Tax Law Update
On August 7, 2018, the Ninth Circuit withdrew its July 24 decision in Altera so that new panel member, Judge Susan P. Graber, can now consider the case. The Ninth Circuit's Altera decision is discussed in our Tax Law Update here. In the aftermath of the death of Judge Reinhardt, who had concurred in the original majority opinion, Judge Graber was appointed to the panel on August 2 under a special procedure that permits the replacement of recently deceased judges involved in an active proceeding. Because the ultimate resolution of the case means billions of dollars to many technology companies, the eyes of Silicon Valley will be on the newly constituted panel over the next few months as Altera is revisited. Specific items to note include:
Many multinationals choose to migrate economic ownership of intangible property (IP) offshore through qualified cost-sharing arrangements (QCSAs). QCSAs must, by definition, comport with the requirements of applicable Treasury Regulations. Altera challenges the applicability of one regulation in particular—Treasury Regulation § 1.482-7A(d)(2)—which provides that in the context of QCSAs, stock-based compensation must be treated as a per se expense to be allocated between related parties. If such amounts are treated as an expense, then a significant amount of such costs (which would otherwise reduce U.S. taxable income) must invariably be allocated to low-tax foreign jurisdictions. In the technology company world, where stock-based compensation is a staple of doing business, this means that big dollars are at stake when the ability to take such deductions in the U.S. is lost.
From a substantive standpoint, the regulations at issue seem to many to be at odds with the arm's-length principle, a bedrock transfer pricing rule which requires that related parties allocate costs the way unrelated parties acting at arm's-length would do so. Altera noted that unrelated parties overwhelmingly do not share stock-based compensation, and maintained in court that the regulations were therefore invalid.
In 2015, Altera claimed in the Tax Court that the regulations violated the Administrative Procedure Act as an arbitrary and capricious exercise of regulatory authority. In a unanimous 15-0 decision, the Tax Court agreed with Altera and struck down the regulations. On appeal at the Ninth Circuit, the court reversed the Tax Court in a 2-1 decision, the deciding vote for which came from Judge Reinhardt, who passed away five months after oral argument but prior to the issuance of the decision.
Pursuant to its internal procedures, the Ninth Circuit has now replaced Judge Reinhardt with Judge Graber, who will reexamine the case de novo. As part of this review, Judge Graber will view recordings of prior oral arguments and consider the briefs previously filed by both parties. After her review, Judge Graber may then confer informally with the other panel members to share her initial reactions and opinions. Assuming the other two members of the panel maintain their current positions, Judge Graber's vote will break the tie and could result in a 2-1 decision going the other way from the original panel's decision.
While the ultimate resolution of Altera is now anyone's guess, the August 7 withdrawal has many pundits speculating. At the risk of reading too much into things, we indulge in a short "devil's advocate" exercise below.
Please contact any member of the Orrick Tax Group to further discuss the potential impact of this development on your business.