Source: https://procedurallytaxing.com/category/auer-deference/
Timestamp: 2019-04-21 10:25:17+00:00

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On Wednesday of this week, October 11, the Ninth Circuit will hear argument in Altera, a case about transfer pricing and administrative law. Politically, Altera is a case about big multinational technology companies and under-resourced government regulators. Technically, it is about the transfer of intellectual property rights from U.S. affiliates of a multinational firm (a “U.S. group”) to one or more non-U.S. offshore subsidiaries under a qualified cost sharing arrangement (QCSA).
Firms from Google and Apple to Altera, a semiconductor company owned by Intel, use the QCSA “cost sharing” strategy to support the attribution of intellectual property for tax purposes to low-tax offshore subsidiaries and thereby justify allocation of substantial taxable income to those subsidiaries. The smaller the amount of U.S. group costs included in the pool, the more tax revenue the U.S. loses with respect to the cost-shared IP. Billions of dollars are at stake. Two amicus briefs prepared pro bono by academics and former tax practitioners support the government and multiple amicus briefs on behalf of interested business groups support the taxpayer in this important litigation.
Altera challenged a final Treasury regulation that requires multinationals who enter into QCSAs with offshore affiliates to include the cost of stock options granted to employees who develop the IP (among other expenses) in the pool of costs to be shared. Under cost sharing, if net costs are borne by the U.S. group the non-U.S. affiliates must reimburse the U.S. group for that amount. Prior regulations did not specifically address the issue of stock option cost allocation in a QCSA. In a prior case, Xilinx, the Tax Court and Ninth Circuit held that the government could not make offshore affiliates pay a share of stock option expense under these earlier regulations.
The revised final regulation requires taxpayers to include stock option costs in the pool of expenses for determining cost sharing payments. They provide that this is required under the arm’s length standard and, consistent with the directive of Section 482 of the Internal Revenue Code, is necessary clearly to reflect the income of the U.S. group.
Taxpayers challenged the final regulation and won in Tax Court in a reviewed decision that was unanimous among the judges that participated. The Court held that the regulations departed from the historic understanding of “arm’s length standard” which required the use of data about unrelated party transactions. The Tax Court proceeded to conclude, under a review based on State Farm (US 1983), that the regulatory change was arbitrary and capricious under § 706(2)(A) of the Administrative Procedure Act.
The misconception in the Tax Court’s decision is fundamental. One reason is that the historic understanding of “arm’s length standard” does not require the starting point of data about unrelated party transactions. Sometimes an application of the arm’s length standard uses unrelated party data. For example, if a taxpayer sells a commodity to related affiliates and unrelated firms, the unrelated firm price is the right starting point for the related affiliate price, because it is sufficiently comparable. But in other cases, unrelated party transactions are not comparable enough to serve as good starting points.
The arm’s length standard has always been a counterfactual inquiry. It has always asked how a related party transaction would be treated if, contrary to fact, the same transaction (including the actual relationships presented in fact) were conducted by unrelated parties (i..e, as though the relationship did not exist). This does not mean insisting that the reasoning begin with an unrelated party transaction if that transaction has sufficiently different facts and is not comparable.
Several transfer pricing methods, including the comparable and residual profit split methods, do not require use of unrelated party prices as starting points. Moreover, large chunks of the 482 rules prove that the arm’s length standard is not a brittle instruction to use whatever unrelated party information is available. The 482 regs include many pages of comparability adjustments which at every turn show that a starting unrelated party price, even if available, often needs a lot of work before it can be considered a comparable.
Altera and other multinational tech companies want to avoid paying for the stock option cost component of technology by arguing that unrelated firms that share technology do not require payment for stock option costs. They say that the arm’s length standard requires a starting unrelated party data point, and further that any departure from the unrelated party data point requirement is a significant regulatory change.
One reason that Altera should lose in the Ninth Circuit is because the arm’s length standard does not, and never has, required a starting unrelated party data point in all cases. Government briefs include this argument. They show that uncontrolled joint development agreements were not relevant to the question of whether to include stock option costs in QCSAs because clear reflection of income for high-profit intangibles cannot succeed if it relies on uncontrolled party data. One amicus brief points out that Section 482’s reference to pricing “commensurate with income” only makes sense if the arm’s length standard embraces transfer pricing that is not bound to unrelated party pricing.
Another amicus brief (ours, with coauthors) explains that unrelated party data points cannot be starting points for an arm’s length analysis if the unrelated information is wholly incomparable to the related party situation. This is the case for the evidence that Altera points to, which consists of technology sharing deals among unrelated parties that do not mention stock option costs. This evidence is not relevant for QCSAs because it is not comparable.
Assume that Company C and Company D are unrelated and want to share the R&D costs and benefits for a new innovation on a 50/50 basis.
Option 1: If stock option expenses are included, the pool of expenses is 200, and each company pays 100. No transfer between C and D is required to achieve a 50/50 split of expenses.
Option 2: If stock option expenses are not included, the pool of expenses is 100: 80 contributed by Company C and 20 contributed by Company D. D would transfer 30 to C to achieve a 50/50 split of expenses.
The correct answer is Option 1. Any rational economic actor would estimate and incorporate the stock option expense cost. Note that Company C and Company D do not need to mention stock option costs in order to consider and incorporate them into their transaction. The lack of a specific mention of stock options in the unrelated party deal document does not mean that stock option costs are priced at zero or intentionally disregarded.
The arm’s length standard has always recognized the absence of comparable third-party transactions in some areas of transfer pricing, including the large-scale licensing of IP among related parties. Thus the revised regulation at issue in Altera does not revolutionize the meaning of arm’s length. Instead it stays true to the meaning of clear reflection of income.
Tune in again after October 11 to hear how the taxpayer, the government and the judges of the Ninth Circuit approached this case at oral argument.
On May 16, 2016, the Supreme Court declined to grant certiorari in a case that could have been a vehicle for it to reconsider what is known as Auer deference, United Student Aid Funds, Inc. v. Bible, Docket No. 15-861. The doctrine of Auer deference derives from two Supreme Court opinions, Auer v. Robbins, 519 U.S. 452 (1997), and Bowles v. Seminole Rock & Sand Co., 325 U.S. 410 (1945). Auer deference requires courts to defer to an agency’s interpretation of its own regulations unless that interpretation is plainly erroneous or inconsistent with the regulations. Auer deference even applies to an interpretation of the regulations made for the first time in an agency’s court brief.
The IRS, in recent years, has sought Auer deference to its interpretations of Treasury regulations in high-profile Tax Court cases such as National Education Assn. of the U.S. v. Commissioner, 137 T.C. 100, 112 (2011), Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 134 T.C. 211, 219 (2010), rev’d and remanded 650 F.3d 691, 708-709 (D.C. Cir. 2011), vacated and remanded 132 S. Ct. 2120 (2012), and Rand v. Commissioner, 141 T.C. 376, 380-381, 394 (2013).
However, Auer deference has also, in recent years, been criticized by several conservative Justices of the Supreme Court, who have been looking for an appropriate case in which to reconsider Auer. With the death of Justice Scalia (who was one of those Justices), there apparently were not four votes to grant certiorari in United Student Aid Funds. But, Justice Thomas, who, with Justice Scalia, was one of the principal Justices who sought to overrule Auer, would not let the refusal to grant certiorari go without writing a dissent.
This petition asks the Court to overrule Auer v. Robbins, 519 U. S. 452 (1997), and Bowles v. Seminole Rock & Sand Co., 325 U. S. 410 (1945). For the reasons set forth in my opinion concurring in the judgment in Perez v. Mortgage Bankers Assn., 575 U. S. ___, ___ (2015), that question is worthy of review.
The doctrine of Seminole Rock deference (or, as it is sometimes called, Auer deference) permits courts to defer to an agency’s interpretation of its own regulation “unless that interpretation is plainly erroneous or inconsistent with the regulation.” Decker v. Northwest Environmental Defense Center, 568 U. S. ___, ___ (2013) (slip op., at 14) (internal quotation marks omitted). Courts will defer even when the agency’s interpretation is not “the only possible reading of a regulation—or even the best one.” Ibid.
Any reader of this Court’s opinions should think that the doctrine is on its last gasp. Members of this Court have repeatedly called for its reconsideration in an appro­priate case. See Mortgage Bankers, 575 U. S., at ___–___ (ALITO, J., concurring) (slip op., at 1–2); id., at ___ (Scalia, J., concurring in judgment) (slip op., at 5); id., at ___ (THOMAS, J., concurring in judgment) (slip op., at 1–2); Decker, 568 U. S., at ___–___ (ROBERTS, C. J., concurring) (slip op., at 1–2); id., at ___–___ (Scalia, J., concurring in part and dissenting in part) (slip op., at 2–7); Talk Amer­ica, Inc. v. Michigan Bell Telephone Co., 564 U. S. 50, 68– 69 (2011) (Scalia, J., concurring); see also Christopher v. SmithKline Beecham Corp., 567 U. S. ___, ___–___ (2012) (slip op., at 10–14) (refusing to defer under Auer). And rightly so. The doctrine has metastasized, see Knudsen & Wildermuth, Unearthing the Lost History of Seminole Rock, 65 Emory L. J. 47, 54–68 (2015) (discussing Semi­nole Rock’s humble origins), and today “amounts to a transfer of the judge’s exercise of interpretive judgment to the agency,” Mortgage Bankers, supra, at ___ (slip op., at13) (opinion of THOMAS, J.). “Enough is enough.” Decker, supra, at ___ (opinion of Scalia, J.) (slip op., at 1).
This case is emblematic of the failings of Seminole Rock deference. Here, the Court of Appeals for the Seventh Circuit deferred to the Department of Education’s inter­pretation of the regulatory scheme it enforces—an inter­pretation set forth in an amicus brief that the Department filed at the invitation of the Seventh Circuit. For the reasons stated in Judge Manion’s partial dissent, 799 F. 3d 633, 663–676 (2015), the Department’s interpretation is not only at odds with the regulatory scheme but also defies ordinary English. More broadly, by deferring to an agen­cy’s litigating position under the guise of Seminole Rock, courts force regulated entities like petitioner here to “di­vine the agency’s interpretations in advance,” lest they “be held liable when the agency announces its interpretations for the first time” in litigation. Christopher, supra, at ___ (slip op., at 14). By enabling an agency to enact “vague rules” and then to invoke Seminole Rock to “do what it pleases” in later litigation, the agency (with the judicial branch as its co-conspirator) “frustrates the notice and predictability purposes of rulemaking, and promotes arbitrary government.” Talk America, Inc., supra, at 69 (Scalia, J., concurring).
This is the appropriate case in which to reevaluate Seminole Rock and Auer. But the Court chooses to sit idly by, content to let “[h]e who writes a law” also “adjudge its violation.” Decker, supra, at ___ (opinion of Scalia, J.) (slip op., at 7). I respectfully dissent from the denial of certiorari.
Well, as Yoda said, “There is another.” We will all have to wait to hear a future case in which Auer deference is reconsidered by the Justices – perhaps one named Return of the Jedi v. Commissioner.

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