A hotly contested appeal regarding the IRS’s authority to promulgate regulations is underway in the Ninth Circuit. Last year, in Altera Corp. & Subsidiaries v. Comm’r, the Tax Court entered a unanimous reviewed decision invaliding, under Administrative Procedure Act (APA), a 2003 IRS transfer pricing rule limiting the availability of a safe harbor under Section 482. 145 T.C. 91 (2015). In February 2016, the IRS appealed the Tax Court’s decision to the Ninth Circuit. As of the date of this article, the case has been fully briefed and approximately eight amicus briefs have been filed, with various businesses, industry groups and others supporting the taxpayer and tax and administrative law professors supporting the government.
The dispute centers on the role of a 1986 amendment to Section 482, which provided that “[i]n the case of any transfer (or license) of intangible property . . . the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” 26 U.S.C. § 482. Prior to this amendment, Section 482 provided only that the IRS could “distribute, apportion, or allocate gross income, deductions, credits, or allowances” among related companies “in order to prevent evasion of taxes or clearly to reflect  income.” Id. Both the taxpayer and government agreed that this language implicitly incorporated a long-held principle of transfer pricing that transfers be on an “arm’s length” basis. This principle was also enshrined in prior Treasury regulations, requiring that IRS determine if a taxpayer’s claimed treatment is “consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances . . . by reference to the results of comparable transactions under comparable circumstances.” 26 C.F.R. § 1.482-1(b)(1).
The 2003 rule attempted to retreat from these earlier regulations in the area of stock-based compensation. The evidence introduced during the APA-required notice and comment period was that unrelated parties acting on an arm’s length basis would not share such costs. However, when articulating the basis of its final rule, IRS disregarded this evidence, finding that was little data on high-profit intangibles, which had different characteristics. It instead advanced a theoretical explanation that arm’s length agreements should share stock-based compensation, reasoning that “if a significant element of  compensation consists of stock-based compensation, the party committing employees to the arrangement generally would not agree to do so on terms that ignore the stock-based compensation.” Compensatory Stock Options Under Section 482, 68 Fed. Reg. 51171-02, 51173 (Aug. 26, 2003). IRS’s final rule therefore proceeded to include a blanket requirement that all cost sharing agreements—not just those for high-profit intangibles, or those which involve significant stock-based compensation—share stock-based compensation costs in order to benefit from the safe harbor. 26 C.F.R. § 1.482‑7(d)(2). Importantly, the preamble concluded that this rule was consistent with Congress’s intent, as articulated in the commensurate with income standard, for related parties to share all economic costs. 68 Fed. Reg. at 51172.
The Tax Court invalidated the rule, finding that Treasury had indefensibly disregarded the evidence of arm’s length conduct without sufficient explanation and the broad application of the rule could not be justified by the Treasury’s theoretical findings. It also held that the commensurate with income standard could not trump the need to look at comparable arm’s length transactions. While the current appeal is focused on the complex statutory and regulatory scheme surrounding transfer pricing, it presents several questions with potentially broader application:
- First, what determines whether IRS must rely on empirical evidence in modifying or promulgating new rules? Statutory language? Congressional intent? IRS’s own pre-existing regulations? In holding that the IRS had to take an empirical analysis in its rule making, the Tax Court relied on a case involving a statute which required the agency to consider “relevant available  data.” Motor Vehicle Mfrs. Ass’n of U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 33–34 (1983). Code Section 7805, providing general authority for IRS rule making, contains no such requirement. 26 U.S.C. § 7805. A standard which allows Congressional intent or other regulations to place an affirmative burden on IRS to base its regulations on empirical data rather than theoretical arguments and policy concerns will make it more difficult for IRS to issue new regulations and may increase the costs and time required to do so.
- Second, what justification must the IRS provide to ignore empirical data received during the comment period? Are theoretical justifications sufficient? Previously, the Supreme Court granted deference to a blanket IRS rule determining that individuals who worked 40 hours or more per week for their school were employees rather than students, despite evidence that medical residents were “students of their craft” engaged in “a valuable educational pursuit.” Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 60 (2011). It did so based in part on IRS’s findings that the rule would “improve administrability,” and was consistent with Congressional intent to provide “vital disability and survivorship benefits.” Id. at 59-60. In contrast, the Tax Court in Altera found that IRS failed to justify the rule based on administrability or policy concerns. To the extent that this failure alone dooms the 2003 rule, other regulations which deviate from evidence-based comments without relying on explicit administrability and policy findings may be vulnerable.
- Third, are there limits to IRS’s authority to issue regulations nullifying court decisions? The 2003 rule was issued in the middle of a litigation in which the IRS advanced the view that under the then-existing rule, stock-based compensation was one of “all costs” that should be shared by related parties in a cost-sharing agreement. Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1197 (9th Cir. 2010). The Tax Court and Ninth Circuit disagreed, finding that only costs shared by parties in arm’s length agreements had to be included. Id. Since the 2003 rule was promulgated during the Xilinx litigation, the evidence and theoretical considerations put before the IRS rule making and the courts were similar, but the IRS reached a diametrically opposed conclusion. If a rule issued in such circumstances is never considered a reasonable—if alternative—interpretation of a statute, IRS will have considerable difficulty improving its litigating positions through subsequent rule makings.
- Finally, what is the proper remedy if a court finds a rule is invalid? Amici for the government raised the possibility that the Ninth Circuit could find that IRS’s failure to properly explain its reasoning was harmless error, and uphold the rule. They further suggested that even if the Ninth Circuit agreed that the rule was invalid, it should remand the rule to Treasury so that it could reconsider the rule and draft further explanations of its reasoning. Either remedy would make Altera’s victory exceedingly fleeting and discourage future challenges to IRS regulations.