Ninth Circuit Withdraws Controversial Altera Opinion and Will Allow New Judge to Make Ultimate Determination

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:

• Withdrawal of the Ninth Circuit's July 24 opinion officially revives the 2015 Altera Tax Court opinion, which the July 24 opinion had invalidated.
• A return to this Tax Court "status quo" means that taxpayers are as of this moment not bound by the controversial regulations at issue in Altera when filing their 2018 returns (i.e., taxpayers may allocate stock-based compensation in cost-sharing arrangements as they choose).
• The Ninth Circuit now returns to deliberating the case and will issue a new opinion once it reaches a decision. Because Judge Reinhardt was in the majority of the original 2-1 decision, Judge Graber will now cast the tiebreaking vote, and she is free to agree with either side. 
• If Judge Graber votes to affirm the Tax Court—forming a 2-1 majority that reached the opposite conclusion of the original Ninth Circuit opinion—the transfer pricing regulations at issue in Altera will once again be considered invalid, allowing technology companies that use qualified cost-sharing arrangements to save significant amounts in U.S. taxes by retaining stock-based compensation deductions in the U.S. in order to offset U.S. income.

What's at Issue

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.

Procedural Posture

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.

Taking Bets

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.

Why to Expect a Reversal

• The Ninth Circuit explicitly indicated that Judge Reinhardt had participated in the decision, meaning that use of discretionary authority to revisit the case, particularly on an immediate basis and prior to a petition for rehearing, may signify a concern with the substantive outcome rather than the desire to simply correct a mistake in the procedural process. Moreover, some raised concerns that Judge Reinhardt may not have had an opportunity to consider Judge O'Malley's dissent prior to his concurrence (note also that Judge Reinhardt would have been permitted to change his vote at any time prior to issuance of the decision).
• Public outcry against the July 24 decision has been substantial, particularly in light of the would-be reversal of a unanimous 15-0 decision by subject-matter experts in the Tax Court.
• Current developments bear an eerie resemblance to Xilinx v. Commissioner, a case involving almost identical facts and analogous regulations and in which an initial 2-1 panel decision in favor of the IRS was subsequently withdrawn and reversed.
• Judge O'Malley's dissent is well reasoned and raises plausible grounds for reversal.

Why Not to Expect a Reversal

• Judge Graber's generally moderate judicial views do not suggest an inclination to invalidate regulations under the Administrative Procedure Act and Chevron standards.
• The import of the decision and the unusual circumstances associated with Judge Reinhardt's untimely death may simply suggest a purely procedural desire on the part of the court to ensure a valid opinion rather than any substantive concern with the decision.
• Many tax practitioners feel that equities in this case favor including the stock-based compensation expense in the calculation of the cost-sharing payments.

Please contact any member of the Orrick Tax Group to further discuss the potential impact of this development on your business.