If you are friends with any corporate tax attorneys, kindly forgive them their grumpiness. They get a pass right now. That’s because the government recently dropped an abnormally dense set of income tax regulations on their desks – the ones dealing with debt recharacterization under Internal Revenue Code section 385.
These regs are significant for a number of reasons. In many ways they’re the biggest domestic tax development of the year. They represent a novel approach to protecting the corporate tax base, which has been gradually shrinking because of cross-border profit shifting.
My colleague Jeremy Scott has separately addressed how the regs limit the deductibility of interest incurred on related-party debt. You can read his opinion here. My beef concerns a procedural annoyance, but is no less important to the functioning of our tax system.
The initial version of these regs was released in April of this year and came in at 136 pages. Enough verbiage to furrow one’s brow, but not entirely out of line with our expectations of administrative thoroughness. (Every profession has its unavoidable chores.) But to the frustration of tax professionals across the country, the final regs, released just two weeks ago, run more than 500 pages. The preamble alone is of Tolstoyesque proportions, and contains roughly 350 pages of official reaction to public comments.
This monstrosity was predicted. Last month at the IFA World Congress in Madrid, several speakers foreshadowed it. H. David Rosenbloom of Caplin & Drysdale warned that the preamble would be “ugly” in a way few others have been before. His observation was spot on.
What we’re witnessing is a bizarre exercise in managing litigation risk. The government now feels compelled to acknowledge and discuss each individual comment it receives from taxpayers and practitioners, fearing that failure to do so could render the package “arbitrary and capricious” in violation of the Administration Procedure Act. Its worry stems from the U.S. Tax Court’s decision last summer in Altera Corporation v. Commissioner, 145 T.C. No. 3 (2015).
Altera involved a cost-sharing agreement between related parties and the IRS’s attempt to require the pooling of stock-based compensation costs. An intended consequence of the cost-sharing agreement was the migration of high-value intellectual property beyond the reach of U.S. tax laws.
The government lost at the Tax Court and has appealed the Altera decision to the Ninth Circuit Court of Appeals. Some legal observers hope this will provide an opportunity to overturn adverse case law in the form of Xilinx Inc. v. Commissioner, 598 F.3d 1191 (9th Cir. 2010). Such a reversal might breathe new life into the commensurate with income standard, which has been in the tax code since the mid-1980s but remains strangely underused to challenge aggressive profit shifting.
Personally, I’ve grown ambivalent about the outcome of Altera on the technical matter of which costs should be pooled as part of the cost-sharing agreement. Federal courts have gleefully ignored the commensurate with income standard for decades. Why would they change now? Besides, the government tends to lose all these big lawsuits involving cost sharing and intangibles. Xilinx was a humiliating defeat for the government, and Altera may prove no different.
Transfer pricing disputes are the Cleveland Browns of the federal tax docket -- you learn to lower your expectations.
However, I do hope the Ninth Circuit reverses the Tax Court regarding the perceived Administrative Procedure Act violation. The process of public notice and comment is extraordinarily valuable. It’s useful to see how the government responds to issues raised by practitioners and industry groups. But I question whether requiring the government to address each and every comment -- however frivolous, mundane, or duplicative -- advances our knowledge.
The preamble to the 385 regulations feels more like a recitation than analysis. And that’s not helpful. If anything, this blanket approach hinders our learning because the few morsels of insightful analysis are buried amid a mountain of minutiae. Let’s hope 350-page preambles don’t become common practice.