Eaton Wins Big on Appeal in Long-Running Contentious Litigation Over APAs (8/27/22)

In Eaton Corp. v. United States, 47 F.4th 434 (6th Cir 8/25/22), here and GS here, the Court gave Eaton a victory on all points of contention in long-running and highly contentious litigation over the Advance Pricing Agreement (APA). The APA is an advance agreement as to how the taxpayer will report its covered transfer pricing products or intangibles in future years so that, provided the taxpayer reports pursuant to the agreement, the IRS will not audit except to confirm reporting consistent with the agreement. (At least in earlier audits I handled, the APA methodology could be spread to past open years, if appropriate, but past years were not in issue in Eaton.)  The Court signals its holdings in its opening short paragraph:

            Taxes may well be “what we pay for civilized society,” Compania Gen. de Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (Holmes, J., dissenting), but that doesn’t mean the tax collector is above the law. This case arises from the IRS’s efforts to circumvent basic contract law.

Not an auspicious start for the IRS.

In holding for Eaton, the Court resolved the following issues.

1. In a section captioned “Wrongful Cancellation: Burden of Proof,” the Court resolved a burden of proof issue. (Slip Op. 8-12.) The IRS argued that, since it made the § 482 adjustments in the notice of deficiency because Eaton violated the APA agreement, the standard was “arbitrary and capricious.”  The Court held that, because the predicate issue was whether Eaton violated the APA, the issue is one of contract interpretation as to whether Eaton breached the contract. (Under that notion, only If Eaton breached the contract, would Eaton then have the burden to prove that the IRS’s § 482 adjustments were arbitrary and capricious.)  As to the contract interpretation issue, the IRS bore the burden of proving that Eaton had breached the contract.

2. On the issue of whether Eaton violated the contract, the Court held (Slip Op. 12), applying contract law, that Eaton had not breached the agreement and therefore the IRS did not have the right to cancel the contract and issue the notice of deficiency with § 482 adjustments.

Transfer Pricing: Finite Valuation and Ranges (8/20/22)

        I have just started reading a tax, more or less, history, at least anecdotal history. Michael Keen, & Joel Slemrod, Rebellion, Rascals, and Revenue, (Princeton University Press 2021), here.   Early in my reading, something caught my eye because of a case I perused earlier in the day, Medtronic, Inc. v. Commissioner, T.C. Memo. 2022-84 (Decided 8/18/22), T.C. docket entry 74 at docket entries for the case here and GS here). I say I perused because the opinion is 75 pages (with three-page appendix of the experts’ brief biographies). I read closely only certain parts, including the part I discuss here. Medtronic involves transfer pricing for intangibles, which most commonly involve transactions between a U.S. taxpayer and a foreign affiliate offering opportunities to manipulate (lower) the U.S. tax base and thus achieve major U.S. tax “savings.”  The drill in these cases for the taxpayer is to lower the U.S. tax base and for the IRS to increase the U.S. tax base. That’s an oversimplification, but not much of one. The theoretical mechanism for achieving that is to peg the tax results of the related party transaction to a standard of an uncontrolled transaction between unrelated parties. This standard is notoriously difficult for intangible assets.

           Professors Keen and Slemrod offer a good tongue-in-cheek description (pp. xvi-xvii):

Many of the tax episodes we look at may at first seem far-fetched or ridiculous. Some are stories of disastrous missteps and cruelty. Some, we admit, teach no useful lesson that we can discern, but are just pleasingly gaudy and preposterous. But along with the follies there are also episodes of remarkable wisdom. For it is a theme of the book that, when it comes to designing and implementing taxes, our ancestors were addressing fundamentally the same problems that we struggle with today. And they were no less ingenious—not just in creating taxes, but also in avoiding and evading them—than we are. We should not feel too superior to our forebears, given the taxes we have nowadays. The idea of taxing chimneys may seem quaint to us. But we suspect our descendants will find some of the things that we do today more than a little peculiar, such as taxing multinationals by trying to figure out what some entirely different and hypothetical set of companies would have done in the unlikely (possibly inconceivable) event that they found themselves in the same circumstances. And they would be right.

        My observation of transfer pricing over the years is that these transfer pricing cases are just valuation cases, with a lot of zeroes to justify litigation with a lot of commotion to prompt a lot of legal and expert fees. My anecdotal observation of this type of case over the years is that many unnecessary legal and expert fees are generated in litigating them. But that is another story. 

        For now, I want to focus on Medtronic (this opinion rather than the earlier Tax Court and Eighth Circuit opinions, Medtronic, Inc. v. Commissioner, T.C. Memo. 2016-112 (sometimes Medtronics I), vacated and remanded, T.C. Memo. 2016-112, 900 F.3d 610 (8^th Cir. 2018) (sometimes Medtronic II). As an aside, the petition in the Medtronic case was filed in 2011, Medtronic I was decided in 2016, Medtronic II was decided on August 18, 2018, and Medtronic III was decided 8/16/18, and Medtronic III was decided on remand is dated 8/18/22. Interesting.

More Coca-Cola - On Transfer Pricing and Blocked Income Regulation (11/23/20)

I recently wrote on burden of proof issues in The Coca-Cola Company v. Commissioner, 155 T.C. ___, No. 10 (2020), here.  Tax Court (Judge Lauber) Issues Significant Transfer Pricing Decision in Coca-Cola; Burden of Proof Issues (11/19/20; 11/21/20), here.  Coca-Cola is a transfer pricing case, meaning that it is a valuation case.  Valuation cases are generally humdrum on the issue of valuation, an issue raised in many contexts including in abusive tax shelters since the 1970s when I first began observing them.  Transfer pricing can be abusive as well because valuation can be abused.  I don’t propose to delve into the factual issues bearing on valuation Coca-Cola and whether the underlying valuations Coca-Cola used were abusive.  

I rather today point to this discussion of the “blocked income” issue.  The issue is described in high overview (pp. 184-185, beginning here):

2. Brazilian "Blocked Income"

Petitioner alternatively contends that, if TCCC owned the Brazilian trademarks, Brazilian law would have prevented the Brazilian supply point from paying, for use of those trademarks, royalties anywhere close to the amounts determined in the notice of deficiency. During 2007-2009 Brazilian law restricted the amount of trademark royalty and technology transfer payments that a Brazilian entity could pay to a foreign parent. The parties have stipulated that those maximum amounts were approximately $16 million for 2007, $19 million for 2008, and $21 million for 2009.

Relying on what is commonly called the "blocked income" regulation, respondent contends that these Brazilian legal restrictions should be given no effect in determining the arm's-length transfer price. See sec. 1.482-1(h)(2), Income Tax Regs. The regulation generally provides that foreign legal restrictions will be taken into account only if four conditions are met. See id. subdiv. (ii). Petitioner contends that this regulation does not apply here or that the necessary conditions were met. Alternatively, it contends that the blocked income regulation is invalid under the Administrative Procedure Act and/or Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984).

As the parties have observed, the validity of section 1.482-1(h)(2), Income Tax Regs., has been challenged by the taxpayer in 3M Co. & Subs. v. Commissioner, T.C. Dkt. No. 5816-13 (filed Mar. 11, 2013). The Court has granted a motion to submit the 3M case for decision without trial under Rule 122, and the case is still pending. We will accordingly reserve ruling on the parties' arguments concerning the blocked income regulation until an opinion in the 3M case has been issued.

The Blocked Income Issue as I recall it from my transfer pricing forays over the years hearkens back to Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972), here.  In that case, in high level summary, the Court held that § 482 did not authorize the IRS to allocate income from one related company to another if state law prohibited the income from being paid.  The Blocked Income Issue is whether the foreign law prohibition upon paying royalties prohibits the IRS from allocating the income to the U.S. party.  The underlying “Blocked Income” regulations, 26 CFR 1.482-1(h)(2), here, imposes the following conditions on the First Sec. Bank results (no allocation).

(ii) Applicable legal restrictions. Foreign legal restrictions (whether temporary or permanent) will be taken into account for purposes of this paragraph (h)(2) only if, and so long as, the conditions set forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met.

(A) The restrictions are publicly promulgated, generally applicable to all similarly situated persons (both controlled and uncontrolled), and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign;

(B) The taxpayer (or other member of the controlled group with respect to which the restrictions apply) has exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of such restrictions (other than remedies that would have a negligible prospect of success if pursued);

(C) The restrictions expressly prevented the payment or receipt, in any form, of part or all of the arm's length amount that would otherwise be required under section 482 (for example, a restriction that applies only to the deductibility of an expense for tax purposes is not a restriction on payment or receipt for this purpose); and

(D) The related parties subject to the restriction did not engage in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction, and have not otherwise violated the restriction in any material respect.

I don’t propose to develop the Blocked Income Issue further here, since I am sure it has been adequately developed in the 3M case to which the Coca-Cola both referred and deferred.  Readers should just be aware that further enlightenment is coming in 3M.

JAT Comments.

Tax Court (Judge Lauber) Issues Significant Transfer Pricing Decision in Coca-Cola; Burden of Proof Issues (11/19/20; 11/25/20)

Yesterday, the Tax Court decided The Coca-Cola Company v. Commissioner, 155 T.C. ___, No. 10 (2020), GS here, a transfer pricing company case in which the IRS seems to have substantially prevailed.  Transfer pricing cases are fact intensive cases.  However, in this discussion, I won’t wander through the morass of facts but rather deal with burden of proof issues that, although presented in a fact setting, can be considered at a conceptual level independent of the facts of the case.  However, I do ask that readers keep in mind that transfer pricing cases are, at bottom, simply valuation cases.

I recently wrote an article on burden of proof in tax cases.  John A. Townsend, Burden of Proof in Tax Cases: Valuation and Ranges—An Update, 73 Tax Lawyer 389 (2020), here.  In that article, I discussed the seminal case of Helvering v. Taylor, 293 U.S. 507 (1935), see discussion beginning on p. 411, here.  In that case in summary and without nuance, the Court held that in a deficiency case in the Tax Court, once the taxpayer shows the deficiency is “arbitrary and excessive,” the IRS bears the burden of persuasion (risk of nonpersuasion) to show that the taxpayer has a deficiency.  Three nuance points:  (i) I address in the article (p. 397 n. 28, here) that “arbitrary and excessive,” although stated in the conjunctive is really disjunctive; (ii) if the issue involves a deduction turning upon valuation, the taxpayer will bear the burden of persuasion with respect to value to support the deduction; and (iii) the burden of persuasion is often called the risk of nonpersuasion which is more descriptive of how the burden of persuasion performs, but I used the term burden of persuasion here.

I illustrate the key concept of the article in a simple example. Assume that the taxpayer receives property in a service income transaction.  Taxpayer reports $40 income on his tax return based on valuing the property at that amount.  The IRS determines a deficiency of tax by valuing the property at $100.  The parties litigate in the Tax Court.  The Tax Court cannot find a finite value by a preponderance of the evidence but can find a range where the low end of the range is the lowest value proved by a preponderance of the evidence and the high end of the range is the highest value proved by a preponderance of the evidence.  Let’s say that range is from $70 to $80.  (This range may also be called the range of equipoise where the Court (or other trier of fact) is in equipoise as to the valuation based on the preponderance of the evidence standard.)

In the example, Helvering v. Taylor, 293 U.S. 507 (1935) requires that the value be determined at $70 because the taxpayer has shown the deficiency determination excessive because of the excessive valuation.  The IRS thus bears the burden of persuasion as to an amount that would produce some deficiency amount.  In the example, the evidence proves by a preponderance a value of at least $70 and the Tax Court should determine the deficiency accordingly.

Altera Corp. Petition for Rehearing Denied (11/12/19)

I have written before about the cause célèbre that is the Altera case.  Altera Corp. v. Commissioner, 145 T.C. 91 (2015), here, rev'd 926 F.3d 1061 (2019), here.  Today, the Ninth Circuit denied the petition for rehearing en banc.  See here.

The denial of the petition for rehearing is cursory, as usually the case with denials of petitions for rehearing en banc.

My prediction is that Altera will seek certiorari.  There is no direct conflict.  Altera will urge, I presume, the importance of the issue and conflict in principle with Supreme Court authority regarding interpretation and application of the arbitrary and capricious/State Farm (Motor Vehicle Mfrs. Ass’n of U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983) standard).

There is a significant dissent by Judge Milan Smith (see Wikipedia, here), joined by Judges Callahan and Bade.  Judge Smith does not offer much new there that had not been said by the Tax Court and the Ninth Circuit panel (panel opinion and dissenting opinion).  Basically, Judge Smith claims that the Treasury Regulations failed procedural regularity under the § 706(2)(A) arbitrary and capricious standard, also called the State Farm standard.  The key for Judge Smith is that, in his view, the IRS justified the regulations on the arm's length standard alone rather than the commensurate with income standard and failed to adequately consider the comments in making the final decisions.

I have dealt with this genre of argument in discussing the panel opinions, so I just point to those discussions:  Ninth Circuit Reverses Unanimous Tax Court in Altera (Federal Tax Procedure Blog 6/7/19; 6/20/19; 7/2/19), here.

Altera Petition for Rehearing and DOJ Tax Response in opposition in Altera Case (8/31/19)

I previously discussed the decision in Altera Corp. & Subsidiaries v. Commissioner, 926 F.3d 1061 (9th Cir. 2019), here, where the reconstituted Ninth Circuit panel held that the taxpayer must include stock option costs in its qualified cost sharing arrangement ("QCSA") calculations of costs.  See Ninth Circuit Reverses Unanimous Tax Court in Altera (Federal Tax Procedure Blog 6/7/19; 6/20/19; 7/2/19), here.

Altera filed a petition for rehearing en banc.  See Steve Dixon, Petition for Rehearing En Banc Filed in Altera (Miller & Chevalier Tax Appellate Blog 7/24/19), here (which has a link to obtain a copy of the petition).  As in the panel consideration, several amici curiae have submitted briefs.  The Court ordered the Government to respond, and DOJ Tax has now filed its response opposing rehearing en banc.  See DOJ Tax brief in opposition, here.

I do not link the amicus briefs which, I suppose, may not be all in yet.  I have not yet read them and, if I do, and think any are significant I will add to this blog entry.

The Government's Response Brief is quite good, in my opinion.  It clearly and succinctly steps through the bases touched in the majority panel opinion.  (See my blog above and, of course, the opinion linked above).  Basically, in summary:

1.  Applying the Chevron Framework (Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), here), the regulation requiring inclusion of stock option costs is a reasonable interpretation under Chevron's Step Two within the scope of the statutory ambiguity getting the issue past Step One.

2.  The regulation was procedurally regular under the State Farm test.  Motor Vehicle Manufacturers Association of United States, Inc. v. State Farm, 463 U.S. 29, 41-45 (1983), here. The State Farm test is based on 5 USC 706(c)(2)(A), here, which, surprisingly, DOJ Tax does not cite in its Response.

That's it folks.  Except for the commotion in the case (prominent corporate taxpayer with lots of money at stake and other nonparty corporate taxpayers with lots of money at stake), lots of heat with some light (I think particularly in the majority panel opinion and the DOJ Response linked above, and the fact that the Tax Court in a unanimous reviewed opinion slipped off the rails), there does not appear to me to be enough real substance to the petition to warrant rehearing en banc or petition for certiorari in the case as it stands now.  Just my opinion (and nobody has paid me or would pay me to render it or cares that I have rendered it.)

Amazon Wins Transfer Pricing Dispute on Regulations Interpretation (8/18/19)

In Amazon.com, Inc. v. Commissioner, ___ F.3d ___ (9th Cir. 2019), here, a transfer pricing case, the Court held that, under the applicable regulations (but superseded for later years as noted in footnote 1 discussed below) did not require that residual business assets (like workforce in place, going concern value) be included in the required buy-in for a cost sharing agreement between related parties because they were not independently transferable assets.

Here is the Court's summary (not part of the opinion):

The panel affirmed the Tax Court’s decision on a petition for redetermination of federal income tax deficiencies, in an appeal involving the regulatory definition of intangible assets and the method of their valuation in a cost-sharing arrangement. 

In the course of restructuring its European businesses in a way that would shift a substantial amount of income from U.S.-based entities to the European subsidiaries, appellee Amazon.com, Inc. entered into a cost sharing arrangement in which a holding company for the European subsidiaries made a “buy-in” payment for Amazon’s assets that met the regulatory definition of an “intangible.” See 26 U.S.C. § 482. Tax regulations required that the buy-in payment reflect the fair market value of Amazon’s pre-existing intangibles. After the Commissioner of Internal Revenue concluded that the buy-in payment had not been determined at arm’s length in accordance with the transfer pricing regulations, the Internal Revenue Service performed its own calculation, and Amazon filed a petition in the Tax Court challenging that valuation. 

At issue is the correct method for valuing the pre-existing intangibles under the then-applicable transfer pricing regulations. The Commissioner sought to include all intangible assets of value, including “residual-business assets” such as Amazon’s culture of innovcation (sic), the value of workforce in place, going concern value, goodwill, and growth options. The panel concluded that the definition of “intangible” does not include residual-business assets, and that the definition is limited to independently transferrable assets.

I won't get into the weeds on the opinion because it appears to be an unexceptional application of standard rules of interpretation of the regulation (a similar exercise to interpreting the text of a statute).  The IRS's interpretation of its own regulation was not entitled to Auer deference, which is now substantially constrained by the decision in Kisor v. Wilkie, 588 U.S. ___, 139 S.Ct. 2400 (2019) [Sup Ct Slip Op here; Google Scholar with S.Ct. pagination here].

The important point on the substance of the IRS position is that the IRS changed the regulation.  In footnote 1 (Slip Op. p. 6]:

   n1 This case is governed by regulations promulgated in 1994 and 1995. In 2009, more than three years after the tax years at issue here, the Department of Treasury issued temporary regulations broadening the scope of contributions for which compensation must be made as part of the buy-in payment. See 74 Fed. Reg. 340 (Jan. 5, 2009). In 2017, Congress amended the definition of “intangible property” in 26 U.S.C. § 936(h)(3)(B) (which is incorporated by reference in 26 U.S.C. § 482). Tax Cuts and Jobs Act of 2017, Pub. L. 115-97, § 14221(a), 131 Stat. 2054, 2218 (2017). If this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the Commissioner’s position would be correct.

So, except for the dollars involved (bit, as is the way with Amazon), the case would be unexceptional.

Ninth Circuit Reverses Unanimous Tax Court in Altera (6/7/19; 6/20/19; 7/2/19)

I have blogged on the Ninth Circuit's prior opinion reversing the unanimous Tax Court in Altera Corp. v. Commissioner, 145 T.C. 91 (2015) (reviewed opinion), here. Developments - Federal Tax Procedure Book 2018 Editions and Altera (7/25/18; 7/27/18), here. That opinion was reversed because it was rendered after one of the panelist died.  Ninth Circuit Withdraws Altera Opinions (8/7/18; 8/13/18), here.  Another judge was substituted for the deceased judge and oral argument was heard by the reconstituted panel.

The Ninth Circuit reconstituted panel, with all members apparently still alive, issued its opinion reversing the unanimous Tax Court.  Altera Corp. v. Commissioner, ___ F.3d ___, 2019 U.S. App. LEXIS 17143 (9th Cir. 2019), here.

Altera has been quite a saga, including the strange concept of a dead judge joining a majority opinion.  At the outset, it might be worth doing a tally of the judges on the merits.  In just the win-lose category.  There are two judges giving the win to the IRS, but they are the most important judges -- two of the three judges on the reconstituted panel.  All the other judges (other than the deceased Ninth Circuit judge who apparently voted before his death) who voted on merits held against the IRS.  Those judges are the dissenting judge on the reconstituted panel and all of the judges (15 in number) who voted on the reviewed opinion in the Tax Court.  So, just counting heads, two judges thought the IRS should win; 16 thought the IRS should lose.  (And this is not counting the dead judge's vote for the original panel opinion, which, if counted, would have been 3 for the IRS and 16 for the taxpayer.)  For those with the time to review an anecdote from my earlier appellate career at DOJ Tax for a Government appeal, like Altera, from a reviewed Tax Court opinion with most of the judges voting for the taxpayer, see Developments - Federal Tax Procedure Book 2018 Editions and Altera (7/25/18; 7/27/18), here.

Now to the current opinions from the reconstituted panel with living panel members.  The split is as it was in the withdrawn opinion.  Judge Thomas was for the IRS; Judge O'Malley from the Federal Circuit (by designation for the original and reconstituted panel) was for the taxpayer.  The swing judge was Judge Graber from the Ninth Circuit, designated to the panel to replace the deceased Judge Reinhardt.  Like Judge Reinhardt, the swing judge voted with Thomas whose opinion thereby became the majority just as with the withdrawn opinion.

I am focusing here only on the new panel majority and dissenting opinions.  I make no attempt to compare the differences between the withdrawn opinions and reconstituted panel current opinions; I just assume that, in broad strokes, the positions are the same (with some interim tweaking) since the same judges wrote the panel majority and dissenting opinions. (Readers interested in the withdrawn panel majority and dissenting opinions can look at my prior blog or Google any other comment on them.)  Readers interested in a discussion of the differences between the withdrawn and the current opinions might watch the Miller & Chevalier Tax Appellate Blog, here, because, in a quick posting on the blog on Friday, there the author said:  "Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison."  Steve Dixon, Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera (Tax Appellate Blog 6/7/19), here.

In broad outline, the panel majority opinion holds:

1.  Chevron Analysis.

   a.  Chevron Step One. Section 482 is ambiguous on the issue presented (whether the qualified cost sharing arrangement ("QCSA") must include employee stock option costs in allocating income from the intangible ).  Accordingly, Chevron Step One is passed.

   b.  Chevron Step Two.  The regulations' requirement that employee stock option costs be included in the QCSA costs is reasonable and therefore the interpretation that the court applies, by Chevron deference, in Chevron Step Two.

2.  State Farm Analysis.  The promulgation of the regulation requirement met the reasoned decisionmaking requirement and was not procedurally defective.