Civil Litigation,
Tax
Jun. 18, 2019
Altera redux—Will it get another bite at the APA?
Earlier this month, the 9th Circuit issued its new opinion in Altera v. Commissioner. Like last year’s opinion, which was subsequently withdrawn, the result is disappointing for taxpayers, but with so much at stake it seems inevitable that the decision will be appealed.
Peter J. Connors
Partner, Orrick, Herrington & Sutcliffe LLP
Peter is chair of Orrick's International Tax Practice.
Earlier this month, the 9th U.S. Circuit Court of Appeals issued its new opinion in Altera v. Commissioner, 2019 DJDAR 4948 (June 7, 2019) (Altera II). Like last year's opinion (Altera I), which was subsequently withdrawn, the result is disappointing for taxpayers, but with so much at stake it seems inevitable that the decision will be appealed.
Altera, headquartered in San Jose, entered into a "qualified cost-sharing agreement" with its subsidiary, Altera International in the Cayman Islands. A qualified cost-sharing agreement (in common parlance, a "cost-sharing agreement") allows parties to share in the development of intangibles. This is accomplished by requiring the affiliate to "buy in" to the existing IP. The buy-in payment is called a platform contribution. In return for the buy-in, the affiliate receives the right to exploit the technology in the other jurisdiction. The parties then license to each other the existing technology.
A key aspect of the cost-sharing agreement is the sharing of costs among the group. The affiliate pays its share of the costs for research and development. The issue in Altera relates to how equity compensation figures into the equation. Altera, like many technology companies, gives its employees stock grants. In the tech industry as a whole, such stock-based compensation implicates billions of dollars.
Since 1968, the IRS regulations issued under Internal Revenue Code Section 482 have required companies that make payments to affiliates to use arm's-length rates. In other words, the price that is charged to an affiliate must be consistent with that charged by the same company to unrelated third parties. The determination of an arm's-length rate is generally accomplished by identifying "comparable" transactions. Here, the question is what costs should go into the calculation of the amount borne by Altera International. Altera's position was that only its actual costs should be included. But, in 1997, as companies began issuing stock awards, the IRS began interpreting "costs" to include stock-based compensation, asserting that regulatory changes made in 1995 allowed this treatment. Because the new 1995 regulations conflicted with other regulations, those regulations were held to be invalid in a 2005 Tax Court case involving Xilinx that was affirmed by the 9th Circuit in 2010. The invalidated regulations were subsequently amended and became the subject of the Altera litigation.
Even after the amendment to the regulations, Altera's position was that only the costs that a third party would share should be shared under a cost-sharing agreement. The IRS disagreed and proposed an adjustment under which these additional costs would be allocated to Altera International. Altera argued in the Tax Court that the new regulations improperly included stock compensation in the calculation of costs, in violation of the arm's-length principle. Moreover, Altera argued that, as to the new regulations, the Department of Treasury failed to follow the procedures outlined in the Administrative Procedure Act, which require an agency to give notice of a change in its position so that interested parties can comment on such change. Moreover, the agency's action must not be arbitrary or capricious. In other words, the action must be an appropriate application of the underlying statute -- here, Section 482. Altera also argued that the regulations were not entitled to deference under Chevron.
All 15 Tax Court judges agreed with Altera that the regulations were invalid. That the decision was unanimous speaks for itself. The thrust of the decision was that the Treasury Department failed to follow the APA. The IRS appealed, and a decision was issued in its favor last July (Altera I) by a three-judge panel, but was withdrawn because one of the panel members, Judge Stephen Reinhardt, regrettably passed away before the opinion was issued. (See Peter Connors, Barbara de Marigny and Michael Rodgers, "A Second Bite at the APA: Altera's Rehearing and the Potential Invalidity of Cost-Sharing Regulations," Tax Management International Journal (October 12, 2018)). Judge Susan Graber from the U.S. Court of Appeals for the Federal Circuit was added to the panel and the case was reheard in October 2018. In Altera I, the panel held that the regulations were entitled to Chevron deference and that the APA procedures were complied with. But Judge Kathleen O'Malley disagreed with this position in a very thoughtful dissenting opinion. In Altera II, the same result was reached, but Judge O'Malley once again disagreed. Her dissenting opinion is lengthy and convincing and relies heavily on the Tax Court's opinion. The thrust of her dissenting opinion is that, under the APA, while an agency can issue regulations that depart from prior rules, it must follow the specific procedures outlined in the APA when it wishes to do so. It must first acknowledge that it is in fact making such a change or departure. Further, it must describe the rationale for the change. And it must listen to the comments and address significant concerns The APA's safeguards are designed to ensure that those regulated do not have to guess at the regulator's reasoning; just as importantly, they afford regulated parties a meaningful opportunity to respond to that reasoning.
Here, the stated rationale was that the "commensurate with income" standard, under which, where intangibles are transferred, the intergroup pricing should be based on the income generated from the transferred intangible, was consistent with the arm's-length principle. (The commensurate with income provision was added as an amendment to Section 482 in 1986.) But later, in litigation, the IRS dismissed the idea that having comparables would matter in applying this standard and ignored comments describing how third parties were compensated for contract research in purportedly comparable transactions. Rather, the IRS' position became that the new regulations are an interpretation of the "commensurate with the income" standard.
The IRS believes that, because cost-sharing arrangements evidence a "transfer" within the meaning of Section 482, the "commensurate with income" language allows the IRS to depart from the comparability standard that otherwise applies in intercompany dealings. This was the position adopted by the majority, which reasoned that this approach is supported by language in the Section 482 legislative history. The IRS also argued that the 1986 amendment to Section 482 demonstrated that Congress wanted related companies to share stock-based compensation. But in 1986, when the amendment was made, stock awards were not yet a common feature of compensation plans, so how could Congress have anticipated this result?
The dissent also believes that a cost-sharing agreement is not a transfer of intangibles but rather an agreement for development of future intangibles. This is a very subtle, albiet nuanced, point and it makes one wonder whether the panel really appreciates what happens in cost-sharing agreements. For these reasons, the dissent, like the Tax Court, concluded that the regulation was arbitrary and capricious and in violation of the APA.
There are many other technical arguments advanced by the parties that go beyond the scope of this brief commentary. All this really suggests to the author is that the Tax Court, with its highly specialized jurists, may have been in a better position to analyze the issue.
Altera will undoubtedly appeal the decision. Let's hope that it gets another bite at the APA!
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