Tax Strategy: The alterations of Altera
The Internal Revenue Service amendments to the Code Sec. 482 regulations in 2003 requiring stock-based compensation to be allocated under cost-sharing agreements with foreign subsidiaries had adverse tax consequences for many multinational companies that had tended to allocate those costs to the U.S. entity where those employees were located.
The Tax Court’s unanimous decision in Altera in 2015 invalidating those regulations upended the tax planning and tax obligation reporting of multinational companies and frustrated the IRS’s efforts to regulate transfer pricing. The reversal of the Tax Court opinion by the Ninth Circuit Court of Appeals in July 2018 again sent shock waves through those same multinational companies. Now, the withdrawal of that opinion by the Ninth Circuit for a rehearing of Altera is resulting in additional reverberations.
The basic factual issue in Altera is the validity of an IRS regulation adopted in 2003 under Code Sec. 482 requiring a U.S. taxpayer to allocate a portion of its stock-based compensation costs to foreign affiliates that participate in a cost-sharing arrangement for the development of intangible assets.
The more broadly applicable underlying issues are the deference to be given to IRS regulations and the applicability of Administrative Procedure Act rules to IRS regulations.
The Tax Court opinion
The Tax Court in its 2015 decision had held unanimously, 14-0, that the Treasury had not performed “reasoned decision-making” in promulgating the regulation, as required by Supreme Court precedent. The Tax Court also found that the regulation was “arbitrary and capricious” in violation of Administrative Procedure Act standards due to the abandonment of the “arm’s-length” standard in promulgating the regulations.
The Tax Court found that, in applying the “arm’s-length” standard, compensation is typically not shared among unrelated parties that have entered into cost-sharing agreements, citing the Tax Court’s and Ninth Circuit’s own rulings in Xilinx involving employee stock options. The Tax Court pointed out that many commentators to the 2003 regulations pointed out this departure from the “arm’s-length” standard, but the IRS rejected those comments without developing its own contrary factual analysis.
The 2003 regulations had resulted in many companies incorporating stock-based compensation into their cost-sharing agreements, with provisions for claw-backs should the regulation be invalidated in the courts. The Tax Court opinion resulted in many multinational companies pursuing their own litigation and filing claims for refund.
The Ninth Circuit decision
A three-judge panel of the Ninth Circuit, in a 2-1 decision, overturned the Tax Court. Importantly, the Ninth Circuit opinion accepted the application of the APA. For years, the Treasury had taken the general position that the APA did not apply to Treasury regulations since they were viewed as interpretive regulations of the Tax Code provisions, rather than regulations that were legislative in nature.
The Ninth Circuit, in deciding to do an APA review, would appear to support the Tax Court position that APA review is applicable to Treasury regulations. However, the Ninth Circuit, in performing the APA review, determined that the Treasury had engaged in reasonable decision-making. The Ninth Circuit found that Congress had itself endorsed a departure from the “arm’s-length” standard by adding a 1986 amendment to the Tax Code that transfer-pricing determinations with respect to cost-sharing agreements should reasonably reflect the actual economic activity undertaken by each party, a “commensurate with income” analysis.
The Ninth Circuit panel then turned to the two-step Chevron analysis of the regulation:
1. Is the statute silent or ambiguous in addressing the issue at hand; and,
2. If so, is the Treasury’s interpretation a permissible one under the statute?
The Ninth Circuit found that the statute itself did not clearly address the issue and again found that the Treasury’s interpretation was reasonable since Congress itself, in the 1986 amendment to Code Sec. 482, had endorsed a move away from a strict application of the “arm’s-length” standard with the addition of the “commensurate with income” standard.
Before the Ninth Circuit’s withdrawal of this opinion, a number of companies had already made Securities and Exchange Commission filings warning of a possible increase in tax liability as a result of the decision. While a Ninth Circuit decision was not binding outside of the Ninth Circuit, it was precedent for other circuit courts to consider and many of the technology companies most impacted by the decision are located in the Ninth Circuit.
On Aug. 8, 2018, the Ninth Circuit announced that it was withdrawing its opinion in Altera issued on July 24, 2018. The basis of the withdrawal was apparently the death of Judge Stephen Roy Reinhardt, one of the two judges in the 2-1 majority, after oral arguments and before the decision was issued. Judge Susan Pia Graber has been selected as a replacement. The stated reason for the withdrawal of the opinion was “to allow time for the reconstituted panel to confer on this appeal.”
It is not yet clear what the result of the rehearing will be, but it certainly opens up the possibility of a different outcome. The withdrawal pending the rehearing means that the Tax Court opinion is again the most current ruling in the Altera case.
The next steps
Altera would have had the option to seek a rehearing, to seek a hearing by the Ninth Circuit en banc (heard by all of the judges of the circuit, rather than just three), or to seek an appeal to the Supreme Court. With the withdrawal of the Ninth Circuit decision, the first next step will now be a rehearing by a three-judge panel with Judge Graber participating.
Depending on the outcome of that hearing, there is still the possibility for either party to seek an en banc hearing or Supreme Court review. Supreme Court review does not seem too likely until there is a split among the circuits on the issue. The losing party in the rehearing may therefore request an en banc rehearing by the Ninth Circuit.
What this means for the rest of us
Multinational companies must continue to shift their SEC reporting to reflect the continuing shift of possible tax liabilities with each new version of Altera. For the rest of us, the underlying principles discussed have application beyond the issue of cost sharing among foreign affiliates. The growing consensus seems to be that the Administrative Procedure Act does apply to IRS regulations and the distinction between legislative and interpretive regulations is disappearing. The IRS does seem to be making a greater effort to include language in their regulations showing that they have considered opposing viewpoints and, if rejected, stating the reasons for rejecting those points of view.
Beyond the APA, the withdrawn Ninth Circuit decision would seem to have also lent support to the Chevron standard that tends to give deference to IRS regulations where the statute is silent or ambiguous on the subject and the regulation seems to be a permissible resolution of the ambiguity, even if it was not the only possible resolution of the ambiguity. The next Ninth Circuit decision will add further to the analysis of the viability of IRS regulations to withstand challenge.