Tax Analysts Blog

Warning: Debt-Equity Regs May Cause Persistent Grumpiness

Posted on Oct 26, 2016

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.

Read Comments (2)

Mike55Oct 27, 2016

Great article, and on an important subject. I agree with you that it's silly to require Treasury to respond to each and every comment in a preamble, but don't think it follows that Altera should be overturned. The failure to address comments holding in Altera is certainly controversial (and is thus receiving the most attention), but was just one of the four separate grounds the Altera court relied upon to invalidate the new options cost sharing rule.

Treasury's biggest problem in Altera was not its failure to address comments in the preamble, but rather its alarming concession that it had no contemporaneous factual analysis to support its position ANYWHERE! Call it "bad facts make bad law" if you'd like, but a flawed preamble was just one part of what went wrong for Treasury in the Altera case. The bigger problem was that Treasury didn't do its homework.

In my view the real meat of the Altera decision was the court's refusal to apply the "harmless error" rule, or to otherwise permit Treasury to substitute a new rationale/evidence to save the regs. at trial. Requiring that parties to a cost sharing agreement share option expense makes a ton of sense, so Treasury was anxious to defend the rule's actual text rather than the process used to create that text. The Altera court refused to play along, and I for one think that was the right choice.

If Treasury is allowed to backfill support for its legislative regulations at trial, then the APA's "reasoned decision-making" standard devolves into a "decision-making that is later proven to be reasonable" standard. I much prefer the former (being a stickler for process/procedure when it comes to lawmaking) and, for what it's worth, think it's also the better reading of the APA.

Bob GoulderOct 27, 2016

Mike55: Thanks for reading, and for commenting. Excellent observations. Your last paragraph is on point ... "decision-making that is later proven to be reasonable". If the Service is permitted to do that, certainly problematic.

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