"Commensurate with Income" Features in Altera Reversal
Last week's Ninth Circuit decision in Altera addresses (and raises questions about) a host of intriguing issues for taxpayers, the IRS, and Treasury with respect to the Administrative Procedure Act (APA), Treasury's regulatory authority and what has been termed "tax exceptionalism," the arm's-length standard, and cost sharing, among other issues. One surprising aspect of the decision, however, should not be overlooked—the majority's engagement with the "commensurate with income" language in section 482. While occasionally the subject of discussion among practitioners, that language rarely appears in case law, has never played a prominent role in a decided case under section 482, and is rarely invoked by the IRS in the audit context. Moreover, on its face that language pertains only to a "transfer (or license) of intangible property" and not to the universe of expenses subject to cost sharing, the boundaries of which were the subject of the disputed regulations.
So why did this otherwise reclusive animal make an appearance in this decision? What role did it play in the conclusions drawn by the Ninth Circuit? And what, if anything, does the Ninth Circuit's decision portend about future sightings of (or rather citations to) the "commensurate with income" language in other disputes under section 482? We address each in turn.
Why did the "commensurate with income" language appear in Altera?
That language appeared because it featured in the government's arguments on appeal. As you may already know (especially if you have followed our coverage of the case on our Tax Appellate Blog), the dispute in Altera is over the validity of Treasury Regulations under section 482 that require taxpayers to treat stock-based compensation as an expense to be shared under qualified cost-sharing arrangements. In the Tax Court, the taxpayer had successfully challenged the validity of those regulations on the grounds that Treasury failed to properly consider comments during the notice-and-comment period that unrelated parties do not share the costs of stock-based compensation, and therefore that a rule requiring related parties to share such costs was inconsistent with the arm's-length standard that governs all regulations under section 482.
In mounting its defense of the disputed regulations, the government argued that the arm's-length standard indeed supported its cost-sharing regulations. Where the taxpayer and the Tax Court were wrong, argued the government, was in presuming that only transactional evidence of behavior between unrelated parties in similar circumstances—i.e., evidence from comparables—can meet that standard. According to the government, there is ample indication in the statute and its legislative history that the standard does not demand empirical evidence of unrelated party conduct in every instance. Among other things, the government cited the "commensurate with income" language that Congress inserted in the statute in 1986 in support of that proposition. The government argued that the legislative history behind the insertion of the "commensurate with income" language indicates that Congress approved of the use of so-called "internal" benchmarks to satisfy the arm's-length standard because transactions between unrelated parties involving intangibles may not be exclusively determinative of the arm's-length result. Gov't Br. at 31.
What role did the "commensurate with income" language play in the Ninth Circuit's holding?
The "commensurate with income" language plays two roles in the majority's decision. In the first instance, the majority concluded that because the preamble to the disputed regulations cited to the legislative history relating to the introduction of the "commensurate with income" language into section 482, Treasury satisfied the APA requirement that an agency must give "interested parties notice of its proposal and an opportunity to respond to it." Opinion at 32. The majority acknowledged that interested parties disputed whether Treasury's interpretation of the "commensurate with income" language comported with the arm's-length standard, but the majority decided that was a separate dispute—and "one properly addressed in the Chevron analysis." Id.
By the time the majority picked that dispute back up under Chevron step two, the writing was on the wall. Under the Chevron step-two analysis, the court looks to whether the agency has correctly interpreted the underlying statute. And the agency fails only where its interpretation is "'unmoored from the purposes and concerns' of the underlying statutory regime." Opinion at 39 (citations omitted). The majority found that Treasury's interpretation met that bar because legislative history "supports Treasury's application of the commensurate with income standard in the [cost-sharing context]" and Treasury's "decision to dispense with a comparability analysis [in promulgating the cost-sharing regulations] was reasonable." Id. at 39-40.
Having reached its holding under Chevron step two, the majority then elaborated on Congress's rationale for inserting the "commensurate with income" language in section 482. And here the majority took a broader view of that language and its function under section 482 than anything described in the legislative history, writing that Congress's insertion of that language "was intended to hone the definition of the arm's length standard so that it could work to achieve arm's length results instead of forcing application of arm's length methods." Opinion at 41.
What, if anything, does the majority opinion in Altera indicate about what the "commensurate with income" language means in other disputes under section 482?
Arguably nothing. As the dissent correctly noted, on its face the "commensurate with income" language in section 482 is implicated, if at all, only in a "transfer (or license) of intangible property," and not the determination of which expenses must be shared under a qualified cost-sharing arrangement. Opinion at 63. It is out of place in the dispute in Altera.1 Moreover, although the "commensurate with income" language is featured in the majority opinion's general discussion of the history of section 482, that language plays a direct role in the decision only in determining (1) that Treasury's reference in the rulemaking notice to the legislative history of that language gave reasonable notice of Treasury's intent; and (2) whether Treasury's interpretation of its regulatory authority passed muster under Chevron step two.
This is not to say, of course, that we will never see the "commensurate with income" language invoked in another decision. It is possible that Treasury will promulgate regulations that purport to be consistent with the arm's-length standard without applying methods designed to reach arm's-length results or taking into account empirical evidence of arm's-length behavior. This would represent a major departure from the way the arm's-length principle has been understood in regulations and case law for almost fifty years. International norms such as the arm's-length standard are under pressure in the United States and around the world as countries seek to apply formulary or mechanical rules to tax income that is only tangentially related to activities within their jurisdiction. If Treasury promulgates regulations of this type under section 482 and the majority's decision in Altera survives (it still faces possible petitions for rehearing en banc or for certiorari), Treasury would likely cite the majority's general discussion of the "commensurate with income" language in defense of such regulations.
But that validity context is narrow; Altera does not signal a newfound prominence for the "commensurate with income" language in everyday transfer pricing disputes involving the application of the existing transfer pricing regulations. Some commentators are already suggesting that the decision marks a break from prior law under which transactional evidence serves as a check on the IRS's reallocation of income under section 482. See Ryan Finley, "Altera Reversal Breaks From Traditional Arm's-Length Standard," Tax Notes 2018 WTD 144 1 (Jul. 26, 2018). If that view were adopted, it would represent a major change in the substantive transfer pricing law applicable to all transactions, effectuated through a judicial decision addressing the narrow question of the government's authority to promulgate regulations defining the scope of costs to be shared in cost sharing arrangements. In our view, that conclusion would be misguided. The Altera opinion does not address the scope of the IRS's discretion to reject proffered comparable transactions and hypothesize adjustments based on internal allocations that would be, in the IRS's view, commensurate with income or fair and reasonable. On the contrary, the Treasury Regulations already reflect a series of permissible methods, and contain criteria for determining which method is likely to produce the most reliable measure of the arm's-length result. Those criteria favor methods based on transactional evidence from comparable transactions where information regarding such transactions is available.2 The regulations reflect the reality that—despite the Ninth Circuit's suggestion otherwise—the objectives of section 482 in most cases are best served by applying methods that reference information from comparable transactions.
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1 The majority attempted to respond to this concern. Because that "1986 amendment focused specifically on intangibles," the majority inferred that the amendment therefore "gives Treasury the ability to respond to rapid changes in the high tech industry." Opinion at 44. It then concluded that since "employee stock options are integral to R&D arrangements" and employee stock compensation is on the rise, Treasury's authority naturally extended to that "economic development." Id. This line of reasoning—that a focus on intangibles in amending section 482 somehow affects Treasury's authority to include stock-based compensation of employees developing those intangibles under a cost-sharing arrangement when the statutory language in question is clearly inapplicable—is tenuous at best.
2 See Treas. Reg. § 1.482-1(c)(2) ("Data based on the results of transactions between unrelated parties provides the most objective basis for determining whether the results of a controlled transaction are arm's length").
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