Reuven Avi-Yonah, a professor at the University of Michigan Law School, reviews the arguments raised in Altera v. Commissioner and predicts where the case might go with Tax Notes legal reporter Ryan Finley.
Read the podcast transcript below. This post has been edited for length and clarity.
David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: Altera, the never-ending saga. We've discussed Altera v. Commissioner before. It is a challenge to the 2003 cost-sharing regulations.
In this episode, we'll update you on where things stand, get into some of the arguments being raised, and look ahead to where the case may be going.
Joining me in the studio today is Tax Notes Today legal reporter Ryan Finley. Ryan, welcome back to the podcast.
Ryan Finley: Thanks for having me.
David Stewart: Can you give us a quick refresher on what this case is about?
Ryan Finley: Sure. The case involves a challenge to the 2003 cost-sharing regulations, which introduced an explicit requirement that parties to a cost-sharing arrangement share stock-based compensation costs. Altera argued that the regulation was invalid under the Administrative Procedure Act because Treasury did not respond to evidence submitted during the notice and comment period that unrelated parties wouldn't share stock-based compensation costs.
In a 2015 decision, the Tax Court sided with Altera and invalidated the regulation. The government thereafter appealed to the Ninth Circuit, and after issuing an opinion, withdrawing it, and then issuing another opinion, the Ninth Circuit ultimately reversed the Tax Court and upheld the validity of the regulation.
David Stewart: We spoke about this last time in June. Can you give us an update on what's happened since the Ninth Circuit ruled in favor of the IRS?
Ryan Finley: Sure. The big thing that happened was Altera filed a petition for rehearing en banc, which basically is a review by a larger panel of the original panel decision. They're typically granted only in very unique circumstances, but Altera argued that those circumstances applied in this situation. According to Altera, the panel decision created conflict with Ninth Circuit precedent and set the stage for ultimately a circuit split on the issue.
David Stewart: Was Altera's petition successful?
Ryan Finley: It was not. Altera's petition was denied in November in an order that was accompanied by a dissenting opinion. The order didn't actually explain the basis for rejecting the petition, but it did include this lengthy dissent arguing that the Ninth Circuit actually should have reheard the case.
David Stewart: You just did an interview about this case. Who did you talk to?
Ryan Finley: I spoke by phone to Professor Reuven Avi-Yonah of the University of Michigan Law School. He's actually cited in the Ninth Circuit panel's opinion.
David Stewart: All right, let's go to that interview.
Ryan Finley: Hi, Professor Avi-Yonah. Thanks for joining us and talking about Altera. The first question I have is about the amicus brief that you joined in support of the government's position, which was to deny Altera's petition for rehearing. Focusing more on the section 482 interpretation issues rather than the Administrative Procedure Act, can you walk us through your arguments why the panel decision is correct?
Reuven Avi-Yonah: The main point was that the arm's-length standard never meant that there was a strict comparability requirement in all cases. If you look historically, even during the period between the 1968 regulations and the 1995 regulations where comparability was required under the regulation, there has been a significant status quo. For example, in the early 1990s, it was showing that in over 90 percent of the cases, comparables are not actually used because it was impossible to find adequate comparables, and so the fourth method, as they were called then, were used instead.
Of course, under the current set of regulations, which takes us to 1995, we've got one method: the CPM. It uses a very loose standard of comparability, and really uses statistical analysis. Another one, the profit-split, which is probably the most commonly used method these days, doesn't use comparables at all with residuals, which is a large portion of the profits.
The arm's-length method or standard has never meant that there would necessarily always be a comparable because that would really have made that surprising analysis impossible. Our position in the amicus brief was that it is simply not true to say that because in this set of circumstances, comparables cannot be found, that means that requiring the sharing of all parts means that you violate the arm's-length standard.
Ryan Finley: Just to clarify, are you saying that the commensurate with income standard isn't even necessary for the IRS's interpretation to be right in this case?
Reuven Avi-Yonah: I think that's right. I think they don't need to rely on the commensurate with income standard, but it is also true. That's another point that we made when Congress added the commensurate income language to section 482 in 1986. That is the only time that the language of the statute was changed in all the years it's been around since the early 1920s.
If they explicitly said in the legislative history that they meant the commensurate with income standard to apply regardless of whether it is compatible with the arm's-length standard, understanding that in many cases it will be impossible to find comparables. Those are precisely the kind of cases that the commensurate with income standard was designed to address, namely the cases involving the transfer of high-value intangibles.
Ryan Finley: Speaking of the commensurate with income standard, one of Altera's arguments was that cost sharing actually isn't an intangible property transfer at all, so the commensurate with income standard is irrelevant.
Reuven Avi-Yonah: I don't think that's right, because what cost sharing does is that it transfers the economic right to future income derived from the jointly developed intangibles from usually where the intangible is developed, namely the U.S., to the foreign party. That transfer of economic price, regardless of what happens with the actual patented or copyrighted item involved, is a transfer that I think is covered by the commensurate with income standard.
If you say that there's no transfer involved in a cost-sharing agreement, that essentially means that the cost-sharing method completely undermines the intent of the commensurate with income standard. The whole point there was to cover all the possible ways in which very broadly defined intangibles could be transferred from the U.S. to a low-tax jurisdiction. Put otherwise, to cover all the ways in which profit can be shifted from the U.S. to a low-tax jurisdiction. This is exactly what cost sharing does.
Ryan Finley: Would you say that cost sharing is almost inherently tainted with profit shifting?
Reuven Avi-Yonah: I think cost sharing is problematic per se. Cost sharing goes all the way back to the 1960s, but it really became important after the commensurate with income standard was adopted in 1986. I think the underlying premise of cost sharing is misguided. That's my personal view. The reason that cost sharing is allowed is because the assumption is that the parties, when they're entering a cost-sharing agreement, do not know how profitable an intangible is going to be and, therefore, they risk losing the deductions that are allocated to the foreign party. That is going to create a natural inhibitor towards shifting too much profit on the cost sharing.
The reality is that multinationals have a huge information advantage. When they enter into cost sharing, they usually frequently know exactly how profitable an intangible will be. Therefore, they're not taking any significant risk, and by allocating the deductions that they're planning to the U.S. and to the foreign party, they assure that 80 percent of the profits will not be subject to a transfer pricing challenge. I think that is a very significant advantage. I've testified in Congress several times that I think we should take another look at the entire cost-sharing mechanism and whether we should retain that. After all, it's only a regulation. But now, it's a regulation that has been around for so long that it's unlikely to be changed.
Ryan Finley: That's a good segue to another question I had. Could Treasury have written the regulations in a different way or addressed this kind of issue in another way that protected them from this kind of challenge?
Reuven Avi-Yonah: I think this is a really interesting question in this context because Altera was a case involving the Caymans. There's no governing treaty, obviously, so they're not bound by treaty to apply the arm's-length standard. They could have if they wanted to and said, "We will treat cost sharing as an exception to the arm's-length standard and put that right in the front of regulation." That would have made this kind of challenge impossible.
I think they didn't want to do that precisely because their position was like what we are arguing in the amicus brief —that this is compatible with the arm's-length standard in the absence of comparables. If you don't see comparables, apply the arm's-length standard. In my mind, this suggests that they feel bound by the arm's-length standard, even in the treaty, because it's the international norm.
Ryan Finley: Speaking of international norms, one of the amicus briefs that was filed on behalf of Altera was filed by a group of former foreign tax administrators who said that the Altera decision conflicts with the understanding that every country has under article 9 of the OECD model tax convention of what the arm's-length principle should mean. Do you think they're wrong?
Reuven Avi-Yonah: Yes, I think they're wrong. I also think it's problematic to take the views of former foreign tax officials that have no stake in the maintenance of the revenue into account as significantly representing any kind of international consensus. But I think they're wrong simply because every country essentially faces the same problem of the absence of comparables in these kind of cases, and as a result, every country has developed a different method.
The OECD follows the profits-split method and has accepted that as a so-called profit-based method as equivalent to the comparables-based method. We've long gone past a day in which the Germans, for example, would insist that only the classical method can be used, because in today's world, the reality is that the vast majority of transfer pricing cases you can't find fit for comparability.
In addition, I think it's really ironic to say that now a) because it's not a treaty-based case, and b) because the OECD is very seriously considering changing the application of the arm's-length standard and to some extent even abandoning it. So to say that this is an immutable international standard that cannot be challenged is a little bit ironic under the current circumstance.
Ryan Finley: Looking to the future of this case, assuming Altera tries to appeal to the Supreme Court, do you have any predictions as to what the Supreme Court would do with it?
Reuven Avi-Yonah: Predictions are very difficult. What I can say is that the Supreme Court takes very few federal tax cases, and usually they take them when there's a significant circuit split, which I don't think is in this case. I don't think it is very likely to give rise to a significant circuit split because most of the companies that are affected are in the Ninth Circuit. Now is it possible? Of course.
I'm sure that Altera and its allies will try very hard to get the Supreme Court to take the case. But in general, the Supreme Court has a lot on its plate, and this case involves a relatively narrow issue. I'm dubious that they will take it.
Ryan Finley: Say the Supreme Court rejects Altera's petition. How do you see the case playing out in the Tax Court for cases that would be appealable in different circuits?
Reuven Avi-Yonah: That's a really interesting question because they are trying to make this argument that the Tax Court will definitely refuse to follow the Ninth Circuit and maintain their original position. I'm not sure. The Tax Court opinion is really about the administrative law issued, and less about the section 482 question. I imagine that they would continue following that route and tend to strike down regulations that are, in their minds, inconsistent with the Administrative Procedure Act. But that's a different issue.
As far the section 482 issue is concerned, I'm not sure that the Tax Court will necessarily refuse to follow the Ninth Circuit. I think that the Tax Court is very well aware, since they do a lot of the transfer pricing cases, how difficult it is to find comparables. Therefore, I'm not sure that they will necessarily rule in favor of the taxpayer in a few of the cases, even if they appeal to out of circuit.
Ryan Finley: Professor Avi-Yonah, thanks for joining us on the podcast.
Reuven Avi-Yonah: Thanks for having me.