Today we welcome back guest blogger Stu Bassin for his take on the argument in the Altera case. Stu has blogged with us on several occasions. Because of the importance of the case, we are providing two views of the argument in Altera today. Keith
The Ninth Circuit held the long-awaited argument on the Government appeal of the Tax Court’s ruling in Altera Corp. v. Commissioner, 145 T.C., No. 3 (2015), on Wednesday, October 11. The case arose out of an IRS notice of deficiency which invoked Section 482 (and, specifically, Treas. Reg. §1.482-7(d)(2)) to redetermine the transfer prices employed for intra-group transactions amongst Altera corporate affiliates. The Tax Court’s ruling, which invalidated the regulation under the Administrative Procedure Act (the “APA”) because of defects in the rulemaking process, has drawn wide-spread interest amongst practitioners involved in both transfer pricing and regulation validity matters.
Before the Tax Court, the parties agreed that the law generally requires participants in intra-group transactions to determine transfer prices in accordance with the prices comparable unrelated parties employ in arms-length agreements. The parties disagreed, however, regarding the proper allocation of stock-based compensation costs amongst the affiliates. The IRS supported its deficiency notice with a regulation which specifically required affiliates to share stock-based compensation costs in computing the transfer price, while the taxpayer contended that the regulation was invalid under the APA because it deviated from the comparable arms-length transaction test traditionally employed in computing transfer prices.
According to the taxpayer, during the rule-making process, commenters submitted substantial evidence supporting the proposition that, in practice, cost sharing agreements amongst unrelated entities operating at arms-length do not require sharing of compensation costs. The IRS did not identify any instance of a cost sharing agreement which provided for sharing of compensation costs in the preamble to the final regulations. Instead, it asserted an economic theory-based policy analysis to support its determination that cost sharing agreements must provide for sharing of compensation costs. The taxpayer, therefore, argued that the regulation was invalid because its requirement of sharing compensation costs in computing transfer prices was arbitrary, capricious, and inconsistent with the evidence before the Service during the rulemaking process.
The Tax Court unanimously ruled in favor of the taxpayer, invalidating the regulation and rejecting the proposed Section 482 adjustment. The Tax Court’s analysis focused 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 criticized the IRS for failing to engage in actual fact-finding, failing to provide factual support for its determination that unrelated parties would share compensation costs in their cost-sharing agreements, failing to respond to significant comments, and acting contrary to the factual evidence before Treasury. Accordingly, the regulation failed to satisfy the reasoned decision-making standard established by Supreme Court precedent under Mayo and related cases.
On appeal, Altera was heard by a panel consisting of Chief Judge Thomas, Judge Reinhardt (the dissenter in the Ninth Circuit’s earlier Xilinx decision in favor of the taxpayer in a similar Section 482 case), and Judge O’Malley of the Federal Circuit. All three judges were appointed by Democratic presidents. Arthur Catterall, one of the top appellate lawyers from the Justice Department’s Tax Division, argued the case on behalf of the Government. Donald Falk, a general appellate litigation specialist from Mayer Brown, argued the case on behalf of the taxpayer. Appellate junkies familiar with appellate arguments in tax cases where the panel is largely silent may be surprised to learn that all three judges actively questioned both lawyers and that the argument extended to a full hour.
The Government focused its argument upon the first stage of the Mayo analysis—the agency’s statutory authority to issue a regulation which departed from the comparable arms-length standard for evaluating transfer pricing arrangements. It argued that the Treasury had authority to regulate on the treatment of cost-sharing agreements because of statutory ambiguity produced by tension between the two sentences of Section 482. 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.”
The first sentence, which has been part of the Code for decades and is consistently reflected in many tax treaties, has historically been construed by Treasury and the courts to incorporate a requirement that a taxpayer’s transfer prices be evaluated based upon their comparability to the arrangements negotiated by unrelated entities operating at arms-length. The second sentence, added in 1986 and focusing upon transfers of intellectual property, requires that the income from the transfer be apportioned in a manner “commensurate with income.” According to the Government, the differing results occasionally produced by a commensurate with income standard and comparable arms-length transaction standard create an ambiguity which allows Treasury to issue regulations which deviate from the arms-length standard for cost allocation.
The taxpayer acknowledged that the arms-length comparability standard and the commensurate with income standard are somewhat different and can produce different results in some cases. That difference, however, did not authorize Treasury to abandon the arms-length comparability standard for allocation of stock-based compensation costs. According to the taxpayer, both the statutory language and the legislative history of the 1986 amendment support a far narrower role for the commensurate with income standard. While the legislative history demonstrates that Congress was concerned about problems which had arisen with arms-length comparability analyses employed in connection with intellectual property transfers, the legislative history contains many references endorsing arms-length comparability analysis in other contexts. Similarly, the statutory language of the commensurate with income provision only applies to intellectual property transfers. Ultimately, the taxpayer contended the commensurate with income statutory language did not support abandonment of arms-length comparability in evaluating the allocation of compensation costs under the taxpayer’s cost-sharing agreement.
Virtually all of the panel’s questions focused upon the statutory construction questions and their implications for the scope of Treasury’s authority to promulgate regulations inconsistent with the arms-length comparability standard. The panel appeared to recognize the tension between the arms-length comparability standard and the commensurate with income standard. It questioned, however, the scope of the tension and the range of costs which Treasury could allocate without regard to arms-length comparability analysis. The government contended that the tension allowed Treasury to promulgate regulations governing all aspects of cost sharing agreements, while the taxpayer tried to limit such regulations to the intellectual property transfer arena.
Interestingly, the argument gave relatively little attention to the second stage of the Mayo analysis—the arbitrariness of Treasury’s determination. The government did not challenge the Tax Court’s conclusions that the regulation was contrary to the evidence regarding comparable arms-length transactions. Instead, it argued that Treasury had almost unlimited discretion to prescribe the allocation of costs if the court agreed that Treasury had authority to prescribe rules contrary to the arms-length comparability evidence. To the contrary, the taxpayer argued that the absence of any arms-length comparability evidence rendered the regulation arbitrary and capricious. The panel, however, did not pursue this line of argument, notwithstanding the Tax Court’s focus on the issue.
The panel gave no indication of when it would render its decision in Altera. Full opinions on appeals to the Ninth Circuit tend to take a long time, so it seems likely that it will be several months before a decision is issued.