Good news from the 9th Circuit - Altera reversal

I haven't yet found this online, because it just came out this morning, but the 9th Circuit has reversed the - sorry for sounding shrill here, but it's justified - egregious and embarrassing Tax Court decision in Altera v. Commissioner.  In Altera, the Tax Court held - unanimously! - that the IRS exceeded permissible administrative discretion when it amended its transfer pricing regulations to make them less of a tool for profit-shifting to tax havens than they had previously been. The issue arose under an election companies have to use cost-sharing agreements with their foreign affiliates to profit-shift, and the taxpayers were insisting that the state of the law required that they be allowed to pretend that incentive compensation they paid to their own employees was irrelevant and, in effect, cost zero. This was based on a misleading analogy to how companies at arm's length act when they are engaged in actual cost-sharing and (typically) each have their own incentive compensation arrangements. It also was based in part on embarrassing expert testimony to the effect that incentive compensation should be viewed as costing the company zero.

Not to repeat it all, but I discussed why the Tax Court decision is so bad here, and an amicus brief to the 9th Circuit, lead-authored by Clint Wallace, that I signed here. So it's great that the Ninth Circuit has now reversed, based on a very thorough discussion of the relevant legislative and regulatory history, along with Congress's and the Treasury's underlying policy concerns, and adopting arguments very compatible with (and similar to) those in our amicus brief.

The Tax Court decision did not merely permit taxpayers to game the system in a manner that is entirely contrary to the logic behind cost-sharing (which is itself flawed, but better than having absolutely no constraints). It also seemed to reward an aggressive taxpayer strategy that I was concerned we'd see more of in the future. (And we still may.) This is to spend lots of money making lots of bogus arguments in the notice and comment phase of regulatory issuance, and then to get the regulation struck down as "arbitrary and capricious" unless its preamble is written, not to inform taxpayers and advisors as has been the general past practice, but instead as a litigating document that responds carefully and fully to each argument made in notice and comment, no matter how meritless and frivolous.

The Ninth Circuit is to be commended for getting it right. Now, it's true that it relies on the Chevron standard for reviewing administrative regulations, which may well be on the Supreme Court's chopping block in the near future. But in this particular case, it shouldn't matter, as the IRS regulation at issue, concerning the treatment of incentive compensation in cost-sharing arrangements between affiliates, was not only a reasonable interpretation, but clearly the most reasonable interpretation, and indeed perhaps the only reasonable one.

UPDATE: The 9th Circuit's Altera decision is now available here.

SECOND UPDATE: Leandra Lederman blogs about the decision (including key administrative law aspects) here.