Previously we blogged here (crossposted at Procedurally Taxing) about the government’s May 14 brief in opposition to the taxpayer’s petition for certiorari in Altera v. Commissioner. On June 1, Altera replied to the government’s brief, as explained here by Chris Walker. The case has been distributed for a Supreme Court conference later in June.

The Altera reply brief doubles down on an argument that the government brief has already persuasively dispatched: that Treasury gave the impression during the rulemaking process that comparability analysis—i.e., the analysis of comparable transactions between unrelated parties—was relevant to the determination of an arm’s length result under the transfer pricing regulation at issue, and that then the government changed its tune.

First, some background to level-set for any new readers. In its cert petition, the taxpayer asked the Supreme Court to review a Ninth Circuit decision upholding a 2003 amendment to an existing tax regulation governing intra-group cost-sharing arrangements for the development of intangible property. (We submitted amicus briefs on behalf of the government to the Ninth Circuit in earlier stages of this litigation here (with coauthors Leandra Lederman and Clint Wallace), here and here.)

The regulation conditions the benefits of a qualified cost sharing arrangement, or QCSA, on including stock-based compensation deductions related to developing intangible property in the pool of costs to be shared. If this (and other) QCSA conditions are met, the cost-sharing party—typically an offshore subsidiary of a U.S. multinational firm—owns a share of the rights in intangible property, even though this intangible property is often developed within the United States. Allowing an offshore subsidiary to own a share of intangible property means that a U.S. multinational firm can attribute some profit from intangibles to the offshore subsidiary. This in turn means that the U.S. multinational firm can avoid paying U.S. corporate income tax on some of its profit.

Altera proposes that the Supreme Court should take this case because it is an opportunity to place limits on an inappropriate exercise of administrative agency power. The taxpayer’s cert petition argues that Treasury did not provide a reasoned explanation for the regulation as required under State Farm, in light of evidence cited by commenters that unrelated parties to similar types of arrangements did not share stock-based compensation costs; that the government in litigation engaged in post hoc rationalization to defend the regulation, in violation of Chenery I; and that the Ninth Circuit accorded Chevron deference to a procedurally defective regulation.

The government in response observed that the taxpayer conflates the arm’s length standard with comparability analysis. It explained that the government has maintained a consistent argument throughout the rulemaking process and this litigation. That is, the government has consistently maintained that the 2003 regulation’s rejection of comparability analysis as a means of determining an arm’s-length result in this limited context is consistent with both the “commensurate with income” language of the statute adopted in 1986 and the accompanying legislative history.

The core of Altera’s argument is that the government surprised taxpayers and tax advisers by making a “sea change in tax law without providing any notice of the change or opportunity to comment on it” (Reply Br. 1) and by taking a “new position” in litigation (Reply Br. 2) about the meaning of the arm’s length standard. Altera’s reply brief states this claim in at least three ways. None hold up.

The first thing Altera claims is that “The arm’s length standard has a settled meaning: A transaction meets the arm’s length standard if it is consistent with evidence of how unrelated parties behave in comparable arm’s length transactions.” (Reply Br. 5) Altera may wish that this sentence stated doctrinal transfer pricing tax law, but it does not. As the government’s brief in opposition to the cert petition correctly explains, Altera’s statement conflates the arm’s length standard with comparability analysis. Comparability analysis is not a predicate for determining an arm’s length result. One clear indication of that reality is the residual profit split transfer pricing method contained in regulations promulgated in 1994.

The second claim Altera makes is that the government initially suggested that comparability analysis is relevant to the determination of an arm’s-length result under the regulation at issue in this case, but then changed its mind. This is also incorrect. As the government’s brief explains, Treasury promulgated the 2003 amendment to make explicit what it had consistently argued was implicit in the prior (1995) cost-sharing regulation: that QCSA stock-based compensation costs must be shared to produce an arm’s-length result, without regard to evidence of allegedly comparable transactions. And it consistently pointed to the commensurate-with-income language of the statute and the related legislative history to support its position. It referred to commensurate-with-income both in the 2002 Notice of Proposed Rulemaking and in the 2003 Preamble.

This government’s position in this regard has been at the heart of a longstanding and well-known disagreement between taxpayers and the government. In 2002, lawyers at Baker & McKenzie explained the already-long history, in a comment to the proposed regulations written on behalf of Software Finance and Tax Executives Council:

On audit, in Advance Pricing Agreement negotiations, in docketed Tax Court cases, in published field service advice, and in speeches by Service officials … the Service has taken the position that stock-based compensation … must be included in related parties’ cost sharing pools. … Taxpayers have steadfastly and vehemently disagreed[, … absent] any evidence that unrelated parties … share stock option “costs” in their own cost sharing pools.

The third claim that Altera makes is that taxpayers did not realize that the government was promulgating a rule that did not rest on comparables and were caught by surprise. It writes that “none of the companies, industry groups, or tax professionals that participated in the rulemaking noticed” (Reply Br. 2) that the 2003 amendment made evidence of allegedly comparable uncontrolled transactions not determinative of an arm’s length result in this context. This claim also does not hold up. Indeed, the amended regulation itself – in both its proposed and final form – unequivocally states that a QCSA will achieve an arm’s-length result “if, and only if,” the parties share all development-related costs (including stock-based compensation costs) in proportion to anticipated benefits.

In written submissions and at the 2002 hearing to consider the proposed regulation, commenters certainly realized that the regulation was not based on evidence of comparables. A representative for the American Electronics Association stated that the regulation identified an arm’s-length result “by fiat,” implicitly acknowledging that the government had rejected a comparables-based inquiry. A Fenwick & West partner explained that the regulation “deem[ed] a result to be arm’s length without providing any evidence.” A tax partner at PricewaterhouseCoopers noted the perception that the amendment “seem[s] contrary to the arm’s length standard as evidenced by actual transactions ….” The rest of the regulatory record is consistent. Commenters understood. Taxpayers and tax advisers knew exactly what Treasury was doing.

Altera says it is making an administrative law argument, but it is really interested in a tax policy outcome. The asserted “immense prospective importance” (Reply Br. 4) is illusory. Even if the Court were to grant the petition and then hold that the 2003 amendment is procedurally defective, Treasury could simply re-promulgate the rule without substantive change but with a more detailed explanation. As for past tax years, Altera’s and similarly-situated companies’ financial statements have already incorporated the possibility that corporate income tax will be due based on compliance with the regulation. The real importance of the case for taxpayers lies in the hope that the Supreme Court goes beyond the administrative law issue and expresses a pro-taxpayer view as to the merits. But this tax issue is not presented.

Rather, the cert petition raises a procedural administrative law issue. It works for the taxpayer only if the government changed its tune. But to the contrary, the government has been singing the same tune for two decades or more.

The government did not surprise taxpayers and tax advisers with never-before-seen interpretations of the arm’s length standard. The government consistently explained that evidence of allegedly comparable transactions is not determinative of an arm’s-length result in this context. It consistently referred to the commensurate-with-income statutory language and legislative intent in support of its position. The government has been faithful to its argument and explanation since before the 2003 amendment and continuing through every stage of this litigation. There has been no surprise or change of course. Rather, this case involves the government making the same argument and explanation, over and over again.

Susan C. Morse is the Angus G. Wynne, Sr. Professor in Civil Jurisprudence at the University of Texas at Austin School of Law. Stephen E. Shay is a Lecturer at Harvard Law School. This is piece is cross-posted at Procedurally Taxing.