United States: Altera: How To Challenge Tax Regulations On Administrative Law Grounds

In Altera, the U.S. Tax Court invalidated regulations under section 482 requiring participants in qualified cost-sharing agreements (CSAs) to include stock-based compensation costs in the cost pool to comply with the arm's-length standard.  The discussion below summarizes the history of those regulations and focuses primarily on the court's holding and the implications of that holding with respect to administrative law issues. For a discussion of other issues related to the opinion, see Tax Court Decision in Altera Overturns Important Transfer Pricing Regulations (above).

Background

In 2005, the Tax Court held in Xilinx Inc. v. Commissioner, 125 T.C. 37 (2005), that, under cost-sharing regulations promulgated in 1995, controlled entities entering into CSAs need not share stock-based compensation costs because parties operating at arm's-length would not do so. The Ninth Circuit affirmed, holding that the all costs requirement should be construed as not applying to stock-based compensation because the regulations should be interpreted to accomplish the statutory purpose of grounding the Internal Revenue Service's (IRS) allocation authority in the principle of "parity between taxpayers in uncontrolled transactions and taxpayers in controlled transactions," and the U.S. Department of the Treasury (Treasury) technical explanation of the income tax convention between the United States and Ireland confirmed that the commensurate-with-income standard was meant to work consistently with the arm's-length standard.

While the dispute in Xilinx was ongoing, but before the Tax Court's opinion was issued, the IRS and Treasury proposed amendments in 2002 to the 1995 cost-sharing regulations purporting to clarify that stock-based compensation must be taken into account in determining operating expenses under Treasury regulation section 1.482-7(d)(1), to provide rules for measuring stock-based compensation costs, and to include express provisions to coordinate the cost sharing rules of Treasury regulation section 1.482-7 with the arm's-length standard of Treasury regulation section 1.482-1. Several parties submitted written comments to Treasury, and four individuals spoke at a public hearing.  Many of the commentators informed Treasury that they knew of no transactions between unrelated parties, including any cost-sharing arrangement, service agreement, or other contract, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation. Additionally, several commentators identified arm's-length agreements in which stock-based compensation was not shared or reimbursed.

Despite the comments, the IRS and Treasury issued final rules in 2003 explicitly requiring parties to CSAs to share stock-based compensation costs. The final rule also added regulations providing that CSAs produce an arm's-length result only if the parties' costs are determined in accordance with the final rule. Treasury's files underlying the final rules did not contain any expert opinions, empirical data, articles, papers or surveys supporting a determination that the amounts attributable to stock-based compensation must be included in the cost pool of CSAs to achieve an arm's-length result. There was also no evidence that Treasury had searched any database that could have contained agreements between unrelated parties relating to joint undertakings or the provision of services, nor that Treasury was aware of any written contract between unrelated parties that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation.  Nor was there any evidence of any actual transaction between unrelated parties in which one party paid or reimbursed the other party for amounts attributable to stock-based compensation. The preamble responded to certain comments, but did not justify the final rule on the basis of any modification or abandonment of the arm's-length standard. The preamble also concluded that the Administrative Procedure Act (APA) did not apply to the regulations.

Altera

In Altera, Altera filed a petition with the Tax Court challenging the IRS's allocation of income in accordance with the 2003 cost-sharing regulations.  Altera argued that the final rule requiring participants in CSAs to share stock-based compensation costs to achieve an arm's-length result was invalid because it violated the APA. Although similar APA challenges to tax regulations have been raised in the past, (most notably in basis overstatement cases culminating in the Supreme Court's decision in United States v. Home Concrete & Supply, LLC, 132 S.Ct. 1836 (2012)), courts had not addressed in detail the specific arguments raised by Altera.

The APA establishes several administrative law requirements for the promulgation of rules and regulations by government agencies. For example, agencies generally must provide the public with notice of, and the opportunity to comment on, proposed regulations that are intended to carry the force of law (i.e., "substantive rules"), and the agency must consider any comments before promulgating final regulations. However, this requirement does not apply to interpretive rules or when the agency determines, and explains in detail, that good cause exists for not providing notice and the opportunity for comment. The APA also requires that a court set aside agency action that is "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." In Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Automobile Insurance Co, 463 U.S. 29 (1983), the Supreme Court explained that an agency must have "engaged in reasoned decisionmaking," which means "the agency must examine the relevant data and articulate a satisfactory explanation for its action including a 'rational connection between the facts found and the choice made.'" Finally, the APA contains a harmless error rule reflecting the notion that if the agency's mistake did not affect the outcome or prejudice the petitioning party, the agency action can be upheld despite the mistake.  In Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 57 (2011), the Supreme Court made clear that the APA applies to tax rules and regulations.

In Altera, a unanimous Tax Court found that Treasury failed to engage in reasoned decision-making as required under the APA and State Farm.  Specifically, the court concluded that, in failing to rationally connect the choice it made with the facts, Treasury had engaged in arbitrary and capricious decision-making.  Treasury had failed to engage in material fact finding or to follow evidence-gathering procedures and the regulatory record lacked any evidence to support the result set forth in the 2003 regulations.  Treasury had failed to respond to significant comments when it issued the 2003 regulations and its conclusion that the 2003 regulations were consistent with the arm's-length standard in fact was contrary to all of the evidence before it.  Accordingly, the court ruled that the 2003 regulations were invalid.  In doing so, the Tax Court provided a thorough analysis of the application of administrative law principles to Treasury regulations.  In particular, the court made the following determinations:

  1. Treasury regulations issued pursuant to section 7805(a) are legislative regulations because the IRS intends them to "carry the force of law"; thus, Treasury is required to follow the APA's notice and comment requirements absent satisfaction of the good cause exception.
  2. Tax regulations must be the product of reasoned decision-making; thus, they must have a basis in fact, there must be a rational connection between the facts found and the choice made, significant comments must be responded to, and the final rule may not be contrary to the evidence presented before the final rule is issued.

  3. The harmless error exception requires at least a reasonable showing by Treasury that it had sufficient alternative reasons for adopting the final rule (at the time the rule was adopted and not in hindsight) in light of its mistake.

Practical Considerations

A practical question is what is the impact of Altera? Obviously, the opinion is a victory for taxpayers disputing the 2003 regulations dealing with stock-based compensation, and affected taxpayers now will have to consider whether to amend their cost-sharing agreements going forward to reflect Altera, as well as whether and when "clawback" provisions of existing agreements might be triggered. But the impact of the case and its limits on the IRS's rulemaking authority also could be felt more broadly in the transfer pricing area, as taxpayers may challenge other current (and possibly future) regulation provisions that might not be adequately grounded in the arm's-length standard.

It should be noted, however, that all provisions of the transfer pricing regulations remain binding on the IRS regardless of whether such provisions comport with general arm's-length principles. The Tax Court's opinion in Xilinx, as well as other Tax Court cases, treats IRS published guidance as concessions by the IRS on an issue given that taxpayers rely on such positions in planning their transactions. For example, taxpayers clearly can continue to rely on provisions like the applicable-federal-rate-based safe harbor for intercompany interest, even though the results of the safe harbor undoubtedly depart from an arm's-length result in many cases. The arm's-length standard that the Tax Court discussed in Altera limits the authority of the IRS to issue transfer pricing regulations; the IRS cannot impose regulatory requirements under section 482 that violate that standard.

Even more broadly, the impact of the decision may be felt throughout the tax law, because the decision potentially calls into question the promulgation process for many tax regulations that are currently on the books. Treasury has historically taken the position (incorrectly, as Altera demonstrates) that regulations issued pursuant to section 7805(a) are not covered by the APA and many tax regulations lack an extensive discussion of the justification of the rules as envisioned by State Farm. Taxpayers challenging regulations may want to review regulatory history to determine whether, under Altera, Treasury failed to engage in reasoned decision-making. In this regard, Altera, in conjunction with Dominion Resources, Inc. v. U.S., 681 F.3d 1313 (2012), where the U.S. Court of Appeals for the Federal Circuit applied the arbitrary and capricious standard to invalidate Treasury regulation section 1.263A-11(e)(1)(ii)(B) on the ground that Treasury failed to provide an explanation of the reasons behind the regulation, provides an excellent roadmap for undertaking the analysis. Finally, it remains to be seen whether the analysis in Altera may strengthen arguments against the IRS's reliance on temporary regulations (particularly those issued before 1989 that have never been finalized) and situations where the IRS applies final regulations retroactively. 

It should be noted that Microsoft, which is currently involved in a summons enforcement action with the government in the District Court for the Western District of Washington, recently filed a notice of supplemental authority arguing to that court that Altera is relevant to Microsoft's argument that it will make a substantial preliminary showing that enforcing the summonses would be an abuse of the court's process, in part by showing that the IRS violated the APA in promulgating the temporary regulation at issue in that case.

Altera's successful motion for partial summary judgment did not dispose of all issues in the case; thus, the Tax Court has not issued a decision from which the IRS can appeal the case. Once the remaining issues are resolved and a decision is entered, the IRS will need to decide whether to appeal the case (presumably to the Ninth Circuit).  It is impossible to predict what the circuit court would decide, but it bears noting that the Ninth Circuit affirmed the Tax Court's decision in Xilinx and the Tax Court in Altera cited extensively to Supreme Court and Ninth Circuit precedent (as well as case law from the D.C. Circuit, which hears the majority of administrative law issues) to support its holding that the regulation was invalid.

Altera is a significant case, both in the specific context of transfer pricing and in the general context of the validity of tax regulations. Taxpayers that have followed the 2003 regulations should consider whether to change their transfer pricing practices going forward and whether to file protective refund claims for prior open years.  Additionally, as noted above, taxpayers with clawback provisions should consider whether the clawback obligation has been triggered. Taxpayers outside the specific context of the 2003 regulations should also consider the requirements of the APA, including the notice-and-comment procedures, when evaluating whether to take a position that is contrary to a Treasury regulation.

Altera: How To Challenge Tax Regulations On Administrative Law Grounds

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.