United States: Tax Court Rules Against IRS And Invalidates Treasury Regulation § 1.482-7(d)(2)

On July 17, 2015, the US Tax Court (en banc) ruled in favor of the taxpayer in Altera Corporation v. Commissioner,1  holding that Treas. Reg. 1.482-7(d)(2), which was issued  in 2003 requiring participants in qualified cost-sharing arrangements ("QCSAs") to share  stock-based compensation costs to achieve an arm's-length result, was arbitrary and  capricious and therefore invalid.

Altera US, the parent company of an affiliated group of corporations, developed,  manufactured and sold programmable logic devices ("PLDs") and related hardware and  software for use in programming the PLDs ("programming tools"). Altera US entered into  a technology license agreement with its subsidiary, Altera International, granting Altera  International the right to use and exploit, everywhere except the United States and  Canada, all of Altera US's intangible property relating to PLDs and programming tools. In  exchange for the right granted, Altera International paid royalties to Altera US each year  through 2003. Under an existing R&D cost-sharing agreement, Altera US and Altera  International agreed to pool their resources to conduct research and development  relating to the PLDs and programming tools. Under the R&D cost-sharing agreement,  Altera US and Altera International agreed to share the risks and costs of research and  development activities they performed between May 23, 1997 through 2007.

During each of taxable years ending December 31, 2004, December 30, 2005,  December 29, 2006 and December 28, 2007, Altera US granted stock options and other  stock-based compensation to certain of its employees. Certain of these employees who  received stock options and other stock-based compensation performed R&D activities  subject to the R&D cost-sharing agreement. The stock-based compensation was  $24,549,315 (2004); $23,015,453 (2005); $11,365,388 (2006) and $15,463,565 (2007).  The stock-based compensation was not included in the cost pool under the R&D  cost-sharing agreement. The IRS audited petitioner and issued Notices of Deficiency with  respect to the 2004-2007 taxable years. The Notices of Deficiency allocated, pursuant to  Section 482, income from Altera International to Altera US by increasing Altera  International's cost-sharing payments for 2004-2007.

Section 482 – Arm's-Length Standard

Section 482 authorizes the Commissioner to allocate income and expenses among related  entities. The first sentence of Section 482 provides, in relevant part, as follows:

In any case of two or more organizations, trades or businesses * * * owned or  controlled directly or indirectly by the same interests, the Secretary may  distribute, apportion, or allocate gross income, deductions, credits, or allowances  between or among such organizations, trades, or businesses, if he determines  that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such  organizations, trades, or businesses. * * *

The purpose of Section 482 is to ensure that taxpayers clearly reflect income attributable  to controlled transactions and to prevent the avoidance of taxes with respect to such  transactions.2   In 1986, Congress amended Section 482 by adding the following: "In the  case of any transfer (or license) of intangible property * * *, the income with respect to  such transfer or license shall be commensurate with the income attributable to the  intangible."3   This commensurate-with-income approach was adopted because of the  recognition that there may be extreme difficulties in determining whether the  arm's-length transfer between unrelated parties are comparable.

A later study by Treasury and the IRS explained that the commensurate-with-income  standard is consistent with the arm's-length standard because:

[l]ooking at the income related to the intangible and splitting it according to  relative economic contributions is consistent with what unrelated parties do. The  general goal of the commensurate-with-income standard is, therefore, to ensure  that each party earns the income or return from the intangible that an unrelated  party would earn in an arm's-length transfer of the intangible.4

In Xilinx Inc. v. Commissioner,5  the Tax Court addressed the treatment of stock-based  compensation between controlled entities that entered into a qualified cost-sharing  agreement. The Tax Court held that the Commissioner's allocation of stock-based  compensation failed to satisfy the arm's-length standard of Section 1.482-1(b)(1).

In reaching this holding the Tax Court concluded that, consistent with the 1995  cost-sharing regulations: (1) in determining the true taxable income of a controlled  taxpayer, the arm's-length standard applies in all cases; (2) the arm's-length standard  requires an analysis of what unrelated entities would do; (3) the  commensurate-with-income standard was never intended to supplant the arm's-length  standard; and (4) unrelated parties would not share the exercise spread or grant date  value of stock-based compensation.6   In so holding, the Tax Court observed, in part, that  the IRS's expert agreed that unrelated parties would not share the stock-based  compensation costs, and found that the taxpayer proved that companies do not take into  account either the exercise spread or grant date value of stock-based compensation for  producing pricing purposes. The Ninth Circuit initially reversed the Tax Court, but  subsequently withdrew its opinion in Xilinx and issued a new opinion affirming the  Court.7

The Circuit Court affirmed the finding that all costs requirement should be construed as  not applying to stock-based compensation because the regulations should be interpreted  in the light of the dominant purpose of the statute—parity between taxpayers in  uncontrolled transactions and taxpayers in controlled transactions.

2003 Cost-Sharing Regulations

The Xilinx opinion did not sit well with the IRS. In 2002 Treasury issued a notice of  proposed rulemaking and notice of a public hearing with respect to proposed  amendments to the cost-sharing regulations. The purpose of the proposed amendments  to the cost-sharing regulations was to clarify "that stock-based compensation must be  taken into account in determining operating expenses under § 1.482-7(d)(1), and to  provide rules for measuring stock-based compensation costs."8   A public hearing on the  proposed amendments was held on November 20, 2002.

In response to the Notice, several commentators informed Treasury that they knew of no  transactions between unrelated parties, including any cost-sharing arrangement, service  agreement or other contract, that required one party to pay or reimburse the other party  for amounts attributable to stock-based compensation. Indeed, several commentators  identified arm's-length agreements in which stock-based compensation was not shared or  reimbursed, and several commentators cited the practice of the Federal Government and  cited Federal regulations which prohibit reimbursement of amounts attributable to  stock-based compensation.9

In August 2003, Treasury issued the final rule. The final rule explicitly required parties to  QCSAs to share stock-based compensation costs.10  The final rule also added  sections 1.482-1(b)(2)(i) through 1.482-7(a)(3), Income Tax Regs., to provide that a QCSA  produces an arm's-length result only if the parties' costs are determined in accordance  with the final rule.11

The final rule provides two methods for measuring the value of stock-based  compensation: a default method and an elective method. Under the default method, "the  costs attributable to stock based compensation generally are included as intangible  development costs upon the exercise of the option and measured by the spread between  the option strike price and the price of the underlying stock."12   Under the elective method,  "the costs attributable to stock options are taken into account in certain cases in  accordance with the 'fair value' of the option, as reported for financial accounting  purposes either as a charge against income or in footnoted disclosures."13

When it issued the final rule, the files maintained by Treasury relating to the final rule did  not contain any expert opinions, empirical data or published or unpublished articles,  papers, surveys or reports supporting a determination that the amounts attributable to  stock-based compensation must be included in the cost pool of QCSAs to achieve an  arm's-length result. Those files also did not contain any record that Treasury searched  any database that could have contained agreements between unrelated parties relating to  joint undertakings or the provision of services.

At the outset, the parties disagreed whether the final rule was a legislative rule or an  interpretative rule. If interpretative, as alleged by the Service, the requirements of APA  Section 553 did not apply; thus there was no need to publish a notice of proposed  rulemaking, provide interested persons an opportunity to participate in the rulemaking  and incorporate a concise general statement of the rule's basis and purpose. The Tax  Court concluded that the final rule was a legislative rule subject to the APA Section 553  because Treasury intended that the final rule to have the force of law. The court further  concluded that the final rule must satisfy the "reasoned decision-making standard"  followed in State Farm14 , because the "validity of the final rule turns on whether Treasury  reasonably concluded that it is consistent with the arm's-length standard."15

Under the rubric of State Farm, the taxpayer argued that the final rule was invalid  because (1) it lacked a basis in fact, (2) Treasury failed to rationally connect the choices it  made with the facts if found, (3) Treasury failed to respond to significant comments, and  (4) the final rule was contrary to the evidence presented to Treasury. The Tax Court  agreed with the taxpayers.

The Tax Court found that the final rule lacked a basis in fact because Treasury failed to  provide a reasoned basis for its conclusions from any evidence in the administrative  record. According to the court, there was no evidence in the record that supported  Treasury's belief that unrelated parties would share stock-based compensation costs.  Moreover, the Tax Court refused to defer to Treasury's expertise because the court found  that commentators introduced significant evidence showing that parties operating at  arm's-length would not share stock-based compensation. The Tax Court also found that  Treasury failed to respond directly to any of the evidence that unrelated parties would not  share stock-based compensation costs. Specifically, the court held that "[m]eaningful  judicial review and fair treatment of affected persons require 'an exchange of views,  information and criticism between interested persons and the agency.' Treasury's failure  to adequately respond to commentators frustrates our review of the final rule and was  prejudicial to affected entities."16

Lastly, the Tax Court concluded that the final rule was contrary to the evidence before  Treasury when it issued the final rule. The court noted that the significant evidence submitted by commentators demonstrated that unrelated parties to QCSAs would not  share stock-based compensation costs; Treasury never found the submitted evidence  incredible, and accepted the commentators' economic analysis. Accordingly, Treasury's  explanation for its decision ran counter to the evidence. Because the court found that the  final rule lacked a basis in fact, and was contrary to the evidence presented, the court held  that the final rule failed to satisfy State Farm's reasoned decision making standard and was  therefore invalid. Finally, the Tax Court held that the harmless error rule of APA  Section 706 was not applicable because it was not clear that Treasury would have adopted  the final rule if it had been determined to be inconsistent with the arm's-length standard.

The Altera decision is significant for taxpayers with cost-sharing agreements. The  decision may also have a broad impact on future regulatory rulemaking and challenges to  existing IRS regulations.


1  145 T.C. No. 3 at 51 (2015).

See Treas. Reg. 1.482-1(a)(1)

3  Tax Reform Act of 1986, Pub. L. No. 99-514, Sec. 1231(e)(1), 100 Stat. at 2562. 

4  Notice 88-123, 1988-2 C.B. at 472.

5  125 T.C. 37 (2005), affd 598 F.3d 1191 (9th Cir. 2010). 

6  145 T.C. No. 3 at 70-75. 

See Xilinx Inc. v. Commissioner, 598 F.3d at 1191.

See 67 Fed, Reg. 48997, 48998 (July 29, 2002).

9  145 T.C. No. 3 at 72-73.

10  See Treas. Reg. § 1.482-7(d)(2). 

11  See T.D. 9088, 2003-2 C.B. 841, 847-848. 

12  Id., 2003-2 C.B. at 844. 

13  Id. 14   United States v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983)

15  145 T.C. No. 3 at 68.

16  145 T.C. No. 3 at 74.

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