United States: Ninth Circuit Panel Upends Arm's Length Standard In Cost Sharing

Last Updated: August 14 2018
Article by Jenny A. Austin, Thomas Linguanti and Kensington A. Wolgamott

July 24, 2018, marked a significant, although potentially short-lived, victory for the Internal Revenue Service (IRS), as a panel of the US Court of Appeals for the Ninth Circuit reversed by 2 votes to 1, the full US Tax Court's unanimous opinion in Altera Corp. v. Commissioner.1 The Ninth Circuit opinion in IRS's favor upholds the validity of the Treasury Department's 2003 final regulation mandating that stock-based compensation (SBC) costs be treated as "costs" to be shared between parties to a qualified cost sharing arrangement (QCSA). The majority of the Ninth Circuit panel concluded that (1) the challenged regulation is valid under the Administrative Procedure Act (APA) because the Treasury Department did not exceed the authority granted by Congress under Section 482 to establish regulations to address cost allocations in a QCSA; and (2) that the challenged regulation is entitled to Chevron deference because it is not arbitrary, capricious, or manifestly contrary to the statute. Although the case has been closely followed by the technology community in particular, given the prevalence of SBC in that sector, the Ninth Circuit panel's opinion could have broader ramifications for most US-based multinationals regarding the future of cost allocations under QCSAs, the use of the APA in tax cases, and most importantly, the meaning of the arm's length standard.

I. Background – Altera's QCSA

Altera Corp. (now a US subsidiary of Intel) entered into a QCSA in May 1997 with a Cayman subsidiary, Altera International. Pursuant to the terms of the QCSA, the parties agreed to share the risks and costs of research and development (R&D) activities. In tax years 2004–2007, Altera Corp. granted stock options and other SBC to some of its employees responsible for conducting the R&D activities covered under the QCSA. They shared those SBC costs until 2005, when they amended the QCSA to exclude SBC costs in light of the Tax Court's opinion in Xilinx, Inc. v. Commissioner,2 which had held that the IRS's obligation to include SBC in QCSAs under the prior Treasury regulations was contrary to the arm's length standard.

As a result of the amendment to the QCSA, Altera Corp. and its US subsidiaries did not include R&D-related SBC costs in their cost pool from 2004–2007. IRS thus asserted a deficiency for those years, on the basis that Treas. Reg. §1.482-7A(d)(2) required allocation of the SBC costs between the parties to the QCSA. Altera responded by challenging the validity of that regulation under the APA in the Tax Court.

II. The Tax Court Opinion

Before the Tax Court, Altera asserted that Treas. Reg. §1.482-7A(d)(2) was invalid under the APA because Treasury had failed to "adequately consider and respond" to public comments on the regulation in 2003, particularly with respect to undisputed evidence presented to Treasury that unrelated parties do not share stock option "costs" in comparable circumstances such as joint venture agreements, thus rendering the regulation arbitrary and capricious.3 The full Tax Court agreed, unanimously holding that the APA applies to tax regulations and that the lack of an adequate response from Treasury to the public's comments on the application of the arm's length standard made the regulation arbitrary and capricious, and, therefore, invalid, under the APA.

The Tax Court's opinion was important in affirming that the APA applies to tax regulations. But it was also particularly important for its conclusions regarding the arm's length standard. In this regard, the Tax Court held that "the Commissioner's allocation of income and expenses between related entities must be consistent with the arm's length standard, and that the arm's length standard is not met unless the Commissioner's allocation can be compared to an actual transaction between unrelated parties."4

III. The Ninth Circuit Opinion

In rendering its opinion, the majority of the Ninth Circuit's panel did much more than simply validate the procedural underpinnings of Treas. Reg. §1.482-7A(d)(2) under the APA. If it stands, the opinion may create significant uncertainty for multinational companies seeking to rely on the arm's length standard not only in the context of cost sharing, but also perhaps more broadly in the context of other intercompany transactions.

The arm's length standard, which has been the backbone of transfer pricing and was fundamental to the Ninth Circuit's opinion in Altera, requires pricing an intercompany transaction by reference to the pricing that would have been agreed upon between unrelated parties acting at arm's length. Because, among other things, the IRS had failed to adduce evidence that parties at arm's length share stock-option "costs" in their QCSAs and substantial evidence to the contrary had been presented during Treasury's consideration of the proposed regulations, Altera argued that the regulation at issue was necessarily arbitrary, capricious, and unreasonable.

The majority of the Ninth Circuit's panel seems to have departed from the traditional, established view of the arm's length standard. Instead, the majority reasoned that, in line with the IRS's position, the allocation of costs between related parties for certain activities should be based on the proportion of the related income enjoyed by each controlled taxpayer—even without any facts or objective evidence of the same type of allocation by unrelated parties. In Altera's case, this meant that even without comparable data that uncontrolled parties would share SBC costs, the IRS could apply a "commensurate with income" analysis under the 2003 regulations, which involved distributing the "costs" of employee stock options in proportion to the income each taxpayer received. In fact, the majority determined that this method of allocating the SBC costs between the parties was appropriate despite the evidence demonstrating that uncontrolled parties affirmatively did not share SBC costs.

The dissent asserted that Treasury (and the disputed regulation) violated the APA as interpreted by State Farm5 by failing to provide "adequate notice of its intent to change its longstanding practice of employing the arm's length standard."6 The dissent would have held Treas. Reg. §1.482-7A(d)(2) to be arbitrary and capricious, and thus invalid under the APA. The dissent also would have affirmed the Tax Court opinion that "expenses related to [SBC] are not among costs to be shared in [QCSAs] under Treas. Reg. §1.482-7A(d)(2)," on the basis that the Ninth Circuit's prior opinion in Xilinx7 both controlled and mandated affirming the Tax Court's decision.

IV. What Happens Next?

The uncertainty created by the Ninth Circuit panel's majority opinion has already caused many companies and tax practitioners to ask "so what's next?" In addition to the effect that this opinion, should it stand, might have on companies with QCSAs who are resident in the Ninth Circuit, that the opinion expands the interpretation of the arm's length standard creates the potential that the opinion could have ramifications beyond the QCSA context.

Whether the Altera opinion will stand, however, remains unclear. The taxpayer has the option to seek a rehearing by the panel as well as an en banc review by the Ninth Circuit (i.e., a review by the entire court, not just the panel), as well as, of course, seeking review by the US Supreme Court. Typically, parties seek further appellate court review before seeking Supreme Court consideration, although none of these options will guarantee further review; they are all in the discretion of the courts. There are, however, several reasons that might counsel the taxpayer to seek further review by the Ninth Circuit and, in turn, the Ninth Circuit to be willing to consider the taxpayer's request. First, Judge Stephen Reinhart, who was noted in the opinion as having fully participated in the case and formally concurring with the majority, passed away four months before the release of the opinion, which implies that, while he may have agreed with the outcome, he may not have had the opportunity to read the reasons for it before he died. His death raises the question as to whether the opinion was that of only one Ninth Circuit judge. The Ninth Circuit has picked Judge Susan Pia Graber to be his replacement if a rehearing is sought. Second, the panel's opinion seems contrary in many ways to the Ninth Circuit's reasoning in Xilinx. While the two panels were considering different versions of Treasury's cost sharing regulations, they were each considering the same arm's length standard. Third, the import and potential effect of the panel's view of the arm's length standard may itself be important enough to merit the Ninth Circuit's further review and potential review by the Supreme Court.

Right now, the only "known" is that a Ninth Circuit panel, by a vote of 2 to 1, has upheld Treasury's 2003 final regulation mandating that SBC "costs" be treated as "costs" to be shared between parties to a QCSA. Whether that opinion stands in the Ninth Circuit, whether it will be followed by courts other than the Ninth Circuit, and whether, perhaps most importantly, its interpretation of the arm's length standard marks a singular change in the way in which that commercial standard has been interpreted for many decades are all unknowns to be watched carefully.


1 145 T.C. 91 (2015), rev'd, Nos. 16-70496, 16-70497, 2018 US App. LEXIS 20524, at *1 (9th Cir. July 24, 2018).

2 567 F.3d 482 (9th Cir. 2009); rev'g and remanded 125 T.C. 37, withdrawn, 592 F.3d 1017 (9th Cir. 2010); aff'd 598 F.3d 1191 (9th Cir. 2010).

3 Motor Vehicle Manufacturers Association of the United States v. State Farm Mutual Auto Insurance Co., 463 US 29 (1983) (hereinafter State Farm).

4 Altera Corp. & Subsidiaries, 2018 US App. LEXIS 20524, at *11.

5 463 US 29.

6 Altera Corp. & Subsidiaries, 2018 US App. LEXIS 20524, at *46 (O'Malley, J., dissenting).

7 598 F.3d 1191 (9th Cir. 2010).

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