June 20, 2019
On June 7, 2019, in Altera Corp. v. Commissioner, a reconstituted panel of the U.S. Court of Appeals for the Ninth Circuit issued a new opinion upholding the validity of a Treasury Department regulation addressing the treatment of stock-based compensation expenses for transfer pricing purposes. Last year, the Ninth Circuit withdrew its previous opinion in the case—a 2-1 split decision—due to one of the judges passing away prior to publication. Unfortunately for taxpayers, the newly assigned judge agreed with the deceased judge, and the court’s new opinion reflects neither a change in outcome nor a change in the overall analysis. Nevertheless, the court refined and clarified its analysis on a few key points. The decision has particular importance for multinational companies in the technology sector that invest substantial sums in developing intangible assets.
As we discussed in a prior client perspectives memorandum dated July 30, 2018, the U.S. Court of Appeals for the Ninth Circuit, on July 24, 2018, reversed the U.S. Tax Court’s unanimous decision in Altera in favor of the taxpayer. The case involves a challenge by an Intel Corporation subsidiary to the validity of a Treasury Department regulation that requires a U.S. corporation to allocate a portion of its stock-based compensation expenses to a foreign affiliate that is a participant in a cost-sharing agreement to develop intangibles.
A short time after issuing its original opinion, the Ninth Circuit withdrew the opinion because one of the judges on the panel that heard oral argument had passed away before the opinion was issued. To give a new judge an opportunity to fully participate in the decision, the court ordered that oral argument would be held again. The withdrawal of the original opinion and the setting of a second argument raised conjecture that the new judge might not agree with the deceased judge, and that the original panel’s 2-1 split in favor of the government might flip in favor of the taxpayer.
The case was reargued before the reconstituted panel on October 16, 2018. The Ninth Circuit issued a new opinion on June 7, 2019. Contrary to hopes, the new opinion reflects neither a change in outcome nor a change in the overall analysis. Like the withdrawn opinion, the new opinion holds that Treasury’s issuance of a regulation requiring the allocation of stock-based compensation expenses to a non-U.S. affiliate under a cost-sharing arrangement was both procedurally and substantively reasonable, despite the absence of any evidence that unrelated parties dealing at arm’s length have ever shared such expenses. (For a detailed discussion of the original opinion’s analysis, please refer to our client perspectives memorandum dated July 30, 2018.) Nevertheless, a few key points on how the court refined and clarified its analysis are noteworthy.
Non-Exclusiveness of Comparable Transaction Methodology
First, the new majority opinion repeatedly emphasizes that the comparable transaction analysis that the taxpayer claimed to be the touchstone of the arm’s length standard is not the exclusive methodology for determining the appropriate transfer price under section 482. The court’s emphasis on the non-exclusivity of the comparable transactions methodology, however, is somewhat of a straw man. The taxpayer’s point concerning the relevance of comparable transaction analysis was a conceptual one, not a methodological one.
It is true that the transfer pricing regulations have long recognized that there will often be situations in which no comparable transaction data is available, necessitating resort to other transfer pricing methodologies to determine an arm’s length price. But the flexibility embodied in the regulations does not change the fact that the ultimate goal of any transfer pricing methodology is a result consistent with the result that would have been reached by unrelated parties dealing at arm’s length. During the notice and comment process, there was substantial evidence that unrelated parties dealing at arm’s length do not in fact view equity-based compensation as a cost shared when developing intangible assets, and there was no evidence to the contrary. Therefore, in the taxpayer’s view, the regulation’s insistence that equity-based compensation expenses be allocated to a foreign affiliate in a cost-sharing arrangement was arbitrary and capricious. In categorically requiring allocation of such expenses, it wholly disregarded the body of evidence regarding comparable uncontrolled transactions.
State Farm and Chevron as Related but Distinct Inquiries
In a clarification more favorable for taxpayers, the new Ninth Circuit opinion makes clear that a taxpayer’s challenge of the validity of a regulation under State Farm is independent of its challenge under Chevron. In this regard, the new opinion added language describing the two inquiries as “related but distinct.” The new language explains that State Farm is used to evaluate “whether a rule is procedurally defective as a result of flaws in the agency’s decisionmaking process,” whereas Chevron is “used to evaluate whether the conclusion reached as a result of that process—an agency’s interpretation of a statutory provision it administers—is reasonable.” Although the withdrawn opinion adopted the same framework, the new opinion expressly reaffirms that “[a] litigant challenging a rule may challenge it under State Farm, Chevron, or both.” The court’s emphasis of this point is significant in light of the Justice Department’s recent assertion that State Farm does not apply to Treasury regulations because they involve statutory interpretation rather than empirical fact-finding inquiries.
“Transfers” under the 1986 Amendment
In another refinement, the new Ninth Circuit opinion rejects the taxpayer’s argument that the 1986 commensurate with income amendment—which the government argued allows for departure from the strict arm’s length standard—is not applicable to this case because the cost-sharing arrangement was established before any intangibles were created and thus did not involve the “transfer” of intangible assets. In rejecting the taxpayer’s argument, the new opinion focuses on the statutory language providing that the commensurate with income standard applies “[i]n the case of any transfer . . . of intangible property.” This reasoning seems flawed. As the dissent points out, while the term “any” is ordinarily read as a broadening modifier, in this case it modifies “transfer,” not “intangible.” The majority tries to elide the logic of dissent’s straightforward statutory reading by reasoning: “When parties enter into a [qualified cost-sharing arrangement], they are transferring future distribution rights to intangibles, albeit intangibles that have yet to be developed.” This formulation begs the question of how something that does not yet exist can be transferred.
Commensurate with Income as an “Internal” Standard
The new Ninth Circuit opinion concludes in another new passage that the commensurate with income standard adopted in 1986 is a “purely internal one, that is, internal to the entity being taxed.” The court proceeds to refer numerous times to the commensurate with income standard as an “internal” one, never fully explaining the concept that it attributes to congressional intent. The court cites legislative history for the “internal” standard proposition but fails to quote any passages that refer to such a standard. Instead, the court notes that:
Congress expressed numerous concerns that pre-1986 allocation methods permitted entities to undervalue their tax liability by placing undue emphasis on “the concept of comparables” and basing allocations on industry norms, rather than on actual economic activity. Doing away with analysis of comparable transactions, and instead requiring an internal method of allocation, proves a reasonable method of alleviating these concerns.
This appears to be an unwarranted leap in logic. It is by no means clear that merely “expressing concern” with the “concept of comparables” is justification for “doing away with analysis of comparable transaction.” Remarkably, the court later cites and quotes a recent technical explanation of a recently adopted tax treaty that states unequivocally that the commensurate with income standard is not to be read as inconsistent with the arm’s length standard.
The dissenting judge revised her opinion to address the new aspects of the majority opinion’s reasoning. The revised dissent adds language criticizing the majority’s jettisoning of the arm’s length standard, conceptually rooted in comparable transactions between unrelated parties, as being based on a fundamental misreading of both the case law and the legislative history of the 1986 commensurate with income amendment. In this vein, the revised dissent observes:
Since the 1930s, Treasury regulations consistently have explained that, “[i]n determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.”
In highlighting the historical consistency of the arm’s length standard as properly understood, the new dissent continues to cast doubt on the soundness of the majority’s reasoning.
Given that the reconstituted panel issued another split decision and that several major companies in the technology sector filed amicus briefs, it appears likely that a petition for rehearing en banc will be filed with the Ninth Circuit. While such petitions are long shots statistically speaking, it will be interesting to see whether the taxpayer can convince a sufficient number of Ninth Circuit judges that its arguments merit rehearing.
 Altera Corp. v. Comm’r, Nos. 16-70496, 16-70497, Slip Op. (9th Cir. June 7, 2019) (“Op.”).
 The original Ninth Circuit opinion had acknowledged the judge’s passing, but did not attach significance to it. Altera Corp. v. Comm’r, 122 AFTR 2d 2018-5222 (9th Cir. 2018) (noting that the deceased judge “fully participated in this case and formally concurred in the majority opinion prior to his death”). In a recent case involving the same judge and an opinion also issued before he passed away, the Supreme Court held that a federal court may not count the vote of a judge who dies before the opinion is issued because “a judge may change his or her position up to the very moment when a decision is released.” Yovino v. Rizo, 139 S. Ct. 706, 709 (2019).
 Order, Docket No. 16-70496 (9th Cir. August 16, 2018).
 Op. 9 (“Although the Secretary [of the Treasury] adopted the arm’s length standard, courts did not hold related parties to the standard by exclusively requiring the examination of comparable transactions.”) (citing Frank v. Int’l Canadian Corp., 308 F.2d 520, 528–29 (9th Cir. 1962)), 11 (“Following the promulgation of the 1968 regulation, courts continued to employ a comparability analysis, but not to the exclusion of other methodologies.”), 29 (“What is more, although Altera suggests there can be only one understanding of the methodology required by the arm’s length standard, historically the definition of the arm’s length standard has been a more fluid one.”), 30 (“It is true that, more recently, an understanding that the primary means of reaching an arm’s length result suggested the analysis of comparable transactions. But, in the lead-up to the 1986 amendments, Congress voiced numerous concerns regarding reliance on this methodology. Further, as we have discussed, courts for more than half a century have held that a comparable transaction analysis was not the exclusive methodology to be employed under the statute.”).
 See, e.g., 26 C.F.R. § 1.482-2(e)(1)(iii) (1968).
 Treas. Reg. § 1.482-1(b)(1) (2003) (“In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.”).
 Op. 23.
 Id. (citing and quoting Catskill Mountains Chapter of Trout Unlimited, Inc. v. EPA, 846 F.3d 492, 521 (2d Cir. 2017)).
 Id. 23 (same).
 Andrew Valarde, DOJ May Be Wrong on State Farm, But How Much Does It Matter?, 163 Tax Notes 1476 (June 3, 2019).
 Op. 26 (quoting section 482) (emphasis in original).
 Id. at 79 (citing United States v. Gonzales, 520 U.S. 1, 5 (1997) (finding that use of “any” modifies the term it precedes)).
 Id. at 26 (emphasis in original).
 Id. at 27.