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 But the result was the same as the withdrawn July 2018 decision—the Ninth Circuit upheld the validity of Treasury’s cost-sharing regulation that requires taxpayers to include the cost of employee stock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some observations after comparing the majority and dissent in the new decision with those in the Ninth Circuit’s withdrawn decision.

In the new decision, Judge Thomas recycled much of the language and logic from his withdrawn opinion, and Judge O’Malley reused much of her original dissent.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The majority did not address this issue in its withdrawn opinion, so some background is in order.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.’”

Third Circuit Affirms Subpart F Income Inclusion Ruling in SIH Partners

A unanimous Third Circuit this morning affirmed the Tax Court in SIH Partners in an opinion that will please government lawyers who are increasingly dealing with APA challenges to Treasury regulations.  As explained in our previous posts here, the issue in SIH Partners was whether loan guarantees by two CFCs resulted in income exclusions, even though the guarantees were not equivalent to an actual repatriation because, among other things, there were many other guarantors.  Because the regulations on their face set forth a bright-line rule that takes no account of the individual circumstances of particular loan guarantees, the taxpayer argued that the regulations were invalid under the APA as arbitrary and capricious.

The Third Circuit noted “the Tax Court’s masterful analysis rejecting” the taxpayer’s challenge to the validity of the regulations, but it then stated that it did not need to rely on that analysis because the taxpayer’s argument failed for another reason.  The court said that the taxpayer, in arguing that a bright-line rule treating all loan guarantees the same was unreasonable, had pointed to IRS administrative guidance issued over the years that relaxed the rule depending on the circumstances.  The taxpayer, therefore, was asking the court to use “hindsight” in violation of the established rule that the validity of an agency action must be assessed based on the administrative record that was before the agency at the time.  The court did not dispute that experience under the regulation might have demonstrated that “the regulations do not always address economic reality,” but it found that fact immaterial.  The court declared:  “We cannot and will not find half-century old regulations arbitrary and capricious, based on insights gained in the decades after their promulgation, when the challenger . . . has not made a showing that those insights were known or, perhaps, at least should have been known to the agency at the time of the regulations’ promulgation.”  Indeed, the court said that the taxpayer’s argument would be better characterized as complaining about the IRS’s failure to amend the regulations to meet the “later observed economic realities,” instead of a complaint that the regulations were arbitrary when first promulgated.  Since no one requested that the IRS amend the regulations, the court said, this argument could go nowhere.

The court’s “hindsight” criticism seems unfair, as the essence of the taxpayer’s argument was not that the administrative guidance was itself a later event that called for amending the regulations, but rather evidence of an obvious flaw in the bright-line regulation as promulgated that Treasury should have recognized from the start.  The court acknowledged that the taxpayer had made this point in oral argument, but simply responded that regulations do not have to be “the most perfect solution possible.”  In the court’s view, the regulation set forth a “straight-forward” rule that comported with the statutory language and hence was not arbitrary.  The court added that no commenter at the time raised “the possibility of multiple-counting of loan guarantors being an issue with the regulations.”  That suggested that this practice was “exceedingly rare” at the time, which meant that it was hardly unreasonable for the regulation not to address it at the time.

The court then went on to make a couple more observations that may well find their way into  briefs in future cases raising APA challenges to regulations.  The taxpayer had argued that the bright-line rule of the regulation was inconsistent with the policy of the statute, which was to address loan guarantees that were effectively repatriations.  The court did not take issue with the taxpayer’s description of the statutory policy.  Instead, it remarked that “we are satisfied that the regulations are not arbitrary or capricious merely because they may not adhere to the policies embodied in the statutes in every case.”  The court also gave short shrift to the taxpayer’s contention that the regulations lacked enough explanation to satisfy the State Farm requirement of “reasoned decisionmaking.”  The court stated:  “Because the challenged regulations barely rocked the statutory boat [that is, they closely tracked the statutory language], and because of the lack of public commentary and the straight-forward nature of the regulations, little explanation was needed.”

As to the second issue in the case, the court held that the taxpayer was not entitled to the lower tax rate applicable to dividends.  Like the Fifth Circuit in Rodriguez v. Commissioner, 722 F.3d 306 (5th Cir. 2013) (see our reports here), the court held that the fact that the payment could be analogized to a dividend did not actually make it a dividend.

A petition for rehearing is due in 45 days, and, if rehearing is not sought, a petition for certiorari is due in 90 days.  The prospects for the taxpayer to get a favorable result from either of those avenues of further review are probably pretty slim.

Third Circuit Decision in SIH Partners

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

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

The Primary Issue in Dispute

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

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

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

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

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

Plain Language of the Regulation

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

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

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

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

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

Regulatory History

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

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

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

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

Subsequent Statutory Changes

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

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

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

Cost Sharing and the Arm’s-Length Standard

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

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

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

The Nature and Life of the Residual Business Assets

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

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

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

Other Issues

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

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

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

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

Amazon.com Tax Court Opinion

Divided Tax Court Decides E&P Computation Issue in Eaton

In Eaton Corp. v. Commissioner, 152 T.C. No. 2 (2019), a divided Tax Court decided (by a 10-2 margin) that the CFC partners in a U.S. partnership must increase earnings and profits (E&P) for the partnership’s subpart F inclusions. Members in the taxpayer’s group owned several CFCs (the “CFC partners”) that were partners in a U.S. partnership. That partnership in turn owned several lower-tier CFCs (the “lower-tier CFCs”) that generated subpart F income. There was no dispute that the U.S. partnership had to include the subpart F income of the lower-tier CFCs. The question before the Tax Court on motions for summary judgment was whether the CFC partners were required to increase their E&P in the amount of the U.S. partnership’s income inclusions (which ultimately determined whether the U.S. parent must include income from a section 956 investment in U.S. property by the CFC partners).

In an opinion by Judge Kerrigan, the majority held that the law required the CFC partners to increase E&P for the U.S. partnership’s income inclusions. Although the opinion does not expressly state so, it appears to adopt the IRS’s arguments for increasing the CFC partners’ E&P.

The court began with the language of section 964(a), which provides that “[e]xcept as provided in section 312(k)(4), for purposes of this subpart the earnings and profits of any foreign corporation…for any taxable year shall be determined according to rules substantially similar to those applicable to domestic corporations, under regulations prescribed by the Secretary….” (emphasis added). The court then held that because the rules “applicable to domestic corporations” are those in section 312 and its accompanying regulations, the computation of foreign corporation E&P under 964(a) should be made under the “elaborate, technical rules” of section 312 and its regulations.

The court observed that under Treas. Reg. § 1.312-6(b), the computation of E&P includes “all items includible in gross income under section 61….” Although there “is no explicit rule in section 312, section 964, or their accompanying regulations specifying how a CFC’s distributive share of partnership income…should be treated for purposes of computing its E&P,” the court looked to “the general rules set forth in subpart F and section 312.” Under those general rules, the court reasoned that the CFC partners should compute gross income “as if they were domestic corporations,” which meant including their distributive share of partnership income under section 702. And since the U.S. partnership’s gross income “includes subpart F income and section 956(a) inclusions from the lower-tier CFCs,” the court concluded that the CFC partners must increase their E&P by the subpart F amounts that are included in their gross income.

According to the court, the taxpayer’s “primary argument” was that “the section 964 regulations supply a freestanding, self-contained, and comprehensive system for determining the E&P of a foreign corporation” without need for recourse to section 312 or its regulations. Specifically, the taxpayer relied on Treas. Reg. § 1.964-1(a)(1), which provides that the E&P of a foreign corporation is computed “as if such corporation were a domestic corporation by” following three enumerated steps. The court portrayed the taxpayer’s argument as interpreting “the preposition ‘by’ in an extremely narrow sense, to mean ‘by doing these three things and nothing else.’”

The court rejected that reading of Treas. Reg. § 1.964-1(a)(1) on the grounds that the three enumerated steps in that regulation are insufficient for computing E&P. To compute E&P at all, it is necessary to know how corporate transactions and events—like property distributions, stock distributions, redemptions, discharge of indebtedness income, and depreciation—affect E&P. And since the regulations under section 964 address none of these transactions or events, the court held that they cannot alone determine foreign corporation E&P. Rather, recourse to section 312 and its regulations is necessary. The court also observed that the section 964 regulations specifically provide that the depreciation rules in section 312(k) do not apply in computing foreign corporation E&P. And the court inferred that this meant that section 312 and its regulations must apply in computing foreign corporation E&P, otherwise there would be no need to explicitly bar the application of the section 312(k) depreciation rules.

Presumably because it dismissed the taxpayer’s primary argument, the court took the opportunity to explain what the three steps enumerated in Treas. Reg. § 1.964-1(a)(1) are meant to do if they are not—as the taxpayer’s argument maintained—the sole mechanism for computing foreign corporation E&P. The court referred to paragraph (ii) of that regulation, which provides that foreign corporation E&P requires conforming the foreign corporation’s P&L statement to U.S. GAAP. The court concluded that the three steps under Treas. Reg. § 1.964-1(a)(1) “specify a preliminary process by which a foreign corporation’s P&L statement is conformed to, or made to resemble, that of a domestic corporation by making a series of tax accounting adjustments.”

The court also addressed the taxpayer’s other argument that the CFC partners’ subpart F inclusions “do not increase the dividend[-]paying capacity of the upper[-]tier CFC partners.” The court observed that “[t]here are many instances in which E&P are increased when amounts are included in income but no cash is received,” citing original issue discount and income accrual as examples.

Most of the rest of the Tax Court joined Judge Kerrigan’s opinion, with Judge Pugh abstaining and Judge Morrison writing a brief concurrence (in which he clarifies his opinion that it is the language in Treas. Reg. § 1.964-1(a)(1)—and not, as the majority stated, the language in section 964(a)—that imports section 312 and its regulations into the computation of foreign corporation E&P). Judge Foley, however, wrote a dissent in which Judge Gustafson joined.

The brunt of that dissent is that if Treasury wanted to import the section 312 regulations into the computation of foreign corporation E&P under section 964, then it should have done so expressly. After criticizing the majority’s inference about the 312(k) depreciation rules excluded under section 964(a), the dissent offers support for the taxpayer’s primary argument that the regulations under 964 are the exhaustive source of instruction on computing foreign corporation E&P. The dissent observes that there were previously five steps under Treas. Reg. § 1.964-1(a)(1) and that the calculation of E&P “was complete upon the conversion to U.S. dollars.” Moreover, the dissent argues that Treasury could have expressly incorporated the rules under section 312 but did not do so. (The majority held that the language under 964(a) instructing that foreign corporation E&P is computed “under regulations prescribed by the Secretary” could be “reasonably read to include regulations promulgated under section 312,” even if those regulations predate section 964(a). The dissent disagreed, asserting that the majority’s analysis “sets bad precedent and is a rickety analytical construct.”)

Given that it involves a purely legal issue and a divided Tax Court, the case seems destined for appeal, so stay tuned for further updates.

Eaton Tax Court Opinion

Briefing Completed in SIH Partners

The final briefs have now been filed in the SIH Partners case.  The government’s response to the taxpayer’s opening brief is long, but hammers extensively on one point — namely, that the regulation is “categorical” in establishing that a loan guarantee issued by a CFC will be treated as taxable.  (The word “categorical” appears 29 times in the government’s brief.).  And the government maintains that this “bright-line” rule flows directly from the statutory text.  Given that premise, the government is able to give most of the taxpayer’s arguments short shrift.

In particular, the government says that the settled legal landscape made it easy for tax planners.  If the taxpayer chose to use its CFC to guarantee the loan, then it should accept the predictable tax consequences of that choice, rather than allegedly seeking a “sea change” in the governing rules that would replace a bright-line rule with a facts and circumstances inquiry.  Whether or not the loan guarantee reflects something like an “actual repatriation,” or was actually necessary for credit purposes, or is affected by other guarantors are all “wholly irrelevant” in the government’s view.  

The government similarly disposes of the taxpayer’s administrative law argument.  It states that the statutory text established a categorical rule and the commenters did not argue that Treasury should adopt a non-categorical rule; therefore, the relatively sparse explanation for the regulation was not problematic.  In the government’s words, “that an explanation is brief does not mean that it is inadequate.”  Interestingly, the government goes on to make a fallback argument that it acknowledges was not presented to the Tax Court.  It argues that, even if the regulation is invalid for failure to comply with the APA, the outcome of the case would not change because the statute is “self-executing,” and therefore the statute itself would make the loan guarantee a taxable event.

Finally, the government states that the taxpayer has provided no sound reason for the court not to follow Rodriguez and other lower court decisions that reach the same result, and therefore the taxpayer is not entitled to be taxed at the lower qualified dividend rate.

The taxpayer begins its reply brief by citing to a notice of proposed rulemaking issued 11 days before the government’s brief was filed.  The proposed regulations would “reduce the amount determined under section 956” in certain instances in light of the Tax Cuts and Jobs Act.  The taxpayer argues that the reasoning in the notice contradicts the government’s position because the notice describes the IRS’s “longstanding practice” as trying to “conform the application of section 956 to its purpose,” and thus to try to achieve symmetry between section 956 taxation and actual repatriations of earnings.

Apart from the new proposed regulations, the taxpayer argues that the statutory language governing guarantees did not establish a categorical rule, but rather left the proper tax treatment to be determined by regulation.  Therefore, Treasury had to make a choice and was required to explain the bright-line choice that it made.  And similarly, regulation was required, and the statute cannot be treated as self-executing.  

With respect to the dividend rate issue, the taxpayer urges the court not to follow Rodriguez.  In that connection, it states that the Rodriguez court mistakenly believed that Congress specifically designates when section 951 inclusions are to be treated as dividends, when in fact there are Treasury regulations that treat inclusions as dividends without specific statutory authorization.

Third Circuit to Consider Validity of Subpart F Regulations Governing Loan Guarantees

In SIH Partners v. Commissioner, the Tax Court upheld the IRS’s determination that loan guarantees by two controlled foreign corporations (CFCs) resulted in income inclusions subject to taxation in the U.S. as ordinary income under subpart F. The CFC earnings were actually distributed to the U.S. shareholder in 2010 and 2011 and reported then as qualified dividends taxable at 15 percent. But the IRS determined that, under the section 956 regulations, those earnings should have been taxed at the 35 percent ordinary income rate in 2007 and 2008 when the CFCs served as co-guarantors of loans.

The taxpayer raised three basic objections to the Commissioner’s determination. First, it argued that the regulations implementing Code section 956(d)—the regulations under which the IRS treated the loan guarantees as investments in U.S. property to be included in U.S. income—were invalid under the Administrative Procedure Act. Second, it argued that even if the regulations were valid, there should be no income inclusion under the particular facts and circumstances of the guarantees. Third, it argued that, in any event, the Subpart F income should be taxed at the lower qualified dividend rate because the underlying theory of the section 951 income inclusion is that the guarantee is deemed to be a dividend.

The Tax Court rejected all three arguments. It discussed at length the taxpayer’s argument that Treasury failed “the reasoned decisionmaking and reasoned explanation requirements” of Motor Vehicle Mfrs. Assn. v. State Farm Mut. Automobile Ins. Co., 463 U.S. 29 (1983), because it did not explain the regulatory treatment of guarantees when it issued the regulations back in 1963-64. (Compliance with State Farm has increasingly become an issue in tax cases in recent years. The Tax Court identified a State Farm problem with the cost-sharing regulations in Altera because of Treasury’s failure to address particular comments in the rulemaking (see our report on the Tax Court’s Altera decision here), and the Federal Circuit struck down on State Farm grounds a section 263A capitalization regulation in the Dominion Resources case (see our report here)).

The Tax Court found that the regulatory process for the section 956 regulations complied with State Farm’s reasoned decisionmaking requirement, describing this case as distinguishable from State Farm for several reasons, including that: (1) it “did not reverse previously settled agency policy”; (2) the regulations “were not promulgated contrary to facts or analysis that supported a different outcome”; (3) “Treasury’s decision did not (and could not) purport to rely on findings of fact”; and (4) “no substantive alternatives to the final rules were presented for Treasury’s consideration during the rulemaking process.” The Tax Court was untroubled by the lack of explanation for the regulatory determinations, rejecting the notion that “an on-the-record consideration of any particular factors is required for rulemaking under section 956(d).”

The Tax Court also ruled that the regulations were not “arbitrary and capricious” in imposing a blanket rule that treats any CFC guarantor as holding U.S. property equal to the principal value of the obligation guaranteed. The court stated that the legislative history indicated that “Congress itself thought extensively about which transactions should be treated the same as repatriations of CFCs’ earnings,” and there was nothing to suggest that “Congress expected Treasury to craft ad hoc exceptions based on some sort of facts-and-circumstances test.” Thus, even though the court acknowledged that the blanket rule led to illogical results in some cases where the full amount of the guarantee cannot reasonably be viewed as a repatriation, the court concluded that it “is not manifestly contrary to the statute or unreasonable that the agency would choose a broad baseline rule for pledges and guarantees as opposed to a less administrable case-by-case approach.” Finally, the court observed that it was “relevant,” albeit not dispositive, that the regulations in question had been on the books for nearly 50 years before the guarantee transactions.

Having upheld the validity of the regulations, the Tax Court gave short shrift to the taxpayer’s other contentions. The taxpayer argued convincingly that the circumstances of the guarantees, including the existence of other guarantors, were such that there clearly was no equivalent to an actual repatriation in the full amount of the guarantees. The court declared this evidence “irrelevant” because the regulations were categorical and made “no provision for reducing the section 956 inclusion by reference to the guarantor’s financial strength or its relative creditworthiness.” With respect to denying the lower qualified dividend rate, the court relied on its prior decision in Rodriguez v. Commissioner, 137 T.C. 174 (2011), aff’d, 722 F.3d 306 (5th Cir. 2013), which held that treating a CFC’s investment in U.S. property “as if it were a dividend” under section 956 does not mean that the tax rate for actual dividends should apply. See our prior coverage of Rodriguez here.

The taxpayer has appealed to the Third Circuit, raising the same basic three arguments. In challenging the validity of the regulations, the taxpayer argues primarily that the regulations are arbitrary and “ignore both congressional intent and economic reality” by creating “broad-brush rules” that treat “every CFC guarantor of a U.S. person’s loan as though it has made the full amount of the guaranteed loan.” The taxpayer maintains that even the IRS in its past administrative guidance had recognized that it is arbitrary to ignore particular facts and circumstances showing that a guarantee is not equivalent to a repatriation; hence, the government is staking out new ground with its current position requiring strict adherence to the letter of the regulation. Secondarily, the taxpayer argues that Treasury’s failure to provide a sufficient reasoned explanation for the regulatory rule violated State Farm principles.

Assuming that the regulations are valid, the taxpayer argues that the court of appeals should follow prior IRS guidance and remand the case to the Tax Court to examine the particular facts and circumstances “to determine whether, in substance, there was a repatriation of CFC earnings.” Finally, the taxpayer argues that the Rodriguez case was wrongly decided and therefore the included income should be taxed at no higher than the qualified dividend rate. The taxpayer points out that the government’s theory for accelerating the recognition of income from the actual repatriation date to the earlier guarantee date is that the guarantees were “an investment in U.S. property that is substantially equivalent to a dividend.” If so, the taxpayer argues, the government cannot “simultaneously argu[e] that they are not substantially equivalent to a dividend for purposes of the applicable rate.”

The government’s answering brief is due November 16.

SIH – Tax Court opinion

SIH – Taxpayer Opening Brief

Fifth Circuit Reverses Tax Court in BMC Software

The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”

The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.

BMC Software Fifth Circuit Opinion

Second Circuit Summarily Affirms in Barnes

November 5, 2014 by  
Filed under Barnes, International, Penalties

The Second Circuit did not make the parties wait very long to learn the outcome of the Barnes Group’s appeal from the Tax Court’s imposition of dividend treatment on its multi-step transaction that enabled it to use in the United States cash that was located in Singapore.  See our prior reports here and here.  Little more than a month after oral argument, the court of appeals today issued a summary order affirming the Tax Court in all respects.  The first page of such unpublished orders recites that they “do not have precedential effect,” but they can be cited in future cases pursuant to Fed. R. App. P. 32.1 (albeit only in limited circumstances in the Second Circuit, see 2d Cir. Local Rule 32.1.1).  In any event, the court issued a nine-page opinion briefly touching on the issues.

First, the court of appeals quickly agreed with the Tax Court that the IRS had not run afoul of the principle that it should not argue against its own revenue rulings.  Even though Barnes had relied on Rev. Rul. 74-503 in determining the tax consequences of a key step in the transaction, the court of appeals accepted the Tax Court’s explanation that Rev. Rul. 74-503 could be disregarded because it “addressed the tax treatment of an isolated exchange of stock, and therefore provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction doctrine.”

The court then upheld the application of the step-transaction doctrine, agreeing with the Tax Court that the intermediate steps would have been fruitless unless they were part of a single integrated plan.  The court rejected the taxpayer’s argument that the doctrine should not apply because the steps had a valid business purpose, finding that the Tax Court’s contrary finding of no valid business purpose was not clearly erroneous.  Specifically, the court of appeals stated that “any non-tax benefit of including the financing subsidiaries was, at best, a mere afterthought.”  Similarly, the court held that the Tax Court did not clearly err in premising its constructive dividend conclusion on a finding that Barnes failed to show that certain interest or preferred dividend payments were ever made.

Finally, the court of appeals upheld the imposition of the 20% accuracy-related penalty.  It ruled that its previous distinction of Rev. Rul. 74-503 as not applying to a situation involving multiple steps also made that ruling unavailable as “substantial authority” that could eliminate the penalty.  And it ruled that Barnes had no “reasonable cause and good faith” defense because the PwC opinion on which it had relied “does not advise as to the tax consequences of the entire series of transactions transferring funds from ASA to Barnes.”

Barnes – Second Circuit opinion

Briefing Completed in Barnes

June 16, 2014 by  
Filed under Barnes, International, Penalties

All of the briefs have now been filed in the Barnes case.  The government’s response brief defends the Tax Court’s decision as a run-of-the-mill application of substance over form principles.  Quoting from True v. Commissioner, 190 F.3d 1165 (10th Cir. 1999), it argues that the step-transaction doctrine applies because the “Bermuda/Delaware exchanges did not ‘make[ ] any objective sense standing alone’ without contemplation of the other steps.”  In arguing that these steps served no business purpose, the government relies heavily on evidence that the “reinvestment plan” was based on tax planning that the taxpayer’s accountants had previously done for another client.  The government asserts that “Barnes and PwC went to great lengths to create out of whole cloth a business purpose for a tax-avoidance plan that originated in PwC’s database.”  Rather than a legitimate business plan, the government alleges that “the entire repatriation scheme consists of essentially nothing more than a circular flow of funds among Barnes and its wholly owned subsidiaries.”

The government’s brief also notes that, if the court of appeals is unpersauded by the Tax Court’s opinion, it should remand for additional factual determinations to resolve two alternative government arguments that were not reached by the Tax Court:  1) that the transaction had the principal purpose of tax evasion and therefore deductions could be disallowed under Code section 269; and (2) that the Delaware preferred stock was held under the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4).

With respect to the issue discussed in our previous post regarding the taxpayer’s argument that the government was prohibited from disavowing Rev. Rul. 74-503, the brief largely tracks the Tax Court’s discussion.  In other words, the government does not question the soundness of the principle stated in Rauenhorst that the IRS cannot argue against its Revenue Rulings.  Rather, the brief simply doubles down on the step-transaction point and argues that the taxpayer could not reasonably rely on that ruling here because this case does not involve “bona fide § 351 exchanges.”

With respect to the penalty issue, the government again criticizes PwC’s role, arguing that PwC had a “conflict of interest” in issuing an opinion regarding the transaction because it had an interest in a favorable tax result that would allow PwC to “market [the tax plan] to other corporations seeking to repatriate funds from a controlled foreign corporation.”  Accordingly, the government argues that the taxpayer could not reasonably rely on the PwC letter for “objective advice.”  The government also argues that the taxpayer could not reasonably rely on the opinion because “PwC did not opine on the integrated repatriation scheme as a whole.”

The taxpayer’s reply brief argues that the government’s brief “mischaracterizes the substance of the plan” because the Bermuda and Delaware subsidiaries did not operate as conduits for a dividend payment.  Instead, it accuses the government of making a policy-based argument that would “impermissibly convert Section 956 into an anti-abuse rule.”  The brief then disputes in detail the government’s description of the transaction and underlying facts.

With respect to the penalty issue, the reply brief states that the government “essentially rewrites the Tax Court’s factual findings” in criticizing reliance on the PwC opinion.  The brief notes that PwC was Barnes’ long-time tax advisor and did not market the transaction to Barnes.  It also states that the Tax Court held that the PwC advisor “was a competent professional who had sufficient expertise to justify reliance” and that Barnes “provided necessary and accurate information to the advisor.”  In particular, the reply brief responds to the government’s “conflict of interest” accusation against PwC by noting that the Tax Court specifically observed that there was nothing “nefarious” about PwC keeping tax planning ideas in a database and by asserting that “the government’s unfounded assertions that PwC did not provide an adverse opinion in order to sell the transaction to others is ludicrous and without any factual basis.”  The reply brief also argues that the government is incorrect in stating that the PwC opinion did not address the entire transaction, quoting the PwC opinion itself as stating that it “is premised on all steps of the proposed transaction.”

Oral argument has not yet been scheduled.

Barnes – Government’s Response Brief

Barnes – Taxpayer’s Reply Brief

Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash

February 21, 2014 by  
Filed under Barnes, International, Penalties

In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates.  As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions.  For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt.  Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.

The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware.  The Delaware subsidiary then loaned the cash to Barnes.  Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received.  (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.)  Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.

The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes.  The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons.  First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant.  Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case.  The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation.  In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations.  The court, however, devoted  little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here.  Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.

The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such.  According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.”  The court stated that the doctrine applies if any of three tests are satisfied:  (1) the binding commitment test; (2) the end result test; and (3) the interdependence test.  Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.”  The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.”  This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.

The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.

Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.

The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty.  The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter.  The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight.  In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.”  Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.

With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends.  In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”

The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous.  The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes.  In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.”  For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend.  Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.

Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503.  The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings.  It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.

It will be interesting, and instructive for other cases, to see how the government deals with this point.  If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling.  There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503.  Will the government question the premise of the taxpayer’s argument in any way?  Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of  Rev. Rul. 74-503 cannot reasonably be applied here?  Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?

Third, the taxpayer contests the court’s penalty determination.  With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling.  With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction.  It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion.  Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”

The government’s brief is due May 15.

Barnes – Tax Court opinion

Barnes – Taxpayer Opening Brief

 

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