. Reg. § 1.482-1(b)(2)(i) now states that “Treas. Reg. § 1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement . . . produces results consistent with an arm’s length result.” Contrary to Xilinx, Treas. Reg. § 1.482-7(d)(2), as amended, specifically identifies stock-based compensation as a cost that must be shared.

Altera did not include ESOs or other stock-based compensation in the cost pool under the cost-sharing agreement it entered into with a Cayman Islands subsidiary. In accordance with the 2003 regulations, the IRS asserted that those costs should be included in the pool, and that, as a result, Altera’s income should be increased by approximately $80 million in the aggregate.

The Tax Court’s Analysis. Ruling on cross motions for summary judgment, the Tax Court, in a 14-0 decision reviewed by the full court, agreed with the taxpayer that the 2003 amendments to the cost-sharing regulations were invalid under the APA because Treasury did not adequately consider the evidence presented by commentators during the rulemaking process that stock-based compensation costs are not shared in actual third-party transactions.

The Tax Court first addressed the threshold issue of whether the 2003 regulations were governed by the rulemaking requirements of section 553 of the APA. To that end, it analyzed whether the regulations were “legislative” (regulations that have the force of law promulgated by an administrative agency as the result of statutory delegation) or “interpretive” (mere explanations of preexisting law). (This legislative/interpretive distinction under the APA is different from the distinction between legislative and interpretive Treasury regulations that was applied for many years in tax cases, but rendered largely obsolete by the Supreme Court’s Mayo decision.) Relying on Hemp Indus. Ass’n v. DEA, 333 F.3d 1082 (9th Cir. 2003), the Tax Court found that the 2003 cost-sharing regulations were legislative because there would be no basis for the IRS’s position that the cost of stock-based compensation must be shared under section 482 absent the regulation and because Treasury invoked its general legislative rulemaking authority under Code section 7805(a) with respect to the regulation.

APA section 553 generally requires the administrative agency to publish a notice of proposed rulemaking in the Federal Register, to provide interested persons an opportunity to participate in the rulemaking through written comments, and to incorporate in the adopted rules a concise general statement of their basis and purpose. APA section 706(2)(A) empowers courts to invalidate regulations if they are “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” The Tax Court cited Motor Vehicles Mfrs. Ass’n v. State Farm, 463 U.S. 29 (1983), as holding that this standard requires “reasoned decisionmaking” and that a regulation may be invalidated as arbitrary or capricious if it is not based on consideration of the relevant factors and involves a clear error of judgment.

The Tax Court found that the stock-based compensation rule did not comply with the reasoned decisionmaking standard because the rule lacked a factual basis and was contrary to evidence presented to Treasury during the rulemaking process. The Tax Court stated that, although the preamble to the 2003 rule stated that unrelated parties entering into cost-sharing agreements typically would share ESO costs (thereby relating the regulation to the arm’s-length requirement of section 482), Treasury had no factual basis for this assertion. Commentators had provided substantial evidence that stock-based compensation costs were not shared in actual third-party agreements, which the Tax Court itself had found (and which the government conceded) in Xilinx. Treasury could draw no support from any of the submitted comments nor did it engage in any of its own factfinding to support its position. Absent such factfinding or other evidence, the Tax Court concluded that “Treasury’s conclusion that the final rule is consistent with the arm’s-length standard is contrary to all of the evidence before it.”

The Tax Court also stated that Treasury’s failure to respond to any of the comments submitted was evidence that the regulation did not satisfy the State Farm standard, stating “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is [because m]eaningful judicial review and fair treatment of affected persons require an exchange of views, information and criticism between interested persons and the agencies.” As a result, the final rule failed to satisfy State Farm’s reasoned decisionmaking standard.

Challenges for Treasury. The Altera decision highlights the limitations of the Treasury Department’s rulemaking authority when the regulation is based on a factual determination. In that situation, the deference normally given to Treasury because of its expertise as an administrative agency carries little weight unless it is supported by specific factfinding Treasury has done with respect to the rule at issue. In other words, Treasury cannot expect tax regulations that seek to implement a fact-based standard to be upheld simply because Treasury believes that they reach the right theoretical result. Instead, Treasury must explicitly cite the evidence and explain how that evidence provides a rational basis for the regulation.

The Altera decision should motivate Treasury to incorporate responses to submitted comments in its descriptions of final regulations. By specifically citing Treasury’s failure (1) to respond to comments or (2) to engage in independent factfinding as being important components of judicial review under the APA, the Tax Court’s decision effectively directs Treasury to spend more resources during the rulemaking process.

More broadly, the Altera decision underscores the constraints placed on Treasury and other administrative agencies under the APA. Although Mayo announced that Chevron deference principles would apply to Treasury regulations in the future, that was not a radical shift in the law because Treasury regulations had always been subjected to a deference analysis that bore considerable similarity to Chevron. By contrast, as the Tax Court noted, Treasury regulations have not traditionally been measured by APA standards, and Treasury’s notice-and-comment procedures have not been analyzed under State Farm. The Tax Court’s unanimous decision in Altera shows that judicial review under the State Farm standard is more than a mere paper tiger; where Treasury does not demonstrate that it adequately considered the relevant factors, including submitted comments, its regulation is at risk of being overturned. Although Altera as of now is binding authority only in Tax Court cases, challenges to Treasury regulations in other forums likely will cite its reasoning with respect to what constitutes reasoned decisionmaking for purposes of judicial review under the APA.

Considerations for Taxpayers. Absent reversal on appeal, Altera will have an impact on all related-party cost-sharing agreements. Although cost-sharing agreements governed by the 2003 regulations typically have provided for a sharing of stock-based compensation, they often have provided for a retroactive adjustment back to the start of the agreement if there is any relevant change in law. Taxpayers with cost-sharing agreements should carefully review their agreements and tax positions to determine whether their agreement provides for an adjustment mechanism or whether if claims for refund for open years are appropriate based on the Altera holding.

In addition, taxpayers should consider whether Altera has opened the door for additional regulatory challenges, both in the transfer pricing arena and elsewhere, in contexts where the regulations were premised on factual or theoretical assumptions by Treasury that lack sufficient evidentiary support. The Altera case already has been brought to the attention of the district court handling the Microsoft summons litigation in the Western District of Washington as relevant to determining whether the Treasury regulations at issue there are valid, and the case will likely also be cited in cases involving the validity of other transfer pricing regulations, such as the regulations currently under review by the Tax Court in 3M Co. et al. v. Commissioner; No. 005816-13. In addition, the transfer pricing regulations governing services transactions, which were developed following the regulations at issue in Altera, also define the term “cost” to include stock-based compensation and therefore may be vulnerable to reasoning similar to that in Altera.

Finally, taxpayers and other commentators should consider the Tax Court’s reasoning in Altera in developing comments to proposed regulations. Altera demonstrates that such comments can be important in laying a foundation for future judicial challenge even if the commentators are not successful in persuading Treasury to adopt their position.

Altera – Tax Court opinion