We welcome back guest bloggers Professor Susan C. Morse and Stephen E. Shay. Professor Morse teaches at University of Texas Law School and Steve Shay teaches at Harvard. Both are great speakers and writers with a deep knowledge of international taxes honed when they worked together at the Boston law firm of Ropes and Gray. They provided insight on the Altera decision in which the Tax Court decided the case in a fully reviewed 15-0 opinion back in 2015 after the filing of their amicus brief, immediately prior to the oral argument and following the oral argument. The opinion provided perhaps the most important procedural development of 2015 and the reversal is big news as well. The post is a little longer than our normal post but the opinion it discusses is much longer and more important than most of the cases we cover. This is a big win for the IRS. Keith
On July 24, the Ninth Circuit upheld a key IRS transfer pricing regulation, worth billions of dollars in federal revenues, that requires sharing employee stock compensation costs as a condition for a “qualified cost sharing arrangement” or QCSA. In Altera Corp. v. Commissioner, a 2-1 panel reversed the Tax Court’s decision, which had invalidated the regulation under the Administrative Procedure Act (APA).
The conditions for a qualified cost sharing arrangement are described in U.S. tax regulations. If these are satisfied, the IRS will not make transfer pricing adjustments to the costs shared and will treat the cost sharing subsidiary as the co-owner, for tax purposes, of the intellectual property (IP) rights whose costs were shared. QCSAs benefit U.S. multinationals, since they allow MNCs to allocate to non-U.S. subsidiaries (usually in low-tax countries) income from their ownership of the IP.
The “sharing” of the cost of stock options granted to employees (such as engineers) who develop the intellectual property means that some related tax deductions are shifted to the non-U.S. subsidiary (to match with the shifted profit) rather than all of the deductions reducing the U.S. parent’s taxable income. These amounts are very large in the tech sector in particular and the industry has fought for years to avoid treatment of these expenses as costs to be shared in a QCSA. The failure to allocate the costs supports unjustified income shifting from the U.S. to countries where the foreign subsidiaries are located.
Altera, now part of Intel, claimed that its taxable income would be $80 million less if it were not required to share stock option costs. The Wall Street Journal has reported that the issue is worth at least $3.5 billion to Google alone. If the regulation were invalidated, the U.S. government would lose billions of dollars in tax revenue.
Treasury Regulation 1.482-7A was promulgated in 2003 under the authority of Internal Revenue Code Section 482, after notice and comment. Section 482 charges the Commissioner with reallocating income or deduction items “clearly to reflect” related taxpayers’ taxable income.
Altera argued that Section 482 required application of a narrow version of the “arm’s length” principle that only allowed the IRS to take account of costs if they were found in comparable cost sharing arrangements between unrelated parties. Because the stock option cost sharing regulation took the position that all relevant expenses had to be shared, and did not carve out stock option expenses not shared by unrelated parties, Altera contended – and the Tax Court agreed — that Treasury’s regulation was arbitrary and capricious and therefore invalid under the procedural strictures of the APA for failure to adequately explain its position in response to contrary comments. The Tax Court relied on the 1983 Supreme Court precedent State Farm and held that the reasoning supporting the stock option cost sharing regulation could not be discerned from materials such as the Preamble to the final regulations.
The thorough Ninth Circuit opinion starts with a history lesson on Section 482. The concept of “arm’s length” as primarily a comparable transactions method, which Altera focuses on, stems from 1968 regulations, which the court acknowledges featured a new “focus on comparability” (slip op. at 16). But the court explains that comparable transactions never had a monopoly on Section 482 adjustments. Cases in the 1940s, 1950s and 1960s had rejected the view that Section 482 only turned on comparable transactions. As of 1981, more than ten years after the 1968 regulations, the GAO found that only 3% of IRS adjustments were based on “direct comparables.” (Slip op. at 17)
In 1986, a statutory amendment to Section 482 added a sentence, which requires income allocations “commensurate with the income attributable to the intangible.” In 1994 and 1995, regulations regarding direct and cost sharing intangible transfers were promulgated in response to the statutory change. The cost sharing regulations implemented the commensurate with income standard by conditioning shared ownership of intellectual property under QCSAs on shared allocation of all relevant costs incurred to produce the intangibles. As the Ninth Circuit explained in a footnote, “[c]ontemporary commentators understood that [in the cost sharing regulations], by attempting synthesis between the arm’s length and commensurate with income provisions, Treasury was moving away from a view of the arm’s length standard grounded in comparability.” (slip op. at 21 n. 4) The regulations involving direct transfers of intangibles also adopted some exclusively internal pricing rules using profit splits, which were understood as part of the arm’s length standard. These regulations have not been challenged by taxpayers for failure to rely on (unavailable) comparables. In 2003, Treasury promulgated the regulation at issue in Altera, which explicitly requires the sharing of stock option expense when a firm seeks the protection of a cost-sharing agreement under U.S. regulations.
The Ninth Circuit opinion adheres to general administrative law requirements, consistent with the Supreme Court’s 2011 Mayo decision. The court first evaluated Treasury’s compliance with § 706 of the APA under the State Farm’s “reasoned decisionmaking” understanding of the clause prohibiting “arbitrary” or “capricious” agency action. Then it considered whether the agency’s interpretation of the statute was permissible under Chevron.
Altera’s State Farm argument ran as follows. In the notice-and-comment process, tech industry and other commentators said that requiring related parties to share stock option costs couldn’t be arm’s length because unrelated parties did not share such costs. Commentators contended that nothing could replace comparable transactions, not even if exposure to a contract counterparty’s stock price would be unacceptable for unrelated parties but appropriate for related firms. Altera claimed that Treasury’s response to these comments was inadequate under § 706 of the APA.
Treasury responded, for example in the Preamble to the final regulation, by saying that the comments about comparable transactions were beside the point, because Section 482 does not require comparable transactions. In the regulation’s Preamble, Treasury justified the stock option cost-sharing regulation as consistent with “the legislative intent underlying section 482,” “the commensurate with income standard” and “the arm’s length standard.” Treasury’s view was that “arm’s length” meant a result consistent with what arm’s length parties would have bargained for, not a result that had to be predicated on comparable transactions.
Said the court: “[T]he thrust of Altera’s [State Farm] objection “was that Treasury misinterpreted § 482. But that is a separate question – one properly addressed in the Chevron analysis. That commentators disagreed with Treasury’s interpretation of the law does not make the rulemaking process defective.” (slip op. at 32) The court held that Treasury complied with the State Farm requirement because its regulatory intent could be discerned. It plainly “set forth its understanding that it should not examine comparable transactions when they do not in fact exist and should instead focus on a fair and reasonable allocation of costs and income,” (slip op. at 32). It treated the arm’s length standard as “aspirational, not descriptive.” (slip op. at 43)
The Ninth Circuit followed its State Farm analysis with an analysis of Chevron deference. Here, the question was not whether Treasury had clearly articulated its understanding of its authority under § 482, but rather whether it had stayed within the limits of that authority. As to Chevron step one, the court quickly found that Congress left gaps in transfer pricing law for the Treasury to fill with guidance. It is hard to see a different path. The statute includes broad delegation language, saying that “the Secretary may … allocate gross income, deductions [and other items of commonly controlled organizations] if he determines [it] necessary in order … clearly to reflect … income.”
The court’s Chevron step two analysis was also straightforward. When Congress added the commensurate with income standard to the statute in 1986, it communicated that “the goal of parity is not served by a constant search for comparable transactions” and that “the amendment was intended to hone the definition of the arm’s length standard.” (slip op. at 41) The commensurate with income statutory language directed Treasury to do precisely what it did, which was to promulgate internal standards to address the inadequacy of a narrow, comparable transactions approach to arm’s length. The court rejected the argument that Xilinx Inc. v Commissioner, a 2010 Ninth Circuit case, controlled its decision, in part because Xilinx involved the interpretation of pre-2003 regulations, which did not mention stock options.
Judge O’Malley, a Federal Circuit judge sitting by designation, dissented. On the Chevron issue, she wrote that Xilinx should control. Despite the 1986 addition of the “commensurate with income” standard to the statute and the express mention of stock option costs in the 2003 revisions to Treas. Reg. 1.482-7A, she wrote that the regulations had a “fundamental ‘purpose’” (slip op. at 51) consisting of the narrow, traditional arm’s length standard derived from comparable transactions. On the State Farm issue, she wrote that “Treasury may well have believed that, given the fundamental characteristics of stock-based compensation in QCSAs, it could dispense with arm’s length entirely…. But the APA required Treasury to say that it was taking this position….” (slip op. at 59).
Judge O’Malley also suggested a different interpretation of the text of Section 482, saying that the commensurate with income standard’s reference to a “transfer (or license) of intangible property” was not broad enough to include a qualified cost-sharing agreement. This interpretation, raised in an amicus brief submitted by Cisco Systems, cannot be right. Absent a cost-sharing agreement (or another kind of transfer or license other than a QCSA), intangibles would be owned by the affiliate whose workers created them. For Cisco, this would likely be Cisco Systems, Inc., the parent, publicly traded California-incorporated company that sits atop of the multinational Cisco firm and presumably employs Cisco’s engineers. But because of the cost-sharing agreement, some rights, for instance non-U.S. rights, to the intangibles are owned for tax purposes by a non-U.S. subsidiary, say Cisco Systems Netherlands Holdings B.V., which is apparently the holding company for Cisco’s European, Middle East and Africa business. The only explanation for Cisco Systems Netherlands Holdings B.V.’s tax ownership interest in intangibles created by Cisco Systems, Inc. is that, at least for tax purposes, Cisco’s cost-sharing agreement transferred or licensed intangibles from the U.S. parent to the (low-tax) non-U.S. subsidiary. Also, in practice, in addition to the transfer or license for tax purposes worked by the QCSA, cost sharing arrangements are accompanied by IP licenses to the cost sharing subsidiaries to protect their use of the IP.
A request for panel rehearing is not likely, since one of the panelists in the majority, Judge Stephen Reinhardt, unexpectedly passed away in March 2018. However, the taxpayer might request the Ninth Circuit to review the Altera decision en banc (which would not include Judge O’Malley, the dissenting judge, since she sits on the Federal Circuit). And appeal to the Supreme Court is possible as well.
Altera now involves a remarkable tangle of complex legal issues. It raises federal courts rules, international tax regulations, and intricate administrative case law. How strong is Altera’s hand in the event of appeal?
The federal courts issue is procedural: how should a judge’s vote be recorded when the judge dies before an opinion is issued? A footnote explains that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion before his death.” This is consistent with Ninth Circuit rules and the approach of some other circuits (though not all), giving perhaps little reason to think that the Ninth Circuit would reconsider the issue en banc. If the question is Supreme Court review, Altera might not be the best case for further consideration of this issue. There should be no actual concern that Judge Reinhardt would have changed his mind. Reinhardt voted for the government twice in Xilinx, as he was in the majority in the initial case and in dissent on rehearing. This means that he thought the government properly required the sharing of stock option costs even under the pre-2003 regulations that did not mention them.
The international tax and administrative law questions together raise the issues of compliance with Chevron deference and State Farm APA requirements. Here too, Altera does not hold a strong hand. Despite Judge O’Malley’s efforts, it is impossible to read the statute as limiting Treasury’s authority to the narrow, comparable transactions view of arm’s length analysis that the taxpayer advances. As the history of Section 482 shows, the statute clearly is not limited to traditional arm’s length analysis based on comparable transactions. This validates Treasury’s Preamble disagreement with commentators’ view that comparable transactions had to be used as a starting point.
In other words, the question is not close. Even if Chevron deference were cut back to Skidmore “power to persuade” deference, there would still be room under Section 482 for regulations that did not follow the narrow version of arm’s length based on comparable transactions. Plus, Altera covers an area that is a paradigm of technical tax expertise (unlike, for instance, the issue said to be outside Treasury’s wheelhouse in King v. Burwell). Even if the Supreme Court is inclined to consider limits to Chevron deference, Altera is not a good vehicle for that project.