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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The government’s opening brief is due March 16.

Chamber of Commerce – District Court opinion

 

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