On July 27, 2015, in Altera Corporation v.
Commissioner, 145 T.C. No. 3 (2015), the Tax Court held
Treasury regulation section 1.482-7(d)(2) (the
"Regulation") invalid. This decision is significant to
taxpayers who are parties to cost-sharing arrangements with foreign
affiliates but, if sustained, could also have a significant impact
on the IRS's regulations procedures going forward and could
make it easier in some cases for taxpayers to challenge other IRS
regulations.
Cost-sharing arrangements ("CSAs") enable a U.S. entity
and its foreign affiliate to co-develop intellectual property
("IP") and share in the associated research and
development ("R&D") costs in a tax-efficient manner.
It has long been a point of controversy between the IRS and
taxpayers whether, in addition to other compensation, the value of
stock options and other stock-based compensation ("SBC")
issued to relevant employees must be included in the costs to be
shared (a "cost pool") by the participants in a CSA. In
an attempt to settle the question, the IRS issued the Regulation in
2003, requiring all participants in CSAs to share any relevant SBC
costs.
Altera involved a U.S. corporation ("Altera
US"), which was a party to a CSA with an offshore subsidiary,
International. Altera US issued SBC to employees who performed
R&D activities. Although the CSA included the employees'
cash compensation in the cost pool under the CSA, it did not
include the value of the SBC. The IRS relied on the Regulation to
increase International's cost-sharing payments to Altera US
(which increased Altera US's taxable income) in the amount of
International's proportionate share of the SBC. Altera US
challenged the allocation on the grounds that the Regulation is
invalid.
The Tax Court struck down the Regulation under the principles of
Motor Vehicle Manufacturers Association of the United States,
Inc. v. State Farm Mutual Automobile Insurance Co., 463 U.S.
29 (1983), and sections 553 and 706(2)(A) of the Administrative
Procedure Act ("APA"). It held that issuance of the
Regulation was an act of legislative rulemaking (rather than
"interpretive" statutory construction), and the IRS had
failed to satisfy the full bevy of notice and comment requirements
imposed by the APA. Specifically, the court held that the IRS acted
in an "arbitrary and capricious" manner—rather than
having engaged in reasoned decision-making—because (i) the
Regulation lacked a basis in fact; (ii) the IRS failed to connect
rationally the requirement to include SBC costs in the face of the
facts; (iii) the IRS failed to respond to significant comments
received from the public that suggested unrelated parties do not
typically share SBC costs; and (iv) the IRS conclusion that the
Regulation is consistent with the arm's-length standard (which
is referred to in the regulations but not the statute) was contrary
to the evidence before it.
If upheld on appeal, Altera could have significant
implications beyond just CSAs and transfer pricing. The court took
a novel approach in its review of the Regulation that, if upheld,
may subject similar acts of regulatory rulemaking by the IRS to
additional procedural requirements in the future (and possibly
expose previously promulgated regulations once thought exempt from
heightened procedural requirements to similar challenges). This
could potentially translate to more successful challenges to
existing IRS regulations by taxpayers.
As an immediate matter, any taxpayer with a CSA should review
whether during any open year it included SBC in the CSA cost pool,
and if so, may want to consider filing claims for refund to protect
itself in the event Altera becomes final, either by being
upheld on appeal or by a government decision not to appeal.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.