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February 25, 2016 At Court

A Sea Change in Court Analysis of Treasury Regulations: How the Treasury Department Won the Battle but Lost the War

By Ann Murphy, Professor of Law, Gonzaga University School of Law, Spokane, WA

In Altera,1 the U.S. Tax Court recently determined that a transfer pricing regulation was invalid because it was not the product of "reasoned decisionmaking" under the Administrative Procedures Act (APA). While the case is hardly earth shattering outside the world of tax practitioners, for those in the tax field it shows how vulnerable the previously nearly "untouchable" regulations have become.

Some background may be helpful. In 2007 and 2008, Kristin Hickman published two articles exploring Treasury's lack of compliance with the APA.2 Analyzing Treasury Decisions and Notices of Proposed Rulemaking from 2003 through 2005, she found a discrepancy between Treasury's acknowledgement of the applicability of the APA (in particular, the notice-and-comment rulemaking procedures set out in section 553) and its practice, which often failed to adhere to the APA. Hickman notes that "the IRS contends that most Treasury regulations are interpretative rules, and thus exempt from the APA's public notice-and-comment requirements."3 Furthermore, the Service relies heavily on the "good cause" exception to the procedural requirements.4 In spite of these APA lapses, "Treasury faced few successful procedural challenges from taxpayers and limited pressure from the courts."5

In Altera, a unanimous Tax Court increased the pressure significantly. It found that Treasury's rulemaking fell far short of its obligations under APA section 553. A series of cases on administrative law created this path to change.

Most tax practitioners are well aware that the Supreme Court's Chevron case6 established a two-step test for determining the validity of statutory construction in agency decisions or regulations. Courts ask first whether the statute under review is ambiguous. If it is not, the agency and court must follow the unambiguously expressed intent of Congress. If it is, "a court must defer to the agency's authoritative interpretation . . . unless it is arbitrary or capricious in substance, or manifestly contrary to the statute."7

Treasury won a battle in Mayo,8 the next tax case in the Chevron line. The Court chose the Chevron test over the National Muffler9 test for tax cases, stating:

[W]e are not inclined to carve out an approach to administrative review good for tax law only. To the contrary, we have expressly [r]ecogniz[ed] the importance of maintaining a uniform approach to judicial review of administrative action.10

As Andy Grewal noted, the government's win in Mayo essentially eliminated "tax exceptionalism" from the "regulatory-deference context."11 Once tax became simply another area of law, subject to the APA as other agency actions are, Treasury had lost the larger interpretive war and could no longer "phone it in" for its regulations.

The Altera Corporation is a technology corporation headquartered in Silicon Valley in California. The parent company, Altera U.S., is a Delaware corporation with a subsidiary, Altera International, which is a Cayman Islands corporation. Altera U.S. and Altera International entered into agreements (a license agreement and a cost-sharing agreement) in 1997. Altera International paid royalties under the license agreement to Altera U.S. from 1997 through 2003. The cost-sharing agreements were in effect from May 23, 1997 through 2007. The parent treated employees' cash compensation as a cost under the R&D cost-sharing agreement, but not their stock-based compensation. On audit, the Service issued notices of deficiency increasing Altera International's cost-sharing payments for 2004 through 2007 for the stock compensation costs, in accord with a 2003 cost-sharing regulation.12

The Tax Court noted the following three requirements for legislative rulemaking under APA section 553:

  1. The agency must publish a notice of proposed rulemaking in the Federal Register;
  2. The agency must provide "interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments with or without opportunity for oral presentation;" and
  3. After consideration, the agency must incorporate in the rules adopted a concise general statement of the basis and purpose of the rules.13

The Tax Court noted that these requirements do not apply to interpretive rules.

Altera and the Service disagreed about whether the regulation was a legislative rule or an interpretive rule. Altera claimed it was a legislative rule. The preamble to the final rule stated that "it has also been determined that [APA] section 553(b) does not apply to these regulations." Nevertheless, Treasury and the Service had issued a notice of proposed rulemaking and notice of a public hearing (NPRM) on the regulation in 2002 and received many comments on the proposed regulation. The Tax Court decided the regulation was a legislative rule to which the APA's rulemaking provisions applied because the adjustments to petitioner's income could be sustained only on the basis of the final rule, and Treasury had invoked its general legislative rulemaking authority under section 7805(a) of the Code in promulgating the final rule.

The parties also disagreed on whether the standard for review of the regulation was set forth in State Farm14 or Chevron. This is where Treasury and the Service lost the war. The Tax Court concluded that Treasury regulations must satisfy the State Farm requirements.

[R]espondent contends that we should not review the final rule under State Farm because the Supreme Court has never, and this Court has rarely, reviewed Treasury regulations under State Farm. However, respondent concedes that Treasury is subject to the APA, and respondent has not advanced any justification for exempting Treasury regulations from State Farm review.15

Citing Mayo, the court indicated it would not carve out a special tax exception to administrative law and concluded that State Farm's "reasoned decisionmaking" was the appropriate standard.

The Tax Court then concluded that there was no articulation of a reasoned basis for the regulatory decision; in fact, commentators' work indicated that no cost-sharing arrangements included stock-based compensation.16 The Tax Court slammed the Service's "hail Mary" play asking that the court recognize Treasury's expertise on the issue of cost-sharing of stock-based compensation: "Treasury admits that it had no knowledge of any transaction in which parties operating at arm's length shared stock-based compensation."17

Ultimately, the Tax Court determined that the regulation lacked any basis in fact. Although improving administrability is a reasonable agency undertaking, the government failed to identify this as an explanation. Even if this was its intent, the Tax Court concluded that it could not uphold the regulation on that basis without supporting factual findings.

The Tax Court also rejected Treasury's argument for application of the "harmless error" rule of APA section 706. In fact, it excoriated Treasury's "ipse dixit conclusion" and its lack of responses to the data-based arguments about stock-based compensation, stating that this "epitomizes arbitrary and capricious decisionmaking."

It seems clear that Altera is a bellwether of change for Treasury. It can no longer rely on tax exceptionalism to support a relaxed administrative-law standard. For legislative regulations, the full APA rules will apply. Challenges to regulations will undoubtedly increase substantially.

[Editor's Note: The government has filed a notice of appeal to the Ninth Circuit in Altera.] ■

1 Altera Corp. and Subs. v. Comm'r, 145 T.C. No. 3 (July 27, 2015).

2 Kristin Hickman, Coloring Outside the Lines: Examining Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 82 Notre Dame L. Rev. 1727 (2007); Kristin Hickman, A Problem of Remedy: Responding to Treasury's (Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 76 Geo. Wash. L. Rev. 1153 (2008) (hereinafter, Remedy).

3 Hickman, Remedy, supra note 2, at 1158.

4 Juan F. Vasquez, Jr. & Peter A. Lowy, Challenging Temporary Treasury Regulations: An Analysis of the Administrative Procedure Act, Legislative Reenactment Doctrine, Deference, and Invalidity, 2003 Houston Bus. and Tax L. J. 248, 253.

6 Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).

7 Altera, supra note 1, at 39.

8 Mayo Foundation for Medical Education and Research v. U.S., 562 U.S. 44 (2011).

9 440 U.S. 472 (1979).

10 Mayo, supra note 8, at 47.

11 Amandeep S. Grewal, Taking Administrative Law to Tax, 63 DUKE L. J. 1626 (2014).

12 Treas. Reg. § 1.482-7(d)(2).

13 Altera, supra note 1, at 33.

14 Motor Vehicle Manufacturers Ass'n v. State Farm Ins., 463 U.S. 29 (1983).

15 Altera, supra note 1, at 47.

16 Altera, supra note 1, at 22-26.

17 Altera, supra note 1, at 55.