David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: Altera, take two. Following the lead of the Ninth Circuit Court of Appeals, we're revisiting the Altera v. Commissioner case. It's been a winding road that started with a unanimous opinion by the U.S. Tax Court in 2015, in which the court found that the 2003 cost-sharing regulations, which required parties to a cost-sharing arrangement to share stock-based compensation costs, violated the Administrative Procedure Act, known as the APA. On appeal to the Ninth Circuit, the court issued a 2-1 opinion in July of 2018 reversing the Tax Court. However, following criticism that the judge who cast the deciding vote had died before the opinion was finalized, the court withdrew the opinion a few weeks later. A replacement judge was named in August, and new oral arguments were held in October. And on June 7th of this year, the court issued a new opinion in the case. Here to talk about where things stand now are Tax Notes Today legal reporters Kristen Parillo and Ryan Finley. Kristen, Ryan, welcome back.
Kristen Parillo: Thanks for having us.
Ryan Finley: Thank you.
David Stewart: So what happened at the Ninth Circuit this time around?
Kristen Parillo: So the Ninth Circuit once again sided with the government and reversed the Tax Court. The new judge, Susan Graber, agreed with Chief Judge Sidney Thomas that the cost-sharing regs satisfied the APA rulemaking requirements. Judge Kathleen O'Malley again dissented. The result wasn't a big surprise. Judge Graber was pretty skeptical of Altera's position at oral arguments. And you could sense that she supported this notion that a cost-sharing arrangement is a transfer or license of intangible properties subject to the commensurate with income standard.
David Stewart: Alright, Kristen, why don't you walk us through the majority opinion? Was it much different from the opinion that was withdrawn?
Kristen Parillo: No, the reasoning was pretty similar to the original, although they did refine some of their key points. On the APA argument, they added this language that said the Chevron and State Farm analyses are related but distinct. They said State Farm looks at the agency's procedural process to determine if a rule satisfies the reasoned decision-making standard. And Chevron looks at whether the conclusion reached under that process is reasonable. So, they said a taxpayer can challenge a regulation under Chevron, State Farm, or both. And since Altera was challenging Treasury's procedural process and the substance of the regs, the majority said they had to do a Chevron and State Farm analysis. They first analyzed the regs under the Chevron two-step test. They said under step one, the statute doesn't explicitly say that Treasury can require parties to a cost-sharing arrangement to share stock-based compensation costs. And then moving to step two, they looked at whether Treasury's interpretation of section 482 was reasonable. Ryan can discuss this further, but they concluded that, based on the legislative history of the 1986 amendment to section 482, Treasury had a reasonable basis for applying the commensurate with income standard to cost-sharing arrangements. The majority then did a State Farm analysis to see if there were any procedural flaws in the process. They said to satisfy the reasoned decision-making standard, Treasury has to look at all the relevant data and then give a satisfactory explanation for whatever action it takes. So, they said since Treasury's conclusion on stock-based compensation costs was reasonable under Chevron, stakeholder comments that unrelated parties don't share those kinds of costs were irrelevant. So they said there wasn't any error in Treasury ignoring those comments.
David Stewart: Ryan, why don't you walk us through the transfer pricing aspects of this and the conclusion that parties to a cost-sharing arrangement can be required to share stock-based compensation costs?
Ryan Finley: Sure, so as Kristen mentioned, the majority said the stock-based compensation rule was based on a reasonable interpretation of the statute. Altera's argument was basically that a comparables-baced approach — which is generally favored under the 482 regulations, at least when comparables are available — is the only valid approach to applying the statute. Although the case didn't actually concern comparables selected for the purposes of applying a transfer pricing method, the comparables were the arm's-length transactions cited in comments objecting to the proposed version of the regulation. So according to the majority, the IRS is not bound to this approach under section 482. They said the statute requires an arm's-length result in terms of the allocation and taxable income, not that the allocation method mimic the way unrelated parties transact. Although the opinion says other valid approaches have coexisted with comparables-based methods since 1928, it emphasizes the significance of the addition of the commensurate with income standard in 1986. The commensurate with income standard, which is the second sentence of section 482, says the income in a controlled intangible transfer must be commensurate with the income attributable to the transfer. The majority said the commensurate with income standard didn't replace the arm's-length standard, but shifted its focus to allow internal methods of allocation. They're focused on aligning taxable income with economic activity. According to the opinion, the 2003 stock-based compensation rule was a reasonable way of achieving this purpose. And because the basis of the rule was the commensurate with income standard instead of arm's-length transactions, the majority said that Treasury and the IRS didn't have to counter examples cited in public comments under the Administrative Procedure Act. All this was similar to the withdrawn opinion, but as Kristen said, the majority devoted more attention to the transfer issue. The commensurate with income standard only applies to transfers or licenses of intangible property, and Altera argued that the sharing of costs for future intangible development isn't covered by the commensurate with income standard because funding the development of new intangibles is not a transfer. Judge Graber focused on this point during the second round of oral arguments, and the opinion now explicitly rejects this argument.
David Stewart: Let's turn now to Judge O'Malley's dissent. Did she basically reiterate arguments made in the original dissent?
Kristen Parillo: Yeah, pretty much. She again argued that the regs were substantively flawed because she thinks the commensurate with income standard applies only to transfers of existing intangibles. And she said a cost-sharing arrangement is still in the future intangibles. And she again said the regs were procedurally invalid because she said Treasury didn't adequately signal in the proposed regs that it was departing from its historical position that a comparability analysis is the only way to arrive at an arm's-length result. She said Treasury cited to the legislative history of the 1986 amendment, but didn't explain what portions factored into its thinking, or even mention that its position was based on this idea that cost-sharing arrangements constitute a transfer of intangible property. She said Treasury expanded on its reasoning in the final regs, but it still didn't give a good enough explanation for why cost-sharing arrangements should be considered a transfer of intangible property.
David Stewart: What impact do we expect this decision will have on transfer pricing?
Ryan Finley: The decision obviously is very significant, and especially because it's coming from the Ninth Circuit. The major West Coast giants, which tend to have valuable IP to offshore, and who often give their employees stock-based compensation, tend to be in the Ninth Circuit. And you can see, from frequent citations to Altera in many tech companies' public financial statements, that many companies think the outcome of the case is material. In terms of the law, the decision would seem to put a roadblock in front of challenges to similar rules on stock-based compensation in the services regulations and in the current cost-sharing regulations. Both require that stock-based compensation be included in the cost base or shared cost pool. IRS officials have also said Altera-inspired arguments have become common for other parts of the regulations that have nothing to do with stock-based compensation, so the decision could affect those challenges as well.
David Stewart: What sort of challenges are we seeing?
Ryan Finley: No challenges have worked their way through the system yet. But a hint of this came up during the second round of oral arguments in Altera. They were talking about periodic adjustments, which are a retrospective repricing mechanism based on profitability that would be very rare in arm's-length transactions. Counsel for Altera was unclear about whether the periodic adjustment rules are invalid for similar reasons that they are inconsistent with behavior of arm's-length parties. But a few days later, they filed a letter saying that periodic adjustments are valid only to the extent that they follow a comparables-based approach. There are other specific rules in the 482 regs that could potentially be subject to similar challenges, so a definitive statement by the Ninth Circuit rejecting the basic premise is pretty significant. It's also interesting in light of the government's ongoing appeal of the Amazon decision, which is another Ninth Circuit cost-sharing case. If the court takes the same kind of flexible income-based interpretation of section 482, it may make the Tax Court's rejection of the IRS's realistic alternatives argument in Amazon harder to defend.
David Stewart: So, what is the next step in this case? Is Altera expected to appeal?
Kristen Parillo: They haven't publicly said yet what they plan to do, but if they want to file a petition for rehearing en banc, they have 45 days from the date the opinion was issued, which was June 7th. So they would have to do that by July 22nd. So, they could skip the rehearing process entirely and go straight to filing a cert petition with the Supreme Court. If they do that, they'd have 90 days from the date of the opinion to file, which would make that deadline September 5th. If they file for a rehearing first and get denied, then the 90-day window for filing a cert petition starts from the day the rehearing request is denied.
David Stewart: Well, Kristen, Ryan, maybe we can come back and talk about a Ninth Circuit opinion for a third time.
Ryan Finley: I really hope not.
David Stewart: Anyway, thank you for being here.
Kristen Parillo: I'm sure we'll be back.
David Stewart: Thank you. And now, Coming Attractions. Each week, we preview commentary that'll be appearing in the next issue of the Tax Notes magazines. I'm joined by executive editor for commentary, Jasper Smith. Jasper, what will you have for us?
Jasper Smith: In Tax Notes Federal, Michael Kohler discusses how partnerships can comply with section 987 based on the 2016 regulations that use the aggregate approach to apply this section to partnerships. Also, Jeffery Kadet and David Koontz examine the risks that may accompany a business restructuring that could change income taxable under the GILTI regime to being income taxable under the FDII rules.
In Tax Notes State, Jared Walczak discusses modernizing the sales tax in Utah as an example that other states could follow. Walter Hellerstein discusses the constitutionality of taxes that fall disproportionately on nonresidents.
And in Tax Notes International, Barry Larking considers recent CJEU judgments that develop a general solution to tax avoidance, and suggests some practical implications going forward. Laurence Clot and Brent Springael examine France's new patent box regime and the ways in which it enhances the existing intellectual property tax.
David Stewart: You can read all that and a lot more in the July 1st editions of Tax Notes Federal, State, and International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can e-mail us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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