Last week bought the latest twist in the saga of a challenge to a critical transfer pricing regulation—a rehearing by the Ninth Circuit of a since-vacated ruling upholding the regulation. The original unanimous reviewed decision by the Tax Court in Altera Corp. v. Commissioner, 145 T.C., No. 3 (2015), invalidated the regulation. A divided panel in the Ninth Circuit reversed, upholding the validity of the regulation over a strong dissent. The majority opinion was soon vacated and the case was reargued on October 16, 2018. Given the importance of the specific regulation at issue in transfer pricing cases, as well as the continuing discussion regarding questions concerning Administrative Procedure Act challenges to IRS regulations, the reargument has generated substantial attention in the tax community.
The underlying dispute involves a cost-sharing agreement governing allocation of stock-based compensation costs between entities related to the taxpayer and invocation by the IRS of Section 482 to recharacterize the terms of that agreement. The taxpayer relied upon the undisputed fact that the terms of its cost-sharing agreement were consistent with the prices which unrelated parties would employ in comparable arms-length agreements, thereby satisfying the legal standard historically applied in evaluating cost-sharing agreements under Section 482. The IRS recharacterized the terms of the agreement, relying upon a regulation which specifically required affiliates to share stock-based compensation costs in a manner “commensurate with the income attributable to the intangible.” The taxpayer disagreed, contending that the regulation was invalid under the APA because it deviated from the comparable arms-length transaction test.
The Tax Court unanimously ruled in favor of the taxpayer, invalidating the regulation and rejecting the proposed Section 482 adjustment, focusing upon the second stage of the regulation validity inquiry mandated by Mayo Foundation v. United States— whether the determinations reflected in the regulation were arbitrary and capricious. The opinion concluded that the regulation was invalid because the IRS failed to engage in actual fact-finding, failed to provide factual support for its determination that unrelated parties would share compensation costs in their cost-sharing agreements, failed to respond to significant comments, and acted contrary to the factual evidence before Treasury.
The IRS appeal to the Ninth Circuit was initially heard by a panel consisting of Chief Judge Thomas, Senior Judge Reinhardt, and Judge O’Malley of the Federal Circuit. Judge Thomas, joined by Judge Reinhardt, wrote the opinion for the court reversing the Tax Court opinion and upholding the validity of the regulation. He reasoned that the 1986 amendment of Section 482 (which added the language containing the “commensurate with income” standard) mandated that the IRS adopt regulations employing the commensurate with income standard in addition to the comparable arms-length transaction standard. Judge O’Malley dissented, urging invalidation of the regulation because it deviated from the arms-length standard.
Because the decisive vote was cast by Judge Reinhardt, who died after the argument and roughly 100 days before the opinion was issued, a procedural issue arose when Altera petitioned for rehearing. The remaining members of the panel were deadlocked, so the court withdrew the original opinion, assigned Circuit Judge Susan Graber (a Clinton appointee) to replace Judge Reinhardt on the panel, and scheduled the case for reargument last week.
At the argument, Judge Thomas was silent and Judge O’Malley appeared to reiterate the position stated in her dissent. So, all eyes focused upon Judge Graber, who was new to the panel and the likely decisive vote on the merits. She focused her inquiry upon statutory construction issues and the relationship between the historic standard of “comparable arms-length transactions” embodied in the first sentence of Section 482 and the “commensurate with income” standard embodied in the second sentence of Section 482. Noting that the statutory language of the second sentence applies only to “the income with respect to such transfer or license [of intangible property],” she questioned whether the cost sharing agreement was a “transfer or license” within the meaning of the statute. The taxpayer argued that its cost-sharing agreement was not a narrow “transfer or license” and that the second sentence’s “commensurate with income” standard was therefore inapplicable. In contrast, the government contended that the indirect role of the cost-sharing agreement in establishing the pricing on the arrangement between the two subsidiaries was sufficient to render the “commensurate with income” standard applicable and controlling.
Judge Graber also asked a series of questions focused upon reconciling the commensurate with income standard with the general requirement under Section 482 that the IRS must allocate costs in a manner consistent with the arms- length standard. The government argued that the legislative history reflects a congressional policy judgment and determination that, in those cases involving transfers of intangible property, only an allocation based upon the “commensurate with income” standard would satisfy the arms-length standard. The taxpayer countered by stating that the legislative history did not support such a construction and observed that, if the government’s construction were adopted, relatively few transactions would remain governed by the traditional arms-length standard.
Finally, Judge Graber inquired whether there was a factual basis or economic theory which supported the regulation’s finding that stock-based compensation costs must be allocated in a manner commensurate with income to satisfy the arms-length standard. The taxpayer noted the absence of a factual record or economic theory supporting the IRS findings, arguing that the only evidence before the agency supported a finding that comparable arms-length transactions did not allocate stock-based compensation costs in the manner required by the IRS. In contrast, the government stated that such evidentiary support was not required to support the IRS determination.
Interestingly, the argument gave relatively little attention to the second stage of the Mayo analysis—the arbitrariness of the IRS determination. The degree of deference accorded regulations under Chevron was hardly discussed. Both sides and the court focused upon the statutory authority for the regulation. They all seemed to agree that, if the statute authorized the IRS to deviate from the arms-length standard, the regulation would survive. Otherwise, the regulation was invalid.
The panel gave no indication of when it would render its decision. Full opinions on appeals to the Ninth Circuit tend to take a long time and the initial panel decision was not released until nine months after the argument. So, it seems likely that a decision will not be issued until early 2019.
 The text of the statute provides—
In any case of two or more organizations . . . owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.
 562 U.S. 44 (2011).
 A footnote to the opinion states that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion prior to his death.”