In Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), the Tax Court, in a unanimous reviewed opinion, held that regulations under Section 482 requiring parties to a qualified cost-sharing agreement (“QCSA”) to include stock-based compensation costs in the cost pool to comply with the arm’s-length standard were procedurally invalid because Treasury and the IRS did not engage in the “reasoned decisionmaking” required by the Administrative Procedures Act and the cases interpreting it. The Commissioner of Internal Revenue (“Commissioner”) appealed this holding to the Ninth Circuit Court of Appeals, Dkt. Nos. 16-70496, 16-70497. The Commissioner filed his opening brief on June 27, 2016. Two groups of law school professors filed amicus briefs in support of the Commissioner’s position. On September 9, 2016, Altera Corporation (“Altera”) filed its answering brief with the Ninth Circuit.
Altera begins with the observation that the Commissioner “has remarkably little to say” about the Tax Court’s rationale in holding the QCSA regulation invalid. According to Altera, the Commissioner either did not respond to the salient points in the Tax Court’s analysis or, more often, actually admitted that those points were correct. Instead, the Commissioner advanced a “new, litigation-driven position” that Section 482’s “commensurate with income” requirement is an independent “internal standard” that “does not require consideration of transactions between unrelated parties.” Indeed, Altera notes, the Commissioner now argues “that the arm’s-length standard may be applied without considering any facts at all.” Thus, rather than engage with the Tax Court’s reasoning, the Commissioner “mistakenly accuses the Tax Court of overlooking an argument that is missing from the administrative record.”
The Commissioner’s argument fails, Altera maintains, for three reasons: (1) the Commissioner cannot defend the QCSA regulation with an argument not adopted by the Treasury and the IRS when the regulation was promulgated; (2) Treasury cannot alter its interpretation of the statute without “acknowledging and justifying the change”; and (3) the commensurate with income standard simply does not mean what the Commissioner says it does.
Citing the Supreme Court’s holding in S.E.C. v. Chenery Corp., Altera argues that the fact that the Commissioner’s new position “bears no discernible relation” to the rationale advanced by Treasury and the IRS when they issued the QCSA regulation “precludes consideration of the Commissioner’s new argument here.”
Altera traces the introduction and continued application of the “parity principle” – that the “purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer” – from its introduction in then-Section 45 in 1928 through its continuation in Section 482 in 1954 to the present. Rather than operating as a “separate standard,” as argued by the Commissioner, Altera says, the commensurate with income standard “clarifies” that the Commissioner’s review of a related-party transfer or license of an intangible “should account not just for the ex ante expectations of the contracting parties” but should also account “for the income actually generated by the intangible.” This, Altera explains, has been the long-standing position of both Treasury and the Commissioner, as evidenced by such public statements as 1988’s A Study of Intercompany Pricing Under the Code (the so-called “White Paper”) and the Report[s] on the Application of Section 482 submitted to Congress by the Commissioner in 1992 and 1999. The Commissioner’s claim is also belied, Altera argues, by the repeated reassurances made by Treasury to the US’s treaty partners – 26 are cited – that the commensurate with income standard “was not intended to override the arm’s-length standard.” Indeed, the preambles to both the proposed and the final QCSA regulation acknowledge the requirement of “consistency” between the commensurate with income and arm’s-length standards. The interpretation of the statute advocated by the Commissioner, then, represents a radical departure from the interpretation maintained for the approximately 17 years between the addition of the commensurate with income standard to Section 482 in 1986 and the issuance of the final QCSA regulation in 2003. But, as noted above, Treasury did not acknowledge or discuss this changed interpretation when it promulgated the QCSA regulation, as required by the APA. Citing the Supreme Court’s recent Encino Motorcars opinion, Altera maintains that this failure is fatal to the validity of the QCSA regulation.
Having pointed to the long-standing position of Treasury and the IRS that application of the commensurate with income standard must be “consistent” with the arm’s length standard, Altera turns to the “substantial administrative record evidence” that “parties dealing at arm’s length do not share amounts attributable to stock-based compensation.” Altera goes on to assert that not only did Treasury and the IRS reject this evidence, but they presented no evidence that such parties would share such amounts, which Altera characterizes as another procedural defect in the issuance of the QCSA regulation. Again citing Encino Motorcars, Altera argues that these procedural defects “preclude [Chevron] deference to the Commissioner’s proffered interpretation here.”
Altera argues that the Commissioner’s underlying interpretation of Section 482 is unreasonable under Chevron’s standard. It avers that his new position is contrary to Congress’s intent, as recognized by the Commissioner in the years since 1986. Altera also advances what is, in effect, a “plain meaning” argument against the Commissioner’s claim to Chevron deference. Noting first that “by its express terms” the commensurate with income standard applies only to the “transfer (or license) of intangible property,” Altera observes that “[h]istorically, the Commissioner has recognized that no ‘transfer (or license)’ occurs when entities develop intangibles jointly.” Thus, Altera argues, the commensurate with income requirement does not apply to QCSAs in the first instance.
Finally, Altera addresses certain arguments raised in the amicus briefs filed in support of the Commissioner’s position. It notes that both groups of amici proposed that, should the Court find Treasury’s explanation to be insufficient, it should remand the regulation to Treasury without redetermining the deficiency at issue. Altera dismisses this proposal, observing that the regulation is “the sole basis for the Commissioner’s deficiency determination.” What’s more, “[t]he Commissioner has not requested that extraordinary relief; accordingly, he is not entitled to it.” Altera also addresses the argument of one amicus group that invalidation of the regulation would have “severe policy consequences and would reduce federal revenue.” It notes that federal revenue will be reduced “[w]henever a revenue-enhancing rule is invalidated,” but “that is no reason to give the Secretary a free pass to dodge his obligations.”
Xilinx, Inc., the taxpayer in Xilinx, Inc. v. Commissioner, in which the Tax Court held for the taxpayer on a similar issue for a pre-QCSA regulation tax year (affirmed by the Ninth Circuit), has submitted an amicus brief supporting Altera’s position. That brief and those of any other amici supporting Altera will be the subject of a separate post. Barring an extension by the Court of Appeals, the Commissioner has until September 23 to file a reply brief.