Petition for Rehearing En Banc Filed in Altera

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

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

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

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

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

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

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

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

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

Altera Petition for Rehearing En Banc July 2019

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

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

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

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

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

In reaching that conclusion, the majority relied on the history of section 482 and especially on the addition of the second sentence of section 482. That second sentence provides that “[i]n the case of any transfer (or license) of intangible property…, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” The majority held that the Congressional intent behind the addition of that language in 1986 is what made it reasonable for Treasury to conclude that it was permitted “to dispense with a comparable transaction analysis in the absence of actual comparable transactions.”

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

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

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

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

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

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

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

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

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

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

Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera

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

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

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

Altera Ninth Circuit Opinion June 2019

Altera Case Submitted for Decision

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

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

These letters are attached below.

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

Altera – Altera post-argument letter

Altera – Government post-argument letter

 

Supplemental Briefing Completed in Altera

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

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

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

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

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

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

The oral argument is scheduled for October 16.

Altera – Altera Supplemental Brief

Altera – Government Supplemental Brief

Altera – Altera Statute of Limitations Supplemental Brief

Altera – Government Statute of Limitations Letter Brief

Altera Set for October 16 Reargument

August 17, 2018 by  
Filed under altera

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

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

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

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

Altera – Ninth Circuit order substituting Judge Graber

Altera – Ninth Circuit order withdrawing opinions

 

Ninth Circuit Reverses Altera and Revives Cost-Sharing Regulations

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

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

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

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

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

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

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

Altera – Ninth Circuit opinion

 

Ninth Circuit Panel Ready to Hear Oral Argument in Altera on October 11

October 9, 2017 by  
Filed under altera

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

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

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