More than a year after the death of Judge Stephen Reinhardt, the Ninth Circuit Court of Appeals upheld its previously withdrawn July 2018 decision that said the Internal Revenue Service (IRS) did not violate the Administrative Procedure Act (the AP Act) when conducting its tax assessment concerning cost-sharing arrangements . The court voted 2-1 in favour of the IRS (Altera Corp. v. Commissioner), setting a precedent on the AP Act and Section 482.
“We disagree with the Tax Court that the 2003 regulations are arbitrary and capricious under the standard of review imposed by the [AP Act],” said Chief Judge Sidney Thomas in the latest ruling. “While the rule-making process was less than ideal, the [AP Act] does not require perfection.”
“We are able to reasonably discern Treasury’s path,” the chief judged continued. “Treasury understood Section 482 to authorise it to employ a purely internal, commensurate with income approach where comparable transactions are not comparable.”
A spokesperson for Intel, which owns Altera, said the company is “disappointed that the Ninth Circuit has reversed the decision of the full Tax Court”.
“We are evaluating the Ninth Circuit’s decision and considering our options for further judicial review,” the spokesperson told TP Week.
The IRS said it could not comment on such cases.
The case was unusual in that Judge Reinhardt supported the majority vote and participated in the proceedings, but died months before the opinion was official. The court decided to withdraw the decision and reassess the case. With Judge Susan Graber replacing the deceased Judge Reinhardt, many tax professionals expected the July 18 decision to be reversed and found in favour of Altera.
Although the case only affects $80 million of Altera’s income, billions of dollars are at stake. Many companies, including Alphabet, Facebook, Twitter and Electronic Arts, have cited the outcome of the Altera case as a serious risk in their financial statements. Last year, Facebook estimated the Altera decision could raise its own tax bill to 25% or even 30%.
The IRS took issue with Altera’s failure to share stock-based compensation (SBC) costs with its subsidiary, claiming that this exclusion from the arrangement violated 2003 regulations that required these costs be shared (Section 482 regulations).
Following the latest decision in Altera, if the cost of employee stock options has to be included in the general pool of costs, inter-company transactions between subsidiaries could take a hit. Stock options are a way for businesses to not just reward employees, but also manage their tax burden.
Facts of the case
The case goes back to 1997 when the IRS and Altera signed an advance pricing agreement (APA) to cover the US company’s arrangements with its subsidiary in the Cayman Islands. The agreement exchanged licensing rights on Altera’s pre-existing intangible assets for royalty payments from the subsidiary. A key part of the fine print of the deal obliged Altera’s US entity and the Cayman subsidiary to pool their resources to share the burden of research and development (R&D) costs.
Everything was fine until the US adopted new regulations through the 2003 Administrative Procedure Act, and the US Treasury Department obliged taxpayers to include employee stock options in the cost pool under cost-sharing agreements.
As a result, the APA was revised in 2005 to fit the new standards. However, Altera found itself in court with the IRS in 2015 over $80 million in corporate expenses going back to transactions from 2004 to 2007. This is a small amount compared to what it may cost other companies if this case is not appealed and ultimately won by Altera.
The IRS argued that the taxpayer had failed to include stock compensation costs as part of its qualified cost-sharing arrangements. This failure, the tax authority argued, reduced Altera’s income in the US and in doing so violated Section 482.
The taxpayer maintained that these regulations were invalid because they were an “arbitrary and capricious” application of the arm’s-length principle (ALP).
The US Tax Court ruled unanimously in 2016 that the IRS didn’t respond appropriately to public comments. But it wasn’t over, and the IRS was soon filing an appeal.
Unlike the Tax Court, the Ninth Circuit Court ruled in favour of the IRS and ultimately said that the taxpayer has to include employee stock options in the cost pool.
Impact of the ruling
The crux of the dispute concerns the ALP and how it should be applied to transactions between domestic and foreign operations.
The Ninth Circuit Court’s decision sets a precedent for a multibillion-dollar industry and also suggests that taxpayers may not be able to take old arrangements for granted. So it’s fair to say Intel is not alone in taking the brunt.
Some tech companies were expecting to gain from a ruling in Altera’s favour. For example, Google’s parent company Alphabet estimated in 2016 that the company may gain as much as $3.5 billion from such a ruling.
When the court issued its July 2018 decision, before promptly withdrawing it, James Fuller, partner at Fenwick & West in California, told TP Week that the way the court’s opinion addressed the issue really would have “screwed up the world of transfer pricing”.
“It would have taken the US off the arm’s-length standard,” he said, stressing that this principle is “the historic approach to transfer pricing in the US and elsewhere”.
Fuller said that if this was the IRS’s intention, it should have given people specific notice under the AP Act when it issued the regulation that that’s what it was doing so that interested parties could comment. “It would have been a huge change,” he said.
All tax regulations, whether issued under a specific grant of authority or under the general authority of section 7805(a), have to undertake a notice and comment period in line with the AP Act. Where a court finds that the rule-making process is not based on reasoned decision-making and supported by evidence in the administrative record, the regulations can be invalidated.
Yet the Ninth Circuit Court of Appeals has ruled that the US authorities “reasonably concluded” that the ALP was honed to deliver an arm’s-length result rather than force the use of any particular method.Many tech businesses have billions of dollars resting on the issue of how they manage their corporate costs. If the cost of employee stock options has to be included in the general pool of costs, inter-company transactions between subsidiaries face greater tax exposure.