Page 7 - Altera: Why the Government Can't Count on Chevron Step Two

acknowledged that Treasury and the IRS had re- ceived industry comments objecting that unrelated parties to a CSA would not share stock-based compensation, yet the preamble also failed to iden- tify a specific and overriding tax administration purpose that required that those comments be ig- nored and pushed aside.38
Therefore, the Tax Court believed it was obli- gated to apply the arm’s-length standard and Chev- ron step two or the State Farm standard to determine if there was empirical evidence that would support the regulation.39 It was in this portion of its opinion that the Tax Court said that whether State Farm or Chevron supplies the standard of review is immate- rial because the reasoned decision-making standard of State Farm is incorporated in Chevron step two.40 Marvel stated further that ‘‘because the validity of the final rule turns on whether Treasury reasonably concluded that it is consistent with the arm’s-length standard, the final rule must satisfy State Farm’s reasoned decision making standard as well as Chevron.’’
The government conceded at trial that the IRS is subject to the APA and that it had advanced no rationale or justification for exempting regulations from State Farm review. In other words, there is no safe passage for the IRS to simply say, ‘‘We like this rule under the regulation because it is good for tax law.’’
The Tax Court found the following: (1) the regu- lation’s requirement that the parties to a CSA share stock-based compensation costs lacked a basis in fact; (2) the IRS failed to rationally connect the choice it made in the regulation with the facts produced during the rulemaking process; (3) the IRS failed to respond to significant comments; and (4) the final rule was contrary to the evidence before the IRS.
On the first point, the Tax Court found that the IRS, by not engaging in any fact-finding, failed to ‘‘examine the relevant data,’’ as required under
38The government argued that in issuing legislative regula- tions under section 482, the IRS is permitted to modify if not abandon the arm’s-length standard. The Tax Court believed it did not have to decide the propriety of the government’s position on this point. See Brand X, 545 U.S. 967.
39The Tax Court said that it has expressly recognized ‘‘the importance of maintaining a uniform approach to judicial review of administrative action’’ (citing Mayo, 562 U.S. at 55). See also Dominion Resources Inc. v. Commissioner, 681 F.3d 1313, 1319 (Fed. Cir. 2012) (invalidating the associated-property rule in reg. section 1.263A-11(e)(1)(ii)(B) under State Farm).
40Citing Judulang v. Holder, 132 S. Ct. 476, 484 n.7 (2011) (under either standard, ‘‘the analysis would be the same be- cause under Chevron step two we ask whether an agency interpretation is ‘arbitrary or capricious in substance’’’ (citing Mayo)).
State Farm, and that it further failed to support its belief that unrelated parties would share stock- based compensation costs under a qualified CSA. Accordingly, the final rule lacked a basis in fact.
On the second point, the Tax Court noted that the preamble indicated that the IRS relied on its belief that unrelated parties entering into qualified CSAs to develop high-profit intangibles would share stock-based compensation if it was a significant element of the compensation. But that statement lacked any empirical data or proof. Therefore, the rationale set forth in the preamble violated the State Farm requirement.
The IRS also advanced the position that the final regulation eases administrative burdens, which can be a reasonable basis for agency action.41 According to the court, the IRS’s argument that the final regulation is reasonable based on administrative convenience that all taxpayers be subject to a uni- form rule requiring cost sharing of stock-based compensation costs couldn’t be justified based on mere speculation. The court noted that the pre- amble failed to state that rationale or provide any other explanation for treating all qualified CSAs the same.42 Moreover, the record lacked any factual findings by the government from which it could reasonably conclude that the purported administra- tive benefits of a uniform final rule could justify erroneously allocating income in some of those cases.
The court therefore concluded that by treating all qualified CSAs identically, the IRS failed to articu- late a rational connection between the facts found and the choice made. When an agency rule is founded on unsupported assertions or unstated inferences, a court must not abdicate its judicial duty and must review the record carefully to deter- mine whether the agency made a reasoned decision based on reasonable extrapolations from some reli- able evidence, Marvel said.43
A third flaw was that Treasury and the IRS failed to respond to significant comments. The IRS said it was not persuaded by the commentators who as- serted that they were unaware of any transaction between unrelated parties that required one party to reimburse the other party for amounts attribut- able to stock-based compensation. The American Electronics Association also informed the IRS that a
41See Mayo, 562 U.S. at 59.
42The preamble to the 2003 final regulation discusses admin- istrability only regarding selection of the exercise spread method and the elective grant method as the only available valuation methods.
43Citing Am. Mining Cong. v. EPA, 907 F.2d 1179, 1187 (D.C. Cir. 1990).
COMMENTARY / SPECIAL REPORT
TAX NOTES, June 6, 2016
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