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By Robert Kantowitz, Esq.
Sandburg Creek LLC, Lawrence, NY
The Tax Court case of Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), a reviewed decision with no dissents, has three important elements. First, of course, is the immediate holding of the case, which is important for the parties involved and for others with a similar issue, namely that the costs of stock-based compensation do not have to be allocated in a cost-sharing arrangement. The second important element is the reason for the decision: the Administrative Procedure Act actually has some teeth, and the government must provide a rational basis for Treasury regulations. The third element potentially is a broader message regarding the way Treasury regulations will be tested over time as they are applied in real cases.
The Altera Case Itself
Altera addressed the validity of cost-sharing Reg. §1.482-7(d)(2) ("the Regulation"), in particular, the requirement that stock-based compensation costs be shared among members of a controlled group, including the non-U.S. members. Naturally, an allocation of those costs in part to non-U.S. members would result in lower deductions, and therefore higher taxable income, for the U.S. members.
A 1995 regulation had generically required that "all costs" of intangible product development be shared, and the IRS had sought to include stock-based compensation costs within the scope of the term "all costs." The Tax Court disagreed in Xilinx v. Commissioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010). The Ninth Circuit specifically noted that the government and the taxpayer had stipulated that unrelated parties at arm's-length would not have allocated such costs, so the Ninth Circuit reconciled the general language of the regulation with the arm's-length principle that underlies §482 and numerous tax treaties by deciding that the generic language of the regulation could not include such costs.
By 2003, Treasury and the IRS had promulgated the Regulation, specifically requiring such stock-based compensation costs to be allocated. In Xilinx, the Ninth Circuit had noted the Regulation but did not address it because it did not apply to the years at issue. In Altera, the Tax Court struck down the specific regulation.
The Reason for the Decision and Its Implications
The Tax Court in Altera held that the Regulation had not been properly promulgated under the Administrative Procedure Act. Specifically, the court determined that the government had not performed its fact-finding and decision-making functions as required by law; there had been no development of empirical data to support a rational basis for the Regulation. Hence, among other things, the Tax Court held that the Regulation failed to meet both the State Farm test (not "arbitrary and capricious") and what the court termed (Slip Op. at 47-48) the identical second prong ("reasonableness") of the Chevron test.
Altera is important in the cross-border context because the Regulation in question — and §482 under which it was promulgated as a legislative regulation – directly affect the allocation of income between U.S. and non-U.S. persons in a related group. More broadly, numerous other regulations that affect multinational groups (as well as some with purely domestic content) might likewise fall for the same reason if it turns out that the premises on which they are presumably based were never supported by any investigation reflected in the administrative record.
It has sometimes seemed that Treasury does not have to satisfy the Administrative Procedure Act in the "real world." See, e.g.,Burks v. United States, 633 F.3d 347, 360 n.9 (5th Cir. 2011). But in Altera, the Tax Court addresses this contention and reminds the government that Treasury regulations, like all others, can be declared invalid if they do not comport with the Act's requirements. Slip Op. at 47.
Given how difficult it is in any given case to get a court to overturn a regulation, even invalid regulations can serve the government's purpose of deterring behavior that the government considers inappropriate. About 15 years ago, I was handed an opinion from a prominent law firm that validated a proposed loss importation transaction on the sole grounds that the regulation explicitly to the contrary had been promulgated in violation of the Administrative Procedure Act's notice and comment procedures. I refused to proceed with the transaction – not because I thought the opinion was actually wrong but because I said that no client in its right mind would want to "buy an audit" with that as its only defense, no matter how strong the case. But in many circumstances, such as in Altera, the issue is not whether or not to undertake a transaction but how to structure a transaction that is driven by commercial considerations or report the tax treatment of what has in any event occurred.
To consider this point further, it has been rare for the courts, or even bar associations in their reports, to hold Treasury's feet to the fire and question the justifications that underlie a variety of presumptions and rules of convenience set forth in regulations. Perhaps this case is a start. One timely and prominent candidate for scrutiny is the long look-back period for the "anti-slimming" provision for inversions in Notice 2014-52, 2014-42 I.R.B. 712, §2.02(b), where, by contrast, the authorizing statute, §7874(c)(4), expresses only a subjective "principal purpose" test. Is anyone aware of any empirical data that could justify connecting asset contractions with a later inversion based on time alone, especially a period that could be almost four years? And who knows what other regulations have a similar fatal procedural flaw?
Broader Implications for the Jurisprudence of Treasury Regulations
Just as important, the Altera opinion – appealable to the Ninth Circuit, which, given the history of the subject matter, is unlikely to reverse it – adds another interesting wrinkle to the jurisprudence regarding review of regulations. In Mayo Foundation v. United States, 562 U.S. 44 (2011), the Supreme Court held that Treasury regulations were subject to review under the general Chevron standard that applies to regulations issued by all agencies. The Court held that there would no longer be any need to undertake the detailed analysis under the more taxpayer-favorable standard of National Muffler Dealers Ass'n v. United States, 440 U.S. 472 (1979), which took into account such things as the lapse of time from the enactment of the statute to the promulgation of regulations and whether the government's interpretation had been consistent. Personally, I believe that the Court got Mayo wrong for two interrelated reasons. First, tax really is different from everything else because only in tax is it always the government against a private actor. By contrast, in other areas, agencies write regulations and promulgate interpretations that establish relative positions of conflicting policy considerations, e.g., environment versus industry, or that affect the rights of other parties inter se, see, e.g., FTC v. Wyndham Worldwide Corp., No. 14-3514 Slip. Op. at 28-35 (3d Cir. Aug. 24, 2015) (discussing deference to the FTC's interpretation of "unfair"). Second, only in tax is there the inherent risk of the agency's not being able to separate its role of impartially interpreting the law from its voracious appetite for revenue. Indeed, following Mayo, I witnessed the spectacle of the IRS Chief Counsel boasting before the New York State Bar Association's Tax Section that "we have slain all the dragons" and proclaiming that, among other things, they now could change regulations at will to support litigation positions as they arose. See Sloan, Williams, and Foster, Supreme Court's Mayo Foundation Opinion Grants Chevron Deference to Treasury Regulations , 63 The Tax Executive 35, 40 (Spring 2011). It was almost as if one could hear hundreds of eyeballs rolling in their sockets.
The Chevron approach is the law, although the Administration's recently issued very broad clean air regulation may trigger litigation challenging whether any agencies really can be entrusted with such discretion. Moreover the Sixth Circuit has stayed enforcement of a clean water rule on grounds reminiscent of what the Tax Court wrote in Altera: "Nor have respondents identified specific scientific support substantiating the reasonableness of the bright-line standards they ultimately chose. Their argument that `brightline tests are a fact of regulatory life' and that they used `their technical expertise to promulgate a practical rule' is undoubtedly true, but not sufficient." In re EPA and DOD Final Rule, 2015 BL 333498 (6th Cir. Oct. 9, 2015).
And in the tax world, the pendulum may also be swinging back incrementally regarding how the Chevron analysis is performed in practice. The Fifth Circuit in Burks wrote:…The Commissioner "may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations."
Burks, above, at 360 n.9 (citation omitted). And in United States v. Home Concrete & Supply, 132 S. Ct. 1836 (2012), the Supreme Court held that the first prong of Chevron — an ambiguity in the bare words of a statute – is never met if the Supreme Court has previously decided that there is no ambiguity as to what Congress intended. (The substantive holding of Home Concrete – that an overstatement of basis is not an understatement of gross income under §6501(e)(1)(A) that triggers a six-year statute of limitations – was partially changed, retroactively, by §2005 of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Pub. L. No. 114-41), but that does not detract from the importance of the case in the jurisprudence of deference.)
Now, the Tax Court in Altera has stated that in testing the validity of a regulation:… if a precedential case holds that a statute unambiguously expresses a congressional intent that is contrary to the agency's construction of the statute, the prior judicial construction controls.
Slip Op. at 40.
One must assume that the term "precedential" is intended to have its normal meaning, which is that if the circuit to which a case would be appealable has so construed the statutory words, then there is no Chevron deference. Indeed, the Tax Court also treats some of its own prior decisions as precedential in the absence of contrary law in the relevant Circuit. (I am referring to cases that are published in the Tax Court Reports. "Small cases" statutorily have no precedential value (§7463(b)), and there may be some question regarding how to categorize memorandum decisions, which are persuasive if not fully precedential. See Robertson and Herndon, The Precedential and Persuasive Value of Unpublished Dispositions, 66 The Tax Executive 83, 87-89 (May-June 2014).) It remains to be seen whether the district courts and the courts of appeals will take the same approach.
It matters a great deal that the courts do retain their significant role in interpreting legislation, as stressed by Judge Wilkinson's conclusion to his concurring opinion in the Home Concrete case in the Fourth Circuit. 634 F.3d 249, 259-60 (2011). Given that courts in the normal course are likely to render precedential decisions on the interpretation of a statute in the absence of regulations, this very process may become a replacement for one old factor, eliminated in Mayo, of asking whether Treasury was dilatory in writing the regulation. As a result, one can hope that the courts will be serious in exercising their inherent power to rein in unlawful actions by the government.
This commentary also appears in the Nobember 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers.
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