In Altera, the U.S. Tax Court invalidated regulations under Section 482 requiring participants in qualified cost-sharing agreements 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, as set forth in more detail in the Tax Court's opinion, 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 Overturns Important Transfer Pricing Regulations.
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 qualified cost-sharing agreements need not share stock-based compensation costs because parties operating at arm's-length would not do so. The U.S. Court of Appeals for 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 Treasury's 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 U.S. Department of the 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 Treas. Reg. § 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 Treas. Reg. § 1.482-7 with the arm's-length standard of Treas. Reg. § 1.482-1. Several individuals and organizations 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, Treasury issued final rules in 2003 explicitly requiring parties to qualified cost-sharing agreements to share stock-based compensation costs. The final rule also added regulations providing that qualified cost-sharing agreements 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, or published or unpublished articles, papers, surveys, or reporting supporting a determination that the amounts attributable to stock-based compensation must be included in the cost pool of qualified cost-sharing agreements 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.
In Altera, the IRS issued notices of deficiency allocating income in accordance with the 2003 cost-sharing regulations. Altera filed a petition with the U.S. Tax Court challenging the IRS's allocation. The parties filed cross-motions for partial summary judgment regarding whether the final rule requiring participants in qualified cost-sharing agreements to share stock-based compensation costs to achieve an arm's-length result was valid. Specifically, Altera argued that the final rule 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 related to 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 held that Treasury failed to engage in reasoned decision-making as required under the APA and State Farm. Specifically, the court held that Treasury failed to rationally connect the choice it made with the facts found that it failed to respond to significant comments when it issued the 2003 regulations, and that its conclusion that the 2003 regulations were consistent with the arm's-length standard was contrary to all of the evidence before it. In essence, based on the regulatory history of the 2003 regulations, the court determined that Treasury had failed to engage in sufficient 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. As a result, the court ruled that the 2003 regulations were invalid because Treasury engaged in arbitrary and capricious decision-making. In doing so, the Tax Court provided a thorough analysis of the application of administrative law principles to Treasury regulations. In particular, the court held the following:
- 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.
- 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.
- 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.
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. The arm's-length standard does not operate as a separate requirement that taxpayers must meet above and beyond contending with the specific provisions of the regulations delineating the IRS's regulatory exercise of its allocation authority under Section 482.
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. Indeed, until 2014, the Internal Revenue Manual provided that it was "not necessary to justify rules that are being proposed or adopted or alternatives that were considered." And, many tax regulations lack an extensive discussion of the justification of the rules 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 Treas. Reg. § 1.263A-11(e)(1)(ii)(B) on the ground that Treasury failed to provide an explanation of the reasons behind the regulation, provide excellent roadmaps 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. In a response, the government asserted that Microsoft's notice of supplemental authority was improperly submitted and should be disregarded because (1) the court has already ruled on Microsoft's motion for evidentiary hearing; (2) the notice is not evidence that addresses any factual issues to be decided at the evidentiary hearing; (3) the notice is premature as to any post-hearing briefing that the court might order or had previously order; and (4) the issued raised by Altera, and their applicability to the summons regulation at issue in Microsoft's case are complex ones that merit a full briefing by the parties at the appropriate time.
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 to the Ninth Circuit given that Altera's principal place of business was in California at the time the petition was filed (unless the parties agree to a different appellate venue, which is unlikely). It is impossible to predict what the Ninth Circuit 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 tax regulation.
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