Two groups of law school professors have filed amicus briefs with the US Court of Appeals for the Ninth Circuit in support of the government’s position in Altera Corp. v. Commissioner, Dkt Nos. 16-70496, 16-70497. Read more on the appeal of Altera here and the US Supreme Court’s opinion addressing interplay between the Administrative Procedure Act (APA) procedural compliance and Chevron deference here. Each group argues that Treas. Reg. § 1.482-7 represents a valid exercise of the Commissioner’s authority to issue regulations under Internal Revenue Code (Code) Section 482 and that the US Tax Court (Tax Court) erred in finding the regulation to be invalid under section 706 of the APA.

One group of six professors (Harvey Group) first notes its agreement with the arguments advanced by the government in its opening brief. In particular, the Harvey Group concurs with the argument that “coordinating amendments promulgated with Treas. Reg. § 1.482-7(d)(2) vitiate the Tax Court’s analysis in Xilinx that the cost-sharing regulation conflicts with the arm’s-length standard.” It then goes on to note its agreement with the government’s argument that “the ‘commensurate with the income’ standard … contemplates a purely internal approach to allocating income from intangibles to related parties.”

Having thus supported the government’s commensurate-with income-based arguments, the Harvey Group argues that the regulation in question is, in any event, consistent with the general arm’s-length standard of Code Section 482. It does so based principally on the proposition that “[s]tock-based compensation costs are real costs, and no profit-maximizing economic actor would ignore them.” However, that said, “there are material differences between controlled and uncontrolled parties’ attitudes, motivations and behaviors regarding stock-based compensation.” Thus, according to the Harvey Group, the Tax Court erred when it concluded that “Treasury necessarily decided an empirical question when it concluded that the final rule was consistent with the arm’s-length standard,” because “[n]o empirical finding that uncontrolled parties do, or might, share stock-based compensation costs is required to support Treasury’s regulation.” Accordingly, the Tax Court’s reliance on State Farm and the cases following it was a “key misstep” by the Tax Court.

The Harvey Group also proposes that, should the Ninth Circuit find that the term “arm’s length standard” or the meaning of the “coordinating regulations” is ambiguous, the government’s interpretation embodied in Treas. Reg. § 1.482-7 should be afforded Auer deference. Read more on deference principles in tax cases and the unique challenges of Auer deference. Auerdeference is a special level of deference that can apply when an agency interprets its own regulations, although there are several limitations on its use.  Finally, if the Ninth Circuit decides that the regulations “have an infirmity,” the Harvey Group argues that “[t]he best remedy is to remand to Treasury for further consideration.”

A second group of nineteen professors (Alstott Group) similarly agrees with the government’s arguments to the Ninth Circuit. The Alstott Group argues that the 1986 addition of the “commensurate with income” standard to Code Section 482 effectively overrode the long-standing arm’s-length standard with respect to related-party transactions involving intangible assets. This leads the Alstott Group to make four “key points”: (1) the 2003 cost-sharing regulation is “substantively reasonable under the commensurate-with-income standard”; (2) the Tax Court misunderstood a basic principle of administrative law; (3) even if the Treasury’s explanation of the regulation were determined to be inadequate, “the taxpayer bears the burden of establishing that any error affected the procedure used or the substance of the decision reached”; and (4) invalidating the regulation would have “significant policy consequences, resulting in billions of dollars of lost tax revenue.”

According to the Alstott Group, in cases involving intangible property, the commensurate-with-income principle “looks to the income generated by the intangible property – it does not look to comparable transactions (because they may not exist).” For this reason, the commensurate-with-income authority “allows the IRS to make adjustments based on the income generated by the [intangible property] in the hands of the [related party]” – (i.e.), without reference to unrelated-party behavior. Accordingly, the emphasis in the regulation – which “simply acts as a safe harbor for taxpayers” – on factors other than arm’s-length behavior “should be upheld as consistent with congressional intent.”

Consistent with its own analysis of the effect of the commensurate-with-income principle, the Alstott Group observes that the preamble to the final regulation invokes that principle as a sufficient independent basis for the cost-sharing rule. It criticizes the Tax Court’s determination that because the Treasury did not rely exclusively on the commensurate-with-income standard, it could not sustain the final rule solely on that basis as a “fatal mistake of administrative law.” In effect, the Alstott Group argues that the Treasury’s explanation of its reasoning underlying the final regulation, while perhaps “of less than ideal clarity,” was nonetheless sufficient for its path to be “reasonably discerned,” thereby satisfying the standards of  the APA.

Finally, the Alstott Group proposes that, if the Ninth Circuit finds that the Treasury did not adequately explain the basis for the regulation, “that failure does not justify the drastic step of invalidating the regulation.” It asserts that “any error by Treasury was harmless” and that if the court finds the Treasury’s explanation to be insufficient, it should remand the regulation to the Treasury without vacating it, “so that Treasury can clarify its explanation.” It suggests that a taxpayer challenging a regulation on APA grounds must show that the Treasury “would have reached a different conclusion had it determined that, as an empirical matter, unrelated companies do not include stock options as costs in similar agreements.”

The taxpayer’s reply brief is due on August 26, 2016, and it remains to be seen whether otheramici will support its position. It appears that the government is being mindful of the Tax Court’s analysis in Altera, as evidenced by media reports regarding recent comments by Russell Kwiat, senior manager of the Internal Revenue Service’s (IRS) advance pricing and mutual agreement program. According to those reports, the IRS is considering the comments received on proposed Code Section 367 regulations that draw on the procedural challenges raised by the taxpayer in Altera.